The Big Market Delusion: Valuation and Investment Implications

Abstract

There is nothing more exciting for a nascent business than the perceived presence of a big market for its products and services, and the allure is easy to understand. In the minds of entrepreneurs in these markets, big markets offer the promise of easily scalable revenues, which if coupled with profitability, can translate into large profits and high valuations. This paper examines how the “big market promise” affects business formation and financing and focus on the role that overconfidence on the part of entrepreneurs and their financiers (venture capitalists and public equity) plays in creating a collective over pricing of companies in alleged big markets. We argue initial overpricing is a common feature of these markets, but results in an inevitable correction that brings the pricing back to earth. Three case studies are developed to illustrate the thesis, one where the process has almost fully played out (dot com retail from the 1990s), one where it has been unfolding for a while, online advertising, and a third, the cannabis market, where it is just beginning. Based on these case studies, we suggest several lessons for investors, regulators, and businesses.

Keywords: Pricing, Value, Bubbles, Venture Capital