Investment Advice from Peter Thiel
- Posted by scheplick
- on May 6th, 2012
Peter Thiel is an asset manager and venture capitalist. He started his career as a founder of PayPal and has been on a steady rise ever since. He was one of the first investors in Facebook ($FB), and now has a stake in Space Travel. With his free-time, he teaches a course on start-ups at Stanford University called CS-183. This post focuses on his Thiel’s Investment advice from his third lecture, “Value Systems.”
Each quote below is taken Blake Masters Tumblr blog. He is a student in the class who summarizes each lecture and posts them online.
Spot a Great Company
Great companies do three things. First, they create value. Second, they are lasting or permanent in a meaningful way. Finally, they capture at least some of the value they create.
Great companies last. They are durable. They don’t create value and disappear very fast.
Consider disk drive companies of the 1980s. They created a lot of value by making new and better drives. But the companies themselves didn’t last; they were all replaced by others. Not sticking around limits both the value you can create and the value you can capture.
The most common multiple is the price-earnings ratio, also known as P/E ratio, which is equal to market value (per share) / earnings (per share). In other words, it is the price of a stock relative to a firm’s net income. The P/E ratio is widely used but does not account for growth.
To account for growth, you use the PEG, or Price/Earnings to Growth ratio. PEG equals (market value / earnings) / annual earnings growth. That is, PEG is PER divided by annual growth in earnings. The lower a company’s PEG ratio, the slower it’s growing and thus the less valuable it is. Higher PEG ratios tend to mean higher valuations. In any case, PEG should be less than one. The PEG is a good indicator to keep an eye on while growing your business.
Value investors look at cash flows. If a company can maintain present cash flows for 5 or 6 years, it’s a good investment. Investors then just hope that those cash flows—and thus the company’s value—don’t decrease faster than they anticipate.
Valuations for Old Economy firms work differently. In businesses in decline, most of the value is in the near term.
LinkedIn ($LNKD) is another good example of the importance of the long-term. Its market cap is currently around around 10 billion dollars and it’s trading at a (very high) P/E of about 850. But discounted cash flow analysis makes LinkedIn’s valuation make sense; it’s expected to create around 2 billion dollars in value between 2012 and 2019, while the other 8 billion dollars reflects expectations about 2020 and beyond. LinkedIn’s valuation, in other words, only makes sense if there’s durability, i.e. if it’s around to create all that value in the decades to come.
Focus on Monopoly Companies
But if you’re a monopoly, you own the market. By definition, you’re the only one producing a certain thing.Consider great tech companies. Most have one decisive advantage—such as economies of scale or uniquely low production costs—that make them at least monopoly-esque in some important way. A drug company, for instance, might secure patent protection for a certain drug, thus enabling it to charge more than its costs of production.
The really valuable businesses are monopoly businesses. They are the last movers who create value that can be sustained over time instead of being eroded away by competitive forces.
Indeed, Adam Smith adopted this view in The Wealth of Nations: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” But exactly why monopoly is bad is hard to tease out. It’s usually just accepted as a given. But it’s probably worth questioning in greater detail.
The DOJ has 3 tests for evaluating monopolies and monopoly pricing.
- First is the Lerner index, which gives a sense of how much market power a particular company has. The index value equals (price – marginal cost) / price. Index values range from 0 (perfect competition) to 1 (monopoly). The intuition that market power matters a lot is right. But in practice the Lerner index tends to be intractable with since you have to know market price and marginal cost schedules. But tech companies know their own information and should certainly pay attention to their Lerner index.
- Second is the Herfindahl-Hirschman index. It uses firm and industry size to gauge how much competition exists in an industry. Basically, you sum the squares of the top 50 firms’ market shares. The lower the index value, the more competitive the market. Values below 0.15 indicate a competitive market. Values from 0.15 to .25 indicate a concentrated market. Values higher than 0.25 indicate a highly concentrated and possibly monopolistic market.
- Finally, there is the m-firm concentration ratio. You take either the 4 or 8 largest firms in an industry and sum their market shares. If together they comprise more than 70% of the market, then that market is concentrated.
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.
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