Musings on Markets: User/Subscriber Economics: Value Dynamics http://aswathdamodaran.blogspot.com/2017/07/usersubscriber-economic...

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Wednesday, July 5, 2017 Twitter

User/Subscriber Economics: Value Dynamics Follow by Email

In my last post, I tried valuing Uber by estimating how much an existing user was worth to the
company and then using that number to extrapolate to the value of all existing users and the
value added by new users. As always, I got many useful comments on what I was missing, what I
could do better and what could be simplified, and I thank you (really). While I could spend this Subscribe To Musings on Markets
entire post rehashing assumptions, I don't intend to! To me, the most useful part of valuation is
Posts
not the destination, i.e., the value that you get at the end, but the journey, i.e., the process of
doing valuation, since it is the process that allows us to isolate the key drivers of value, which, in Comments
turn, focuses discussions on those variables, rather than on distractions. Consequently, I decided
to revisit my Uber user-based valuation to see what I could eke out as implications for user or
subscriber-based businesses. Search This Blog

Estimation versus Economic Risk

I will start by conceding the obvious. I made a lot of assumptions to arrive at the value of a user at
Uber, but I will go further. There was not a single fact in that valuation, since every number was About Me
an estimate. That said, you could say that about the valuation of any company, with the
Aswath Damodaran
divergence really being one of the degree of uncertainty you face, not in whether it exists. At the
risk of restating points that I have made in my other writing, here are three general points that I I am a Professor of Finance
would make about uncertainty in valuation. at the Stern School of
Business at NYU. I teach
classes in corporate finance and valuation,
1. Estimation uncertainty versus Economic uncertainty
primarily to MBAs, but generally to anyone
To deal with uncertainty in a sensible way, you first have to categorize it. One of the
who will listen.
categorizations that I find useful is to break the uncertainty you face when you are trying to value
View my complete profile
a business or an asset into estimation and economic uncertainty. Estimation uncertainty comes
from incomplete, missing or misleading information provided by the company that you are
valuing, whereas economic uncertainty is driven by forthcoming changes in the business that the My web site
company operates in, as well as macro economic factors. Estimation uncertainty can be reduced
http://www.damodaran.com
by obtaining better and more complete information but estimation uncertainty will remain
resistant, no matter how much time you put in and what data analysis that you do. Using my Uber
user valuation, it is true that some of the noise in the valuation comes from Uber being a private, Popular Posts
secretive company and but most of the uncertainty comes from the ride sharing business being in
a state of flux, as regulators and competitors work out how best to deal with shifting consumer User/Subscriber Economics:
An Alternative View of
tastes and changing technologies. This has two implications. The first is that even if you had
Uber's Value
access to more information, either because Uber decides to go public or you are an insider in the
In the week since I posted
company, much of the uncertainty in estimated value per user will remain. The second is that your my Uber valuation , I have
estimated value will change considerably over time, as the facts on the ground change, and that received many suggestions
volatility in value cannot be viewed as a shortcoming of the model. on what I should have done differently in the
valuation, w...

2. Uncertainty is an integral part of valuation Uber's bad week: Doomsday

One critique that leaves me unmoved is that valuing a business or an asset, in the face of Scenario or Business
significant uncertainty, is pointless because you will be wrong. So what? Uncertainty is part and Reset?
Uber just cannot seem to
parcel of doing business and you cannot wish it, pray it or analyze it away. As I see it, you have
help itself, finding a way to
two choices when it comes to uncertainty. You can deal with it frontally by making explicit get in the news, and often in
assumptions or you can go into "denial" model and make implicit assumptions. When I tried to ways that leave its image in tatters. You
value a user at Uber, I made explicit assumptions about user life, renewal rates and a host of could see t...
other variables, and I will cheerfully admit that I will be wrong on every one of them, but what is
User/Subscriber Economics:
the alternative? When pricing a user by looking at what others are paying for users in similar Value Dynamics
companies, you are making assumptions about all of the variables as well, but those assumptions In my last post, I tried
are implicit. In fact, they are hidden so well that you may not be aware of your own assumptions, valuing Uber by estimating
a dangerous place to be when investing. how much an existing user
was worth to the company
and then using that number to extra...
3. Uncertainty can (and should) be visualized
Here is my response to uncertainty. Where data exists but I do not have access to that data, I will A Tale of Two Markets:
try to make my best estimates based upon the existing information, noisy, dated or second hand Politics and Investing!
"It was the best of times, it
though it might be. Where I have access to data, I will check it against other data, common sense
was the worst of times, it
and economic first principles. Where there is no data, I will make my best estimates and to the was the age of wisdom, it
extent that these estimates come with probability distributions, my value itself is a distribution, not was the age of foolishness,
a number. Illustrating this process, with the Uber user valuation: it was th...

