As you already know, competitive analysis is an essential element of the business valuation process in the value investingalong with financial analysis. In competitive analysis, it is important to analyze whether the company has strong and sustainable competitive advantages. In this article I will explain what one of the competitive advantages most important, the network effect, together with some explanatory examples and factors to take into account when analyzing it.
What is the network effect?
The network effect (“network effect” in English) is a competitive advantage that occurs when the value of a certain good or service increases both for new users and for existing users as the number of users of the good or service increases. service increases.
Examples of the network effect
One of the classic examples of companies that benefit from the competitive advantage of the network effect with credit card companies, both Visa and MasterCard. The value of having a certain card is greater for customers if it is used by many people, since it will allow them to use it in many more commercial establishments.
Another much more current example of the network effect is that of social networks, worth the redundancy. The value that a social network brings to its users is related to the number of friends who use that social network. It is useless to be in a social network, no matter how good or advanced it may be if you are the only user.
Factors to take into account when analyzing the network effect
The first key factor to take into account is to analyze the way in which the company monetizes its competitive advantage. For example, the geolocation social network foursquare is a good example of a company that, despite having the network effect in its favor, has not been able to monetize its competitive advantage. As investors, we must look for companies that generate future profits, so a competitive advantage by itself is useless if it does not help generate cash for the company's shareholders.
On the other hand, we must analyze the degree to which the value provided by the company increases with each new customer and the ability of the company to attract new customers. If the cost of attracting a new client is higher than the value that it generates through the network effect, we will not be facing a good deal.
We must also not forget that the network effect does not last forever. The company can enter a virtuous circle if it gains customers or users, but also in a vicious circle if the company loses them. For example, the social network Tuenti, which was very successful in Spain for a few years, took advantage of the positive network effect for a few years until its users began to switch to Facebook, which made the net effect play against him this time.
Finally, we must analyze the power of both suppliers and customers when negotiating. The ideal is to find a company with "pricing power", that is, with the ability to raise prices when it sees fit without jeopardizing the loyalty of its business partners.