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Musings on Markets
My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Wednesday, December 9, 2015

Aging in Dog Years? The Short, Glorious Life of a

Successful Tech Company!
The corporate aging theme is one that I have returned to repeatedly in my posts, and I have looked
at how the aging process creates dysfunctional responses on the parts of managers, who want to
find ways to reverse it, and investors, who make bets on such reversals. It was the under pinning
for my last post on Yahoo, and in that post, I argued that technology companies have compressed
life cycles, i.e., age in dog years, relative to non-tech companies. In this post, I would like to
provide a rationale for why this may be the case and set the stage for my next post on what the
implications are for managers and investors.
The Corporate Life Cycle
The corporate life cycle follows a familiar pattern. It begins with an idea, that develops into a
product, which evolves into an operating business, that matures, and eventually dies.

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About Me

Aswath Damodaran
I am a Professor of Finance
at the Stern School of
Business at NYU. I teach
classes in corporate finance and valuation,
primarily to MBAs, but generally to anyone
who will listen.
View my complete profile

My web site

http://www.damodaran.com

I have also highlighted the transitions that determine whether a company moves to the next stage
and the mortality rate especially early in the life cycle is high. There are wide differences across
companies in how long they take to climb the life cycle, how much time they spend as mature
companies and how quickly they decline. As legal entities, corporations do have a little more give
in the process, i.e., the capacity to slow or even reverse the process for periods, than individuals
do, but not as much as they (and their strategic advisors) think that they do. The one reality that I
think is incontestable is that even the most exceptional companies will age and that whether they
deal with that aging gracefully is what determines how their stockholders will do during the
process.
Determinants of the Life Cycle
To get a sense of what drives differences across companies and how the life cycle evolves, I tried
to take a look at the determinants of each phase of the cycle in the graph below:

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When you start up, your focus is survival, and that will depend on (a) how much access
you have to capital, (b) how much you need to invest to enter the market and (c) the
time lag before you have a product or a service. Your chances of survival improve, if
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The length of the mature phase will depend upon the nature of your competitive
advantages, how big they are and how long they last. If your competitive advantages
are strong and sustainable, your mature phase can last for a long time. Consumer
product companies with strong brand names, one of the strongest and most
sustainable competitive advantages, have longer mature phases than companies that
have a cost advantage, a more transient and short term competitive advantage.

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In decline, the speed with which your business will deplete will depend upon (a) how
quickly new companies can enter the market (b) how quickly they can scale up and
how willing customers are to try new products. In other words, you see that a mirror
image of the qualities that allow for speedy growth also contribute to a quick decline.
In the end game, your choices depend on what your remaining assets look like and
whether they can be liquidated, without substantial losses. If they can, your end will be
speedy and perhaps even painless. If not, your death throes can be long and painful.
Tech versus Non-tech
Before we start on a discussion of how tech companies are different from non-tech companies, we
have to think about what separates the two groups, and that separation becomes hazier by the
day. In the 1980s, at the start of the tech revolution, the distinction was a simple one. If a
companys products or services were computer-related (either personal or business computers), it
was classified as a technology firm. That distinction allowed us to identify Microsoft, Apple and
Atari as technology firms, and bring in HP, IBM and Digital Equipment as the old guard. That
definition no longer works, as almost every product we buy (from appliances to automobiles) has a
computerized component to it, and it has meant that deciding whether a company is a tech
company is a judgment call. Given that reality, I would propose that rather than draw hard lines of
distinction between tech and non-tech, we consider technology on a continuum, where at one end
you have companies whose products and services are entirely technology driven (Google,
Facebook) and at the other, you have companies that almost no technology component to them
(consumer products and cosmetics companies, for instance). With this continuum, you can argue
that Tesla and Ford are both auto companies, but that Tesla has a larger technology component
than Ford.
Why do we care about these distinctions? First, they have practical implications for analysts and
portfolio managers. Sell-side equity research analysts are usually put into sector silos and asked to
keep their focus on the companies that they are assigned. With companies like Amazon, Netflix
and Tesla, high profile names to follow, I have noticed that there are big differences across banks.
Some assign these companies to the technology analysts, some to the businesses that these
companies operate in (Tesla in autos, Netflix in entertainment and Amazon in retail) and some
create new sector groupings just for these gray area companies. Second, for better or worse, the
categorization of a company can affect its pricing. Tesla, classified as an auto company, will look
expensive, compared to other auto companies, but classified as a young tech company, it may look
cheap. That is perhaps why companies seek out the tech label for themselves, even if technology
is only a small component of their offerings.