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My Snap Story: Valuing

Snap ahead of it's IPO!
Five years ago, when my
daughter asked me whether
I had Snapchat installed on
my phone, my response was
“Snapwhat?". In the weeks fol...

Explaining a Paradox: Why

Good (Bad) Companies can
be Bad (Good) Investments!
In nine posts, stretched out
Excel Add On: Crystal Ball (Oracle), Simulation Output
over almost two months, I
have tried to describe how
I have made distributional assumptions on four of my inputs: the portion of Uber's expenses that companies around the world make
go to servicing existing users, the life time of a user, the proportion of expenses that are variable investments, finance t...
and the cost of capital (discount rate) to compute today's value. Since these distributions are all
centered on my base case assumptions, it should come as no surprise that the median value of a Apple: The Greatest Cash
Machine in History?
user ($414) is very close to my base case value ($410). However, there is a wide spread around
As as sports fan, watching
that value, with the numbers ranging a low of $74, when the user life is short, the expenses of Brady and Belichick win the
servicing a user are high, most of the costs are variable and the cost of capital is low, to a high of Super Bowl, Roger Federer
more than $1000 per user, when the opposite conditions hold. Note that at the current pricing of triumph at the Australian
Open and LeBron James carry the...
$69 billion, you are valuing each user close to $900, at the upper end of the distribution.
Myth 5.5: The Terminal
User Economics: Cost Propositions Value ate my DCF!
It is true that the end game for every business is to make money for its investors. That said, there When you complete a
is a tendency to over react, when a young company reports a loss, as was the case when Uber discounted cash flow
valuation of a company with
reported an operating loss of $2.8 billion for 2016, a few months ago. The pessimists on Uber a growth window and a
viewed this as further evidence that the company was on a pathway to nowhere and that terminal value at the end, it is natural to
investors in the company must be delusional to attach any value to it. The optimists argued that it con...
is natural for young companies to lose money and that Uber should be judged on other
Active Investing: Seeking
dimensions such as user growth and market potential instead. At the risk of angering both
the Elusive Edge!
groups, I will use my Uber user valuation to argue that while I agree with the second group that In my last post, I pointed to
losing money is typical at young companies, I will also take sides with the first group that you still the shift towards passive
need a pathway to profitability amidst the losses, for value to exist. investing that has
accelerated over the last
decade and argued that much of that ...
1. Servicing existing users versus acquiring new users
In my Uber user valuation, I started with the operating losses reported by the company ($2.8 The Dark Side of
billion), backed into the total operating expenses for the company ($9.3 billion) and then allocated Globalization: An Update on
Country Risk!
that expense across three categories: servicing existing user (48.17%), acquiring new users
The inexorable push
(41.08%) and corporate expenses (10.75%). While I based this breakdown on the information (on towards globalization has
increase in users and contribution margins in ride sharing) that I had on Uber in 2016, that stalled in the last few years,
information is dated, noisy and second hand. It is entirely possible that the actual break down of but the change it has created is irreversible.
The largest co...
expenses is different from my estimate. If you are wondering why it matters, since the end result
(that Uber lost $2.8 billion) is not changing, there are consequences that you can see in the table
below:
Total Pageviews
Uber User Value: Existing User versus New User Costs

11,176,724
% of Operating Expenses spent on Value of Existing Value of New Uber User % of Value from
acquiring new users Users Users Value Existing users
Blog Archive
0% $6,167 $18,147 $24,314 25.36%
2017 (21)
20% $10,619 $19,035 $29,654 35.81%
July (2)
40% $15,071 $19,923 $34,994 43.07%
The Dark Side of Globalization: An
Update on Count...
60% $19,523 $20,811 $40,334 48.40%
User/Subscriber Economics: Value
80% $23,974 $21,699 $45,673 52.49% Dynamics

