How Adam Smith Might Have Valued Amazon, Netflix, Tesla, And Tiny Biotechs – Seeking Alpha

By daniellenierenberg

Adam Smith (1723-1790) was not who you think he was. I'm talking about the original Adam Smith who wrote The Wealth of Nations (1776) and spent most of his life in Edinburgh, Scotland. The more recent "Adam Smith" - nom de plume of the late George Goodman who wrote The Money Game (1967) - bears much more resemblance to the Adam Smith you think you know.

The first Adam Smith would have had little interest in stock market wisdom because he regarded himself as a moral philosopher rather than an analyst of markets. In fact, he was not even a capitalist. His works do not include the words "capitalist" or "capitalism" because neither came into use in his lifetime. The first mention of "capitalism" in print was in the 1854 novel The Newcomes by William Makepeace Thackeray, whose father had been involved with the East India Company. Karl Marx, oddly enough, helped popularize the term in his classic Das Kapital (1867). The irony is that if Marx did not quite invent the concept of capitalism, he certainly made the term popular in the process of opposing and bashing it.

No one can know what Adam Smith would have thought about free market capitalism as presently practiced, nor can we guess what he would have thought about the aftermarket in shares which we call "the stock market." The first stock exchanges came into being a couple of years after his death and shares were traded in only a small handful of companies including the still extant Bank of New York (NYSE:BK). Security trading over Smith's lifetime was concerned primarily with credit instruments, the exceptions being one-off exchanges organized by and for the British and Dutch East India Companies. So no capitalism, no market opinions from Adam Smith. Sorry to have to tell you.

The primary interest of Adam Smith was the goal which gave his book its full title - an inquiry into the nature and causes of the wealth of nations, in short, the well-being of the general populace. Counterintuitively paired with this was the self-interest which led tradesmen and the early industrialists to seek profit. He used the term "invisible hand" only three times in his writing and just once in The Wealth of Nations, to wit:

The rich consume little more than the poor, and in spite of their natural selfishness and rapacity, though they mean only their own conveniency, though the sole end which they propose from the labours of all the thousands whom they employ be the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species...the beggar, who suns himself by the side of the highway, possesses that security which kings are fighting for."

This is the central core of Adam Smith's thinking. It has always interested me that the ultimate goals of Adam Smith and Karl Marx did not differ greatly. The important difference is that Smith believed in freedom of the market while Marx believed that the solution was the top-down mandate of a command economy. We are familiar at this point with the general course of events in top down economies. The 20th Century resolved that question definitively in favor of Smith's view, which we now call capitalism.

Smith, however, never imagined a world with an after-market of securities measured by such things as price earnings ratios and discounted free cash flow. He would have been astonished at the use of these and other forms of analysis central to modern markets including shares of corporations with thousands of shareholders and many millions of shares. The few larger businesses in his day - a few early industrialists and the enormous East India Companies - did not lend themselves to that kind of analysis.

Does that mean that the thinking of Adam Smith is useless in trying to understand value in the modern financial markets? Not at all. Smith's model of the invisible hand contains a clue as to the way he might have valued companies and their shares. In fact, the view of Adam Smith may take us back to the primary purpose of capital markets which focus on start-ups, IPOs, unicorns, perhaps even SPACs, and all companies in their early stages. Such companies seek capital with which they aspire to bring innovations. They hope to profit by serving the unmet and often unrecognized needs of a body of potential customers.

What Smith saw was the intricate interplay between the needs and desires of customers and the self-interest of a risk-taking capitalist. That is the core transaction of the capitalist system. Without so much as a glance at discounted future cash flow, Smith implicitly understood that for a business the important thing was the population for which a business might add value. The issues for the entrepreneur involve the accuracy of their estimate of that market, the share of that market they might expect to win, the revenues they might expect to receive, and the profit margin they might expect to realize on those revenues.

In short, Adam Smith's thinking may not ordinarily be very helpful in the after-market we call "the stock market" but is central to the universe of young and innovative companies. It is directly connected with the way businesses and customers are conjoined. What a business does for its customers, he implies, provides an outline of its ultimate value. For this reason, I see the conjunction of businesses and customers as potentially useful in thinking about leading companies in the current market, especially for those companies which cannot be analyzed usefully by the standard market metrics of sales, margins, earnings, PE, and discounted cash flow.