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The Tech Life Cycle

If you accept my argument that technology is a continuum, then you can perhaps live with my
definition of tech companies as those that get the predominant portion of their value from
technology. With that definition, I can revisit the corporate life cycle and its determinants and make
the following generalizations (and I am sure that you can think of exceptions with each one):
Scaling up is easy: Tech companies often operate in businesses where entry is not
restricted, the up front investment is minimal and scaling up in easy. If market
conditions are favorable, they are aided and abetted by access to capital and by less
sticky customer preferences in their markets. Not surprisingly, tech companies can
grow quickly.
Holding on is tough: Once tech companies reach the mature phase, they don't get to
have long harvest periods. Their competitive advantages are fleeting and quickly
deplete.
Decline is rapid: The same forces that allow technology companies to grow, i.e.,
unrestricted entry, ease of scaling up and customer switching, also make them
vulnerable to new entrants seeking to take their business away from them.
And there is little left in the end game: Unlike other businesses, which accumulate
physical assets as they grow and thus have a liquidation potential, with technology
companies, there is little of substance to fall back, once earnings power is exhausted.
Here, for instance, is my contrast between the life cycle of the typical tech company, contrasted
with a typical tech company.

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November (4)
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2014 (44)
2013 (36)
2012 (49)
2011 (55)
2010 (45)
2009 (60)

 2008 (42)

Is there evidence that this is what happens in the market? I could use Blackberry as an example,
but I would then be guilty of using anecdotal evidence to advance my theory. Instead, I will argue
that the evidence exists, albeit in scattered form. First, there is evidence that the small tech firms
(that survive the first tests) are able to scale up faster in terms of revenue growth (at least) than
small non-tech firms. The fact that they often lose money while doing so is as much a function of
the accounting inconsistency of treating research and product development costs as operating
expenses, as it a function of operating weakness. The second is that these tech firms, once
established, have a more difficult time maintaining growth. The third is that decline, once it starts at
tech firms, is more difficult to reverse and quicker to accelerate. All of these points are made in this
McKinsey article on growth at tech companies.
A Life Cycle Perspective on Disruption
Disruption is the new buzz word in corporate strategy, a reason that I listed it as on my list of words
that operate as weapons of mass distraction, and is often used to cut off debate or not talk
specifics. From my perspective, the essence of disruption is a that it is a new way of doing
business that radically changes the fundamentals of on established business. In the context of
technology-driven disruption, it a company, with a tech model, coming into a non-tech business,
characterized by long growth periods, extended mature phases and elongated declines.
Consider car service, i.e., the taxi cab and limo business. The old non-tech model for this business
required regulatory approval (making entry difficult) and substantial investment (in cars) in a market
governed by customer inertia. Uber and the other ride sharing companies have upended the model
by bypassing regulatory approval, not investing in cars and breaking through inertia by reaching
out to customers through their smart phones. The results speak for themselves. Not only have
Uber, Lyft and Didi Kuaidi grown at rates unlike any seen by traditional car service companies, but
each has a market reach that is beyond the old model. No traditional cab company can afford to
operate in 300 cities, like Uber does.
The effect of disruption is that it upends the fortunes of mature companies from the old business
model, coasting in their mature phase, convinced that change is slow. Unprepared for the speed of
change emanating from the tech entrants, these old players wait too long to respond, looking to
regulators and rule makers for protection, and not surprisingly, face an implosion. That, in a
nutshell, is what has happened to the taxi cab and limo business in many cities. The new entrants,
though, should not celebrate too quickly, since their tech model disruption comes with its dangers.
Their models are difficult to mine for cash flows and are themselves susceptible to competition. As
I noted in my post on the future of the ride sharing business, disruption is easy, but making money
on disruption is hard.
YouTube Version
9/24