100% $28,426 $22,587 $51,013 55.72% June (3)

March (3)
As you increase the proportion of the operating expenses that are spent on acquiring new users,
February (4)
the value of an existing user goes up because you are spending less money on providing service
January (9)
to that user, but the value of a new user also increases, as the net value added (the difference
between the user value and the cost of acquiring a user) goes up. Ironically, as you spend more 2016 (48)
on acquiring new users and less on servicing existing users, the proportion of your value that
2015 (50)
comes from existing users increases.
User Value Proposition 1: A money-losing company that is losing money providing service to 2014 (44)
existing users/customers is worth less than a company with equivalent losses, where the primary 2013 (36)
expenses are coming from customer acquisitions. 2012 (49)
This is, of course, neither profound nor surprising, and it explains why, left to their own devices
2011 (55)
and without any monitoring, young companies will claim that most or all of their expenses are for
acquiring new customers. If you are investing in a young company, you will have to do your own 2010 (45)
assessment of whether managers are misrepresenting, by looking at expense growth over time 2009 (60)
versus new customers. If the number of total customers remains fixed and expenses keep rising, 2008 (42)
you should be skeptical about managerial claims (that most of the costs are for acquiring new
customers).

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2. Cost Structure
One reason that investors are willing to accept losses at young companies is because they
believe that as the company grows its operations, there will be economies of scale. In income
statement terms, this will result in expenses growing less quickly than revenues and improving
operating margins. That said, you cannot take it on faith that this will always happen or that it will
happen at the same rate for every company. To see the impact on user value of this dimension, I
adjusted the portion of Uber's expenses that are variable (and will grow with revenues) and those
that are fixed (and grow at a lower rate) and captured the value effect in this table:
Uber User Value and Cost Structure

% of current expenses that Value of Existing Value of New Uber User % of Value from
are fixed Users Users Value Existing users

0% $14,733 $15,250 $29,983 49.14%

20% $16,412 $20,191 $36,603 44.84%

40% $17,834 $24,373 $42,207 42.25%

60% $19,040 $27,924 $46,964 40.54%

80% $20,068 $30,949 $51,017 39.34%

100% $20,947 $33,536 $54,483 38.45%

As the proportion of expenses that are fixed rises, the value of both existing and new users goes
up but the latter goes up at a faster rate. Put simply, the economies of scale increase as you
increase the rate at which you are adding scale.
User Value Proposition 2: A company whose expenses are primarily fixed (will not grow with
revenues) will be worth more than an otherwise identical company whose expenses are variable
(track revenues).
If unchallenged, young growth companies will always claim that they have massive economies of
scale but that claim has to be backed up by the numbers. Specifically, investors should pay
attention to the rate of change in revenues and expenses, since with large economies of scale,
the former should change more than the latter. The caveat, though, is that having more fixed
costs can increase risk, because it will increase the risk of failure at young companies and
earnings volatility for more mature firms. As user growth levels off, having more fixed costs will
reduce value rather than increasing it.

User Economics: Growth Propositions

For young companies, we generally view growth as good and while that is generally true, not all
growth is created equal. In fact, even with young companies, there are some strategies that
deliver growth in users or revenues, while destroying value. In a user or subscriber based model,
there are two ways you can grow your revenues. One is to get existing users to buy more of your
products or services and the other is by trying to acquire new users. While both can increase
value, the former will be create more value, for two reasons. First, since it comes from existing
customers, you don’t have to pay to acquire these users and it is thus less costly to the firm.
Second, by increasing the value of a user, it increases the value of any new users as well,
creating a secondary impact on value. Using my Uber user valuation, you can see the impact of
changing the annual growth rate in revenues for an existing user in the chart below:

As revenue growth rate increases, the value of both existing and new users increases, with the
value of Uber hitting $90 billion at high annual growth rates. If there is no growth in revenues, the
value of Uber collapses as new users actually destroy value (because the cost of adding a new
user exceeds the value of that user). Now consider how Uber's value is affected, if we hold
existing user assumptions fixed and change the compounded annual growth rate (for the next 10
years) in the number of users:

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While value increases with user growth rates, it increases at a lower rate than it did when we
varied revenue growth from existing users.
User Value Proposition 3: A company that is growing revenues by increasing revenues/user is
worth more than an otherwise similar growth company that is deriving growth from increasing the
number of users/customers.
Young companies face the question of whether to allocate resources to get new users or try to
sell more to existing users is one of those. At least in the case of Uber, the numbers seem to
indicate that the payoff is greater in getting existing users to use the service more than in looking
for new users.