In Adam Smith terms, a company should be worth a reasonable return for what it contributes to the greater good of the general populace. This single sentence is at the heart of what I am calling the "Adam Smith Model" of valuation. Does it actually work when trying to value innovative companies? Can one make decisions based on this model? To a large degree I think it is the only really helpful approach in valuing companies driven by new products and concepts.

To show how this sort of analysis might work, I will start with my daughter's portfolio of innovative biotech companies, which she put together in the early days of the pandemic. It is a pretty good model of the kind of thing I have always kept a careful distance from. Her surprising success with this portfolio prompted my own internal debate.

My daughter is a bright young woman who will soon turn 50. She has a doctorate in art history from Penn but retrained as a nurse in order to live in the woods in western Massachusetts and raise her children as a single mom close to nature and away from urban centers. Her life is modeled more on Thoreau's Walden than on Ben Graham's The Intelligent Investor. Despite sitting at my dinner table for seventeen years she remained almost entirely ignorant about financial markets until recently. The after-market in stocks seemed to her insufficiently serious to deserve her attention, which might well have been Adam Smith's view had he lived to see it. I confess to having had similar thoughts myself at times but have suppressed them.

In recent years, however, prompted by the realization that she may one day retire and need an income, she has begun to take an interest in markets. Around the beginning of the COVID-19 crisis (on which she had early insight and much sound advice), she put together without telling me a portfolio of biotech companies. She did this on a very small scale. Over four or five months she is up well over 200%, an amount I have never made in anything like that period. Here's an excerpt from an email she sent me on her portfolio:

Yes, that's why I like leronlimab - CytoDyn (OTCQB:CYDY). It has many uses, a high safety profile (I don't give a second glance to drugs with a low safety profile-anyone could have seen that with hydroxychloroquine, and now dexamethasone-which is a broad-target immunosuppressant, hence will never be a commonly used drug for Covid). Leronlimab has a great safety profile and works with a known mechanism vs. the cytokine storm. Anything good for Covid (or the other viruses that are still around: SARS, MERS and Ebola) must not suppress the immune system as a whole (as do all steroids such as dexamethasone). Leronlimab is targeted at the CCR5 receptor-which makes it effective for coronaviruses as well as cancers and autoimmune disease. Amazing for metastatic cancer, including prostate (though the recent studies are on a hard to treat breast cancer), and probably other untreatable but common cancers. It's going to be great for HIV. It's going to work for host vs graft disease (post-transplants, when we go back to doing them). It also appears to work for NASH (non-alchoholic fatty liver disease, which has increased dramatically in numbers, but is silent in most people until it is at a late stage.) It is the next diabetes.

Mesoblast (MESO):

The next wave of medical advances are going to come through better understanding of immunomodulation. Most if not all diseases-including cardiac disease and diabetes--will come to be understood as inflammatory diseases to be manipulated at the cellular level. We will see more and more of these diseases due to our inflammatory (sedentary, antioxidant-deprived) lifestyle and toxic environment. In any case, I'm interested in the companies who are leading the way in specialized research in immunomodulation. Mesoblast is using stem cell technologies to repair the immune system, and applying that technology to many untreatable diseases.

Avalon GloboCare (AVCO):

Same argument as Mesoblast: multiple technologies, targeted immunotherapy. I'm not so interested in any single technology, but they are partnering on several important technologies (stem cells, diagnostic technologies), with broad implications and clinical uses. They are partnering to develop a nasal vaccine for Covid, but again, I'm not as interested in that particular product, but the broader technology. Nasal vaccines are going to be a winner for many reasons-ease of use, global application, and the fact that we will run short on syringes for other vaccines).

Altimmune (ALT):

Same as above: leader in NASH (non-alcoholic fatty liver disease), nasal vaccine technology

Okay, those are my four picks. Amazing for metastatic cancer, including prostate (though the recent studies are on a hard to treat breast cancer). The others, JNJ, Becton Dickinson, and DaVita, you know."