Aging in Dog Years? The Short & Glorious Life

Tech Life Cycle Series

1. The Yahoo Chronicles! is this the end game?
2. Aging in Dog Years? Tech Company Life Cycles (Coming soon)
3. The Compressed Tech Life Cycle: The Manager's Challenge
4. The Compressed Tech Life Cycle: The Investor's Challenge

Posted by Aswath Damodaran at 2:19 PM

Labels: Corporate Life Cycle

6 comments:
d.grioli said...
Excellent post.
It raises a larger question - how do you value "platform" businesses?
I'm guessing that it requires making a lot of assumptions. For example, treating R&D as an
asset. It would be really helpful to see a post listing the sorts of assumptions that an investor
would need to make.
Another guess is that you might be able to use logic to infer a reproduction value for the
company's assets.
For example, assuming you had the data, you might be able to value a business like You
Tube (YT) using the following method.
I'm guessing that the content on YT follows a power law distribution (i.e. 20% of the videos get
80% of the views). So step one would be to focus how many hours of YT content get viewed
the most.
Then look at what it would cost a conventional TV production studio to create the same
number of hours of content.
Then compare the amount that YT can charge for advertising on its premium (i.e. top 20%
viewed content) to the advertising revenue that a conventional TU station might earn.
You could then use this information to calculate the reproduction value of the content.Would
something like this work?
Obviously this isn't perfect. As you correctly point out businesses that can gain scale easily
can also loose scale easily. YT doesn't own the content, the users do and they can easily
leave.
Just an idea.
December 10, 2015 at 12:18 AM

Anonymous said...
I think your analysis is very interesting but I think your thinking is too heavily focused on
consumer-facing or internet technology firms. There is another very large sector of enterprisefocused tech companies (Microsoft and Oracle to name two of the largest) that are highly
entrenched and have a very long maturation/decline curve given the recurring nature of their
revenue streams, high switching costs for customers, enterprise sales focus which is hard to
replicate, etc. The same is similarly but less true for enterprise hardware businesses such as
Cisco and Intel which are also surprisingly resilient.
December 10, 2015 at 5:49 PM

Anonymous said...
Sir - In the spirit of your generalization regarding the life cycle evolution of tech vs non-tech,
would you also say that tech companies have a larger failure rate when they try to scale up ?
ie., a larger proportion fail
December 13, 2015 at 6:23 AM

XeL Arjona said...

First @Anonyous - Agree with your statement. I think that "standard" sector classification
systems need in this field a lil' rectification for techs. I agree that not all "tech" companies fulfil
same kind of -returning curve in time- criteria. Nowadays, most of global GDP moves
depending much more on services than on industrialised production, given this; companies
like you mention tends to be defined much more in a scheme of "corporate infrastructure"
rather than "innovative tech".
December 17, 2015 at 3:06 PM

The Contrarian Individual Investor said...

Perhaps much of what we call Tech Companies are actually just Entertainment/Game
Companies that use technology as their delivery mechanism. Their users tire of this game and
move on to the next app/game. Or perhaps they are just entertainment content creators and
users, having consumed the content, fail to enjoy it and locked into a technology construct,
remove it and download the next app. You could almost put Yahoo, Facebook, mySpace,
Whatsapp, etc. etc. into this space.
For tech manufacturers, who actually make something physical, perhaps many would better
be classified as Jewelry and Fashion Accessory houses.

December 20, 2015 at 1:40 PM

Jeetendra Singh said...

Great insight professor!
Your perspective on treating technology as a continuum is very interesting and very relevant
for investors. Increasing technology component in companies in sectors like automobiles and
consumer durable (washing machines, dish washers, refrigerators etc ) which have historically
seen long growth and stable mature phases may suddenly compress the life cycles and force
many into decline pre-maturely.This would have serious implications on investments in these
sectors.
February 7, 2016 at 2:52 AM
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