User Economics: Business Propositions

At the risk of stretching the user value model too far, it can be used to discuss business models in
the space, from the networking benefits that so many companies in this space claim to possess to
how the revenue model you choose (subscription, transaction or advertising) plays out in user
values.

1. Competitive Dynamics and Networking Benefits

Is it better to operate in a business where the cost of acquiring a new user is low or high? Holding
all else constant, the answer is obvious. A firm will maximize its value if can generate both high
value per user and have a low cost of acquiring new users. That said, if everyone in the business
shares these characteristics, one or another of these variables has to change. If the cost of
acquiring new users is low for everyone, competition will drive down the value per new user, and
if the value per user remains high, competition will drive up the cost of acquiring new users. The
trade off is captured in the picture below:

User Value Proposition 4: The exceptional firm will be the one that is able to find a pathway to
high value per user and a low cost to adding a new user in a market, where its competitors
struggle with either low value per user or high costs of acquiring users.
So how do the exceptional companies pull off this seeming impossible combination of high value
per user and low cost per new user? I may be stretching, but it is at the heart of two terms that we
see increasingly used in business, network benefits and big data.
Network Benefits: If network benefits exist, the cost of acquiring new users will
decrease as a company's presence in a market increases, reaching a tipping point
where the biggest player will face much lower costs in acquiring new users than the
competition, allowing it to capture the market and perhaps use its market dominance
to increase the value of each user. In the case of Uber and ride sharing business, the
argument for networking benefits is strong on a localized basis, since there are clearly
advantages for both drivers and customers to shift to the dominant ride sharing
company in any locality, the former because they will generate more income and the
latter because they will get better service. The argument is much weaker on a global
basis, though ride sharing companies are trying to create networking benefits by
allying with airlines and credit care companies, and how this attempt plays out may
well determine Uber's ultimate value.
Big Data: While I remain a skeptic on the "big data" claims that every company seems
to be making today, it is inarguable that there are companies that use big data to
augment value. These companies collect data on their existing users/subscribers
/customers and use that information to (a) customize existing products/services to

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meet user preferences, (b) create new products or services that meet perceived user
needs and/or (c) for differential pricing. All of these increase user value by altering one
or more of the inputs into the equation, with customization increasing user life and
new products & differential the growth in revenues/user. In my view, the best users of
big data (Netflix, Amazon, Google and Facebook) have used the data to increase their
existing user value. Uber is still in the nascent stages, but its attempts at using data
have expanded from surge pricing to differential pricing.
2. Revenue Models
In my version of user valuation, I look at revenues per user, drawing no distinction on how those
revenues are derived. Broadly speaking, there are three revenue models that a user/subscriber
based company can use, a subscription-based model where users or subscribers pay a
subscription fee to continue to use the service or product, a transaction-based model where users
or subscribers pay only when they use the service of product and an advertising-based model
where users or subscribers get to use the product or service for free, but are targeted in
advertising. Netflix operates on a subscription-based model, Uber is a transaction-based firm and
Facebook generates its revenues from advertising. Some companies like LinkedIn have hybrid
models, generating revenues from subscriptions (from premium members), transactions (from
recruitments) and advertising. There are other inputs into the valuation that will be affected by a
company's revenue model and I have tried to capture them in the table below:

Subscription Transaction Advertising

User Stickiness (User Intermediate

High (High life & Low (Low life & renewal
life & Renewal (Intermediate life &
renewal probability) probability)
Probability) renewal probability)

Revenue per User

High (Low Discount Low Predictability (High Intermediate (Average
Predictability (Discount
Rate) Discount Rate) Discount Rate)
rate)

Revenue per User Intermediate (Intermediate

Low (Low growth rate Low (High growth rate in
Growth (Annual growth rate in
in revenues/user) revenues/user)
Growth Rate) revenues/user)