I love the fact that my daughter comes at investing from an angle so different from mine and with a skill set that does not overlap mine at all. I also love that its method combines brains and a good heart - the assumption that a company is worth the sum of what it contributes to human well being. What I find most intriguing is that her natural way of coming at things aligns so closely with the Adam Smith view. Can growth investing possibly have such a simple foundation?

You will probably have guessed that I have never bought anything like these biotech companies nor used anything resembling this kind of analysis. I do not, and could not possibly, recommend any or all of them. They are well outside my areas of knowledge and expertise. The only counsel I was able to give my daughter included the fact that when buying companies like this you should probably buy a basket of them - something which she had already done, intuitively.

By early July she had tripled her money and was beginning to be worried about what felt to her like an overhyped sector of an overpriced market. This was where she thought my advice might be useful. I laughed and said that she should be giving me financial advice instead of vice versa, but if she was nervous she should probably sell down to her comfort level (she's in a low tax bracket so cap gains aren't a problem). Perhaps she should at least sell down to the point at which she was investing with house money. I added that it was okay to leave a few chips on the table and let her long term bet ride. She agreed and did something close to that.

Her insight had been pretty simple. The value of a company should correspond to the amount of value added via the "invisible hand" to the health, happiness, and well-being of its customers - perhaps even to the general populace. You would start by estimating the size of the market for which it provided a product or service. You would then adjust to take into account the competition for that market and finally the probability of your particular company capturing a major part of that market. Then, and only then, you might begin to make rough estimates as to potential revenues and profit margin. The key correlation is not revenue and profit margin, which are well out in the future, but the value the company is likely to add to society. The payoff in small biotechs like these, if it comes at all, is likely to come in a rush when a large pharma company sees the potential and buys them out, fulfilling the Adam Smith projection of appropriate reward for a large service.

When I started to formulate it this way, I realized that I have missed quite a lot in never owning stocks which might be best measured in this way. This includes not just small biotechs and niche technology startups but also giant current market leaders such as Amazon (AMZN), Netflix (NFLX), and Tesla (TSLA). At every point in the lives of these three companies, I have found that the methods by which I have always valued stocks - things like discounted earnings, dividends, and cash flow - made me unable to put together any reasonable argument for owning them.

Had I finally stumbled upon a valuation model that might provide a rationale for buying them? Up to this point, I have not seen a persuasive methodology for thinking about the value of these companies. Could this simple approach account for their unusually high valuations?

Adam Smith implied that the relationship between a business and the population it served was the invisible force behind what we call capitalism. It takes only a small further step to propose that the population served by a business can also be described as an "asset" owned by that business. In some cases, especially young or innovative companies, it is customers acquired that is the central asset. The idea of a business "owning" its customers is not new. I first read about it in a novel at least fifty years ago when a literary agent retires by essentially selling his customers to a rival - a practice that was apparently commonplace even then.

This customer-based approach seems to be the way the founders of these three market leaders looked at the opportunity. Customers weren't just part of the picture. They were the whole thing. Acquiring customers is what these companies set out to do. Everything else could come later. They were determined to do everything it takes to own the largest number of customers, including running their businesses with negative earnings and free cash flow for a long time. The market caught on to their goals and their prices shot up to the stratosphere.

Amazon, Netflix, and Tesla have always sold at ridiculous multiples of earnings and cash flow, if any, and are ridiculously expensive by pretty much every other traditional measure. When you look at them the way my daughter looks at biotechs, however, the picture changes. You set the standard ratios aside and instead ask: what is the value of these companies if measured by the sum of value they provide in service to their actual and potential customers? The transmission of that value to shareholders is initially as invisible as the invisible hand by which value is distributed to the populace. It is nevertheless reflected in the stock price.

Here's how one might do a broad estimate of value for the three companies:

Today, online commerce saves customers money and precious time," writes Bezos. "Tomorrow, through personalization, online commerce will accelerate the very process of discovery. Amazon.com uses the internet to create real value for its customers and, by doing so, hopes to create an enduring franchise, even in established and large markets.

We believe that a fundamental measure of our success will be the shareholder value we create over the long-term. This value will be a direct result of our ability to extend and solidify our current market leadership position. The stronger our market leadership, the more powerful our economic model.

