There is a growing gap between how the market is pricing businesses with uncertain or potentially widely variant futures. Investors today recognise that a businesses value is the sum of the value produced by existing business lines or products and the expected value of potential future business lines or products. Evaluation of potential future lines of business is how investors can develop a variant perception and is usually accompanied by an analysis of embedded real options.
What are real options? Michael Mauboussin, former Colombia Business School professor in his paper titled ‘Get Real’, defines them as the right – but not the obligation – to make potentially value-accretive investments including new plants, line extensions, joint ventures, and licensing agreements. These options are real because they represent potential investments in intangible or tangible assets.
Analysis of structural winners like Microsoft and Alphabet suggests businesses with data advantages, that deliver their customer solutions digitally exhibit greater optionality. We have identified optionality can manifest in new business, product expansions, business model evolution, and geographic expansion. Of these ways in which optionality can create future value for a business, we believe that businesses with data advantages exhibit higher success rates in product expansion and the formation of new business lines. Why?
Data advantaged companies can harvest their customer data to develop greater insights into their needs and wants or alternately can monetise that customer data by simply selling it. Similarly, the zero-marginal cost of distribution allows companies to continually iterate on their products, receiving live feedback from their customers, reducing the probability of a lack of product-market fit, hence increasing the probability of success. Hence, the opportunity cost of continual innovation and potential failure is significantly lower for digital businesses, particularly those tailored to consumers. This is a nuanced, but important defining advantage that digital businesses have over businesses that deliver physical products as
At Spotify, as customers curate their perfect playlists and spend hours listening to music, the company extracts insights regarding popularity of certain songs across a broad range of demographics. An intimate understanding of their customers enables personalization and supports the production of innovative features or products – real option product extensions like Daily Mixes, Group Sessions and Your Daily Drive, all of which drive engagement and improve customer lifetime value.
Spotify also leverages their unique listener data and offer products to musicians, creating Spotify for Artists – an example of a real option line of business extension. Their understanding of listening habits has allowed them to create a new suite of products for artists based on the same underlying customer data assets. Spotify’s artist data analytics support marketing efforts and enable artists to connect directly with their most passionate supporters. In July 2018, Metallica used Spotify’s streaming data to plan live setlists based on their most popular tracks across a range of US cities, ensuring the band’s setlists at each location were optimised for their crowd.
Whilst these services for artists may not be a major contributor to earnings or revenues today, they improve the value of the product for all stakeholders, and we remain confident in Spotify management’s ability to further monetise them. This idea is a key tenet of investing in real options. Investors must be conscious of the inherent opportunities embedded within companies that perhaps do not appear on the financial statements today but could significantly alter the direction of the business tomorrow.
At Montaka, we use our deep sector and market expertise to select businesses we believe exhibit optionality whilst they remain undervalued to compound your wealth alongside ours.
Phill Namara is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.