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Be the last mover
PayPal's numbers
Take PayPal in March 2001, about 27 months after it started. The business was growing 100% a year, and future cash flows were being discounted at about 30%. Run the numbers, and about three quarters of its value came from cash flows in 2011 and beyond.
What gets overvalued
The same math on other fast-growing tech companies tends to put 75 to 85% of their value in cash flows from far in the future. Growth rates can be measured and tracked precisely today, so they get overvalued, while whether a company will still be around a decade from now is a qualitative question that dominates the value.
The last in a category
That makes the last company in a category the valuable one. Microsoft was the last operating system for decades, Google is the last search engine, and Facebook will be valuable if it turns out to be the last social networking site. Disk drive makers in the 1980s show the opposite: anyone could build a better drive and take over the whole world, and two years later someone else replaced it, and over fifteen years drives improved enormously. That was a great benefit to consumers and did nothing for the people who started the companies.
Why does so much value sit in the distant future?
Valuation models add up expected cash flows for a number of years and then fold everything after that into a single terminal value. For a fast-growing company, profits in the early years are small, so that terminal value is often the largest piece of the total. NYU finance professor Aswath Damodaran has written that terminal value makes up the majority of value in many young-company valuations.
Why did disk drive makers keep losing their lead?
Harvard professor Clayton Christensen studied the disk drive industry for his 1997 book The Innovator's Dilemma. He found that leading makers were repeatedly overtaken as drives shrank from 14 inches to 8 inches to 5.25 inches and below. Each new size first served a small, different set of customers before it improved enough to take over the main market.
How did Microsoft become the last operating system?
Software developers write programs for the operating system with the most users, and users buy the system with the most programs. IBM chose Microsoft's MS-DOS for its personal computer in 1981, and clones of that machine spread the same system widely. Windows 3.0 in 1990 brought a graphical interface to that installed base.
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