Because of our emphasis on the long-term, we may make decisions and weigh tradeoffs differently than some companies... We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions...We aren't so bold as to claim that the above is the 'right' investment philosophy, but it's ours, and we would be remiss if we weren't clear in the approach we have taken and will continue to take.

From the beginning, our focus has been on offering our customers compelling value," explained Bezos. "We brought [customers] much more selection than was possible in a physical store (our store would now occupy six football fields), and presented it in a useful, easy-to-search, and easy-to-browse format in a store open 365 days a year, 24 hours a day."

That's Amazon's mission statement summed up in a few paragraphs. The guiding purpose to this business model is positioning yourself to "own" more and more customers. This customer-obsession of Bezos amounts to is a manifesto for innovative companies. The second paragraph flows directly from the core principle of Adam Smith. Get first things first, Bezos is saying, meaning understanding the potential market and seizing it. Profitability and measurements commonly used by Wall Street come later.

Amazon is no longer a young company in chronological age, but the vision embedded in its mission statement is to remain a young company forever. A Day 1 company, as Bezos calls it, is always visionary and entrepreneurial in its thinking. What Bezos is saying to investors is: disregard the numbers used by Wall Street analysts. They are important measures only for Day 2 companies (slow-moving, mature companies in stasis, for which the next stage is death). Keep your eyes on the main thing - the growth of your customer base and a high level of customer satisfaction. Facebook (FB) and Alphabet (GOOG)(GOOGL) were like that in early stages but moved fairly quickly to address the question of how to monetize their users, eventually succeeding and becoming measurable by ordinary metrics. They are now ordinary growth companies with moderately high PEs, at least in context of the current market. Bezos rejected early monetization. Have faith, he said. We will monetize our customer base when we get around to it.

The greatest single risk for Amazon is its increasing size, which makes it difficult to remain nimble and full of energy. At some point, it will face the horror which confronts history's great empires - running out of worlds to conquer. Political constraints may have something to do with that, but pure size is the major burden. Summing it up, I would buy Amazon at something like 50-60% of its present price if nothing had gone wrong in the business in the meantime.

2. Elon Musk somehow manages to top Bezos. His manifesto, much of which comes out in random statements and tweets, is that Tesla will one day produce pretty much every car sold in the US, maybe even the world. At the very least it will be the driving force in a new industry. His business has a powerful technological core, but the rational for it is the prospect of capturing much of the total customer base for vehicles. It currently appears to be priced on the assumption that Musk will succeed in this ambition to a large degree.

Musk is confident that Tesla's technology will become the universal standard and squeeze most of the current auto industry into terminal decline. Its panache stems from great aesthetics and the promise of enlisting his customers in the project of slowing climate change and helping save the world. Tesla, he implies, will almost incidentally become highly profitable, an outcome to which Musk himself seems to be personally indifferent but in which his investors might have some interest. If he is right, Tesla will probably look cheap if bought today or tomorrow at 160 times its current (and first annual) positive earnings.

Like Bezos, Musk would have us remember: we don't care about all that. That's the old valuation model. What we care about is a market of 17 million vehicles sold annually in the US and a number around five times that in the world. That's the scale of customers Elon wants to own. Once that happens, he will bite the bullet and monetize.

To own Tesla at anything like the current price you have to make a few audacious assumptions. You have to believe that vehicles will continue to be bought on very large scale and that the overwhelming number of vehicles sold will become electric within a short period of time. You then have to believe that Tesla will become the company that owns most of the customers and sells most of the vehicles. It's not impossible, but there are obstacles to overcome.

If Ford, GM, Toyota, Honda and others launch a modestly successful counterattack, or the whole market shrinks, you will see the earnings and cash flow multiples of Tesla shares contract in the general direction of the valuations of those "Day 2" companies. In other words, if you are an investor, you don't want Tesla to become just another car company, nor do you want it to be the last giant in an industry that is contracting and possibly dying. If one of those things happens, Tesla, as measured by the Adam Smith premise, is likely to be a disappointing investment. This is very broad brush analysis, but that's the only way to really deal with Tesla, a company quite similar to my daughter's biotechs. The risks for Tesla seem high and hard to calculate. These are the problems routinely faced by innovative companies in their early stages, and you must also pay attention to the risk that Tesla could run out of time to overthrow the industry while the industry still exists in its present form.

