Do you remember this guy? This is the sock puppet from pets.com. Pets.

com was a
high flying company in
the late 1990s, early 2000 period. They had built an iconic
brand with their sock puppet. They had achieved worldwide visibility,
by selling pet supplies online. Their sock puppet was well known for
his Super Bowl commercials, and it even had a balloon in
the Macy's Thanksgiving Day Parade. And then the dot-com bubble crashed,
and pets.com went out of business. Now, why did that occur? There's lots of
different reasons, but let me highlight one that I think is
really central to the failure of pets.com. At the end of the day, it's not that
hard to sell pet supplies online and in fact there were numerous
competitors to pets.com. This competition made it very hard
to be profitable in this segment. This story highlights what I like to call, the
Fundamental Principle
Business Strategy. Simply stated, if everyone can do it,
it's difficult to create and capture value from it. Pets.com, suffered from the
fact
that lots of people were selling pet products online. To be more technical, let me
provide
the following alternative definition. In a perfectly competitive market,
no firm realizes economic profits, or what are often termed economic rents. So, let
me discuss this
in a little more detail. First off,
this concept of economic profits or rents. The definition is an economic profit or
rent are returns in excess of what an investor expects to
earn from investments of similar risk. In other words, in excess of
the opportunity costs of capital. This is the idea that the economic return
you need from investment must exceed the alternative uses you
might have of that money. Consider the following two examples. One company takes
$100 million and
turns that into a $1 million profit. Another company takes $10 million and
turns that into $1 million profit. Clearly, the latter example is a more
sound and attractive investment. Both generated to be clear $1
million worth of profit, but the first one took more
money to generate it. This, in essence, gets to this idea
of the opportunity cost of capital. How else could they have
invested that $100 million? Could they have invested
it in another investment that would have had a higher
return than $1 million. Let me illustrate this
with some data here. Here we have three companies,
iconic companies. This is data from 1998. And it expresses both,
their accounting profits, what they report in the popular press and
in their annual reports and their actual economic profits, factoring
in this opportunity cost of capital. So first we have IBM. IBM north of $6 billion
in accounting
profit, yet when we calculate the opportunity cost of capital,
mid-$2 billion or so created there. Compare that to Microsoft there. Over four
billion dollars in
accounting profit reported. But nearly $4 billion in
economic profit as well. This is in part because of
the nature of the software business. There's huge fix costs in developing
an operating system let's say. However, once you have
the operating system built, the marginal cost is next to zero. And as a result,
as Bill Gates once famously said, it's like printing money once you
have a dominant operating system. Compare that to General Motors. General Motors in
1998 did produce
a profit, accounting profit that is, nearly $3 billion. However, when we consider
economic profit,
it was nearly a $5 billion loss. Why such a drastic difference there? Well, in
part, it was because hundreds
of billions of dollars had been spent by General Motors to generate that
$3 billion worth of profit. Again, the opportunity
cost of that capital could have been used in other ways
that would have likely have been far more profitable than what
General Motors was doing with that money. So, one might ask,
how do we measure economic profit? Well, a common way that strategy
researchers use is what's called Tobin's Q. In its simplest form,
Tobin's Q is, in essence, the ratio of market value to book value. Technically
though, what we actually wanna
look at is the asset replacement value. So the firm's market valuation. What the
market thinks
the company is worth versus the replacement value
of the assets on hand. So one thinks about Facebook, for example. Facebook has a
very high market valuation,
so the market thinks it's very highly. But the replacement value for
its assets is probably fairly low when you think about the relatively
small employment they have and the number of assets
they have on hand there. That difference is what we're looking for
here. What This is does, in essence, is directly
measure these economic rents we're interested in, above the physical
inputs that the company might possess. The challenge with Tobin's Q is it's often
difficult to actually calculate this replacement value of assets here, and requires
a knowledge that you may not
have at the organizational level. An alternative is what's
called discounted cash flow. Discounted cash flows are ways
of measuring the value of the firm going forward. It's a measure of
the revenue minus the costs minus other investment
the company makes moving forward. We discount those cash flows because
the value of money is worth more today than in the future. And in essence this
discount rate that we
use reflects the actual return on equity, in essence,
this opportunity cost we're interested in. So the discount rate would
reflect both inflation. But also the rate of return we
expect to get above inflation for similar investments of similar risk. And at the
end of the day, we calculate
what's called a net present value. And a positive NPV, or net present value,
indicates rents over and above the referent returns
to all other inputs. And this is somewhat the gold standard for
measuring economic profit.