Intermediate
Growth rate in users Low (Low CAGR in # High (High CAGR in #
(Intermediate CAGR in #
(CAGR in # Users) users) users)
users)

Cost of adding new High (High Cost/New Intermediate (Middling

Low (Low Cost/New User)
users (Cost/New User) User) Cost/New User)

There is no one dominant revenue model, since each has its pluses and minuses. An advertising-
based model will allow for much more rapid growth in a firm's early years, a subscription-based
model will generate more sustainable growth and a transaction-based model has the greatest
potential for revenue growth from existing users.
User Value Proposition 5: The "optimal" revenue model may vary for a firm depending
upon where it is in the life cycle and across firms depending on their product or service offerings
and across investors, depending on whether they are focused on user growth, revenue growth or
revenue sustainability.

3. Real Options
When valuing a company based upon its expected cash flows, there is a chance that you will
under value the company, if it has control of a resource that could be used for other purposes in
the future, even if that usage makes no economic sense today. That is why a technology or
natural resource reserve that is not viable today can still have value, and this is the basis for the
real option premium. In the context of a user-based business, optionality can become a
component of value, to the extent that companies may be able to exploit their user bases to sell
other products and services in the future. While the intuition of real options is simple, valuing real
options is notoriously difficult and after much hand waving, most of us (including me) give up, but
the user-based valuation model provides a framework to at least eke out some general
propositions about optionality and value.

There should be no surprises in this picture, with the value of a real option in a user base tied to
the inputs into an option pricing model.
User Value Proposition 6: The value of optionality from a user base will be greatest at firms with
ots of sticky, intense users in businesses where the future is unpredictable because of changes
in product/service technology and customer tastes.

The Bottom Line

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The most direct applications of a user or subscriber based model is in the valuation of companies
like Uber, Facebook and Netflix. That said, more and more companies are seeing benefits in
shifting from their traditional business models to user-based ones. Apple is a cash machine built
around a smartphone but it is also accumulating information on more than a billion users of these
phones, to whom it may be able to offer other products and services. Amazon started life as an
online retail company but there is no denying the power of its seventy million Prime members in
generating revenues for the company. I have used Microsoft and Adobe products for as long as
they have been around, but with both companies, but my relationship with both companies has
changed. I am now a subscriber (Office 365 and Creative Cloud member) who pays annual fees,
rather than a customer who buys and upgrades software on a discretionary basis. Understanding
user economics and value is central to not only investors in these companies, when valuing and
pricing them, but to managers of these companies, in their day-to-day business decisions. I will
admit, without shame, that my knowledge of user-based companies is rudimentary and that my
user-based model may be amateurish, in what it misses or mangles. That said, if you are an
expert on user-based businesses, I hope that you can build on the model to make it more realistic
and useful.

YouTube Video

Links

1. Crystal Ball (Simulation Add On for Excel)

2. My paper on dealing with uncertainty in valuation

Attachments

1. Uber User Valuation Spreadsheet

2. Uber User Value: Simulation Output

Blog Posts

1. Uber's Bad Week: Doomsday Scenario or Business Reset (June 2017)

2. User/Subscriber Economics: An Alternative View of Uber's Value

Posted by Aswath Damodaran at 12:50 PM

Labels: Uber, Value of a user

3 comments:
Yale Bock said...
Hi Professor,

A very useful framework for evaluating a wide variety of companies and much appreciated you
posted and shared this. By the way, this UCI alum appreciates having a fellow UC system
person so deeply committed to leading the valuation profession and discussion.

Yale Bock, CFA

Y H & C Investments
July 9, 2017 at 2:43 PM

Yale Bock said...

Hi Professor,

Very much appreciate you posting this highly useful framework which is applicable across a
wide variety of businesses. As an UCI alum, nice to see a fellow UC system person leading
the valuation profession and discussion.

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Yale Bock, CFA

Y H & C Investments
July 9, 2017 at 2:47 PM

Daniel Love said...

Hi Professor,

I got stuck trying to understand math of your table under "Competitive Dynamics and
Networking Benefits" about high value vs. low value users, and was hoping you might explain!

How did you calculate the values in the table?

Thank you,

Dan
July 12, 2017 at 4:09 PM

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