3. Netflix is a company I have looked at only recently. Until a few months ago I had never used their product - not once. Entertainment is OK - I'm being entertained by writing this, and I dare to hope that you readers are both entertained and stimulated to further thought by it - but I didn't experience Netflix until a millennial step child and her husband spent some time with us and promptly realized that they couldn't live without it. They put it on a couple of our TVs so that they would have some kiddie movies to bribe their 3-year-old to eat dinner plus an hour of decompressing entertainment for themselves before sleep.

A few months ago my wife and discovered that we still had it, linked somehow to their home two thousand miles away, and it turns out that the shows are pretty good. They turned out to be especially valuable during the lockdown. We had run out of old movies, so we started over with Netflix. I started paying attention to articles on Netflix and ultimately took a look at their numbers.

Egads! They have been unprofitable from day one and their negative cash flow has done nothing but increase. Their costs for content are going up and their competition is mounting. On the other hand, Stranger Things is the kind of nitwit escapism that I found that I like after a long hot day teaching tennis (my wife not so much).

How do I put the two views of Netflix together. In this case, the risks and uncertainties make the stock uninvestable for me. For one thing, I am used to having entertainment piped into me for free (I automatically tune out all ads.) The numbers needed are just too daunting for Netflix, the rising costs for content are worrisome, and ultimate limits in a market now sliced several ways implies limits to growth. I am doubtful that Netflix will ever morph into a company I can measure more conventionally. I'm pretty sure I wouldn't renew if our faraway relatives stopped providing it for free. That's the core of it: I'm a customer of sorts, but they don't really own me. I don't own them either, and am not likely to any time soon.

The outperformance of high growth companies over the last decade and most spectacularly over recent months has naturally invited vigorous debate. The catastrophic dot.com crackup exactly two decades ago has receded sufficiently that alt explanations of market behavior are once again beginning to be proposed in earnest. This article is perhaps one of them but exists within the frame of traditional methods.

The dot.com era which reached its peak in 2000 crashed amidst assertions that eyeballs and clicks were better measures of value than earnings or cash flow. I lived through it as a bystander, listening to fellow fitness enthusiasts in the workout room at my tennis club boast about their portfolios, then noticing their absences one by one as the crisis unfolded. I didn't feel schadenfreude, far from it, only relief that I myself had not been ruined.

Valuations are once again at a point which calls ordinary prudence into question. Are the traditional models of valuation no longer worth using? This was suggested recently by BlackRock quant Jeff Shen who argued here that traditional efforts to solve the "mystery" of value are worthless. The Shen view, by the way, derives from this article by another BlackRock analyst, Gerald T Garvey, published in the prestigious Journal of Portfolio Management. The Garvey article comes down firmly on the growth side of the growth/value debate arguing that "elevated percentage value spreads predict higher risk, not higher returns."

In more down to earth terms, Shen and Garvey are saying that companies whose shares haven't been able to grow in this environment are losing ground and possibly dying, and should be avoided. If a stock goes up a lot it is probably safe because the wisdom of crowds is behind its rise. This is the kind of statement that is true until it isn't. Shen goes on to argue that contemporary investors should look for alt indicators and models such as the happiness of a company's employees. That particular idea didn't exactly blow me away, and neither Bezos nor Musk seem to be proponents of using that principle to focus or drive their businesses.

On the other hand, an effort to measure a company's success in terms of the overall value it provides to its customers does seem to me an interesting way to think about growth companies. Most companies trading in the aftermarket for stocks - by now you know that when I use this awkward but accurate phrase I am referring to the "stock market" - are not high growth companies and are probably best analyzed by traditional measures. Ultimately some form of traditional value measurement must appear within the life-cycle of a successful company.

To Jeff Bezos, the moment when traditional cash measures become important to a company is the day that it wakes up as a Day 2 company, a company that does not attempt to reinvent the world afresh every morning. While such a company may still turn out to be a decent investment, it's important for value investors to pay careful attention to their risk of having their business disrupted by new technologies and methods. This is a fairly straightforward way of thinking about the world we now live in, and I have learned to ask the hard questions about everything I own - even companies with seemingly strong moats.

