When it comes to successful investing, extrapolating a company´s past performance into the future is not enough to pick the best stocks for the long term. Investors need to analyze the company´s competitive strengths to determine if it will be able to continue delivering growing profits for years to come, and the network effect can provide powerful source of self sustainable competitive advantage.
The network effect happens when the value of a product or service increases as more people use that product or service. This can be one of the most potent sources of competitive advantages for a company: more users make the product more valuable, and this attracts even more users, creating a virtuous cycle of self-sustaining growth.
Many Internet companies operate under this parading, it wouldn´t make much sense to have a Facebook Inc (NASDAQ:FB) account if you were the only person in the social network. But that´s not the case at all, Facebook Inc (NASDAQ:FB) has as much as 1.15 billion users, which means there is a high probability you will find many of your friends, family, and people you enjoy on the social network. The more the merrier, and Facebook Inc (NASDAQ:FB) has become the leading social network on the planet, which is a huge competitive asset for the company.
In fact, it has become so big and relevant that many people feel they need to have a Facebook Inc (NASDAQ:FB) account even if they don´t really enjoy using the service much. Facebook is becoming the de facto way to organize events, share photos or to congratulate someone on their birthdays. If everyone else has a Facebook Inc (NASDAQ:FB) account, you need to have one too, if only to stay in touch and connected.
Once a social network is successfully growing, the big challenge is monetizing the user base without hurting the user experience too much, and Facebook Inc (NASDAQ:FB) seems to be making progress in that direction since the company delivered a 25% increase in average revenue per user for the last quarter, driven mostly by a whopping sequential rise of 75% in mobile advertising revenue.
Organizing the World’s Information
Few companies capitalize the network effect as well as Google Inc (NASDAQ:GOOG). The online search giants feeds itself with the information provided by its users, so the more we use services like Search, Gmail, Chrome and YouTube, among others, the better those services get. Google Inc (NASDAQ:GOOG) attracts more users because it provides good services, and it provides better services because it has a growing user base.
That´s why the company doesn´t mind providing it’s tremendously popular services for free, Google Inc (NASDAQ:GOOG) makes big fat cash flows from online advertising, and every time we use its services we also supply the company with valuable information it uses to reinforce the quality of those services and strengthen its competitive position.
Google Inc (NASDAQ:GOOG) even builds some high quality applications for iOS, strengthening Apple´s competitive position in mobile. The search giant wants everyone to use its services and apps, no matter who makes money on the devices as long as Google Inc (NASDAQ:GOOG) can profit from advertising and from the value of information. Leaving privacy concerns aside, that´s a great business model to have.
A Double Network
Buyers and sellers want to go to the online commerce platform, which guarantees plenty of counterparts, so they attract each other in the search for the best products and prices. Amazon has been outgrowing eBay Inc (NASDAQ:EBAY) due to its aggressive competitive drive over the last years, but eBay Inc (NASDAQ:EBAY) is still the platform of choice for many smaller buyers and sellers.
The same dynamics are at work when it comes to PayPal. Merchants want to accept the payment method, which brings more customers to the business, and customers choose PayPal because it’s widely accepted and trustworthy.
With more than 132 million active accounts, availability in 193 countries and strong brand recognition, PayPal has achieved a level of critical mass that competitors can only envy. This means that PayPal is in a privileged position to continue consolidating as the leading online payments method over the next years by being the first mover in a business with strong network effects.
The network effect is a very powerful and sustainable source of competitive advantages. It´s also an important driving force behind the success of many of the most remarkable growth stories of our time, so it’s a factor to watch when making investment decisions. Buying a network of growing profits can be a really smart move to make.
The article Buying a Network of Growing Profits originally appeared on Fool.com and is written by Andrés Cardenal.
Andrés Cardenal owns shares of Google. The Motley Fool recommends eBay, Facebook, and Google. The Motley Fool owns shares of eBay, Facebook, and Google. Andrés is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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