Stock market valuations are a funny thing. J.M. Keynes thought people, as often as not, decided their valuations not on the basis of how much an investment was worth, but on the basis of how much other people thought the investment was worth. Extend the logic a little further, and you stop valuing an investment based of how much other people think it is worth, but on the basis of how much other people think other people think it is worth… and then you can base it on what other people think other people think other people it is worth… and so on.
In George Orwell’s 1984, Winston Smith is told by his interrogator that something is true so long as both of them, being that they are alone in Room 101, agree that it is true. If Winston and his interrogator agree they are both floating in mid-air, then it is true that they are both floating in mid-air. The danger is that if one of them stops believing they were floating in mid-air, then presumably they fall down on their bums. Much the same is true of stock market valuations. Share prices can go up and up so long as people believe they will go up and up, but as soon as somebody loses faith, then the share prices can crash back down again.
There is an alternate basis for valuing investments. This is valuation according to business fundamentals. In other words, it means deciding a valuation based on what something is worth, and not on what somebody else thinks it is worth. If you look at the fundamentals, the prevailing valuations for businesses offering on-line advertising are all nonsense. Obviously this means I am arguing that most people think they are worth more than they are. But everybody else is entitled to dance around these businesses, trying to make money and leaving the dance on a high. However, when the music stops, some investors will look around and discover there are far too many people and far too few chairs, so some of them may suffer the same pain in the bum that Winston Smith was risking.
There a few ways in which the fundamentals for on-line advertising do not support current valuations. One is the lack of barriers to entry for on-line targeted communications. This makes fragmentation likely, and the intense competition will drive down prices whilst permitting users to churn to other sites whenever advertising becomes too obtrusive. Another reason is that there is a limit to how effective advertising could ever be, and hence on the total market for advertising, and the appetite for advertising varies a lot. If the world’s economy takes a turn for the worse, then advertising budgets will dry up, and there is no guarantee that on-line advertising can be effectively substituted for traditional ads. One factor that preoccupies me, but which is rarely mentioned by the press, is that the knowledge that makes targeting so powerful is in danger of becoming ubiquitous. A lot of companies are putting a lot of effort into gathering essentially the same data. On top of the legitimate and semi-legitimate ways companies gather data, lax security means there a lot of data is available illegitimately as well. For example, working in the mailroom of the UK’s Revenue and Customs might be a good way to get lots of personal data that is sent around unencrypted on CDs, including bank accounts for half the UK’s population ;) So the competitive advantage that stems from knowledge is eroded as gradually we create a world where everybody knows everything about everybody else.
One of the funniest things about telcos is that their valuations are so poor compared to the Googles and Facebooks of this world, despite the fact that web enterprises cannot exist without the poor old network carrying all the IP traffic. In the content of targeting advertising, the telcos also have the data needed, but tend to lack the mechanism to extract and use it. A lot of data gets transmitted over those telecoms networks (though obviously the UK government should aim to send a bit more that way). The web enterprises rely on a very roundabout way of getting data, using cookies and the like. They lack visibility across all the customer’s internet activity, and cookies can be blocked or deleted. In contrast, ISPs see everything that a user is up to. The only thing they lack is the technology to collate that data. Deep packet inspection is that technology.US telco CenturyTel estimates it will increase ARPUs by 5% to 10% through deploying deep packet inspection boxes made by NebuAd. However, gathering data on customers in order to target ads is the tip of the iceberg. The same technology can be used to shape and control traffic, or to provide the facility for “lawful intercept” (also known as “spying”). Read here for a great overview of what deep packet inspection can do and how it will change the world. There are a wide number of reasons why telcos will increasingly invest in deep packet inspection, and increasing revenues is only one of them. I can certainly think of some less desirable outcomes from harnessing all the knowledge that is in the network. One positive, though, will be that it will prompt a sharp correction in the value of the Facebooks of the world…