Disruption is a major theme of the contemporary world, and every thoughtful person would do well to put the world together afresh every morning. Even with an open mind, it's hard to anticipate what hidden risks might cause a company's current defenses to collapse. Because of the incredible speed of change and the prevalence of unsuspected collateral effects, this questioning is important in a way that it has never been in the past. That was the important lesson number two from the dot.com event. Buying the disruptors rarely made fortunes, but not being sufficiently cautious about potential disruptees was a good way to lose a fortune.

For these businesses the Adam Smith Model needs to be turned upside down so that it becomes a story about loss of customers. One of the great anecdotal examples was Bill Gates stunning a 1990s gathering of Buffett's value investor pals by using his knowledge of the digital world to inform them that Eastman Kodak (KODK), then a market stalwart, was "toast." The customer criterion proves its importance when inverted. I was unable to estimate the outcome for Amazon - haven't made a nickel directly by buying it - but it was obvious to me instantly that it was going to be the end of the road for many other retailers, as well as many malls and REITs. The history of Sears Roebuck and Walmart were powerful precedents. The only thing not entirely clear was the time frame, which is proving to be much faster than most people expected.

The astonishing thing was how eagerly investors jumped on the Amazon bandwagon, which has many uncertainties, and how slowly the investor mind adjusted to the knock-on effects, which were far more certain. The key to grasping this quickly, is to focus on customers "owned" but sure to slip away, as in the case of Kodak.

The Adam Smith Model is simply one of the ways of making an estimate concerning what the cumulative value should be somewhere down the road at whatever time the company decides to monetize the cash value of owning its customer base. At that point, it will begin to report profits and cash flow, pay dividends, and buy back shares. Apple (AAPL) may be the best current example of this model. It started paying dividends and buying back shares about a year before its growth began to level off. As the dream of perpetual growth disappeared, investors were rewarded by the cold cash that abundantly flowed.

This is the distant event that Bezos' mission statement grudgingly projects. For Bezos, earnings, dividends, and buybacks are Day 2 concerns, and you get the feeling that he would just as soon not live to see them. Being a Day 2 company, is like living a comfortable and happy life: the great second-best award for those who have given up their aspirations to greatness. So Apple was once an innovative company priced on the basis of the Adam Smith Model and has now normalized into a Day 2 company which can be valued by the traditional tools. Who knows, maybe it has a few positive tricks up its sleeve but relentless regular growth is a thing of the past.

Amazon seems to be on the same general course as Apple, but with ordinary shareholder gratification deferred into a less well defined and more distant future. You just have to wait for it, and at an incredibly low discount rate such as the current Treasury rates you are willing to pay up for the ultimate awards now and wait a long time. This is part of the current market infatuation with rapid and persistent growth. If you project very far into the future, the value may approach infinity, or since that concept no longer exists even in physics, you could approximate it by the difficulty Amazon would have if Amazon's business became the major part of the gross product of the planet.

High valuations in the current market can be partially explained by a number of factors including historically low interest rates and the appeal of the tech leaders during a broad public lockdown. It also true, however, that the most optimistic thinking stems from a gambling mentality which is supported by the famous Petersburg Paradox which has come to bear in their valuations. There are a number of recent articles with varied approaches to this subject, and you can sample them by googling Petersburg Paradox.

The Petersburg Paradox is generally credited to Daniel Bernoulli, who published an article on it in 1738, but is sometimes credited to his cousin Nicolaus Bernoulli who talked about it in a letter written in 1713. It is a simple gambling game that doubles your winnings with each successive throw of tails. Its expected return generates an infinite series of events the probability of which decline by the exponential 1/2 to the N power exactly offsetting the exponential increase in winnings (2 to the N power).

Each successive term is exactly 1. The mathematically expected return is the sum of that infinite number of ones. I suppose that this means you max out when the number in dollars is equal to the number of bits (or Planck units) in the universe.

This series, therefore, produces quite large expectation of winnings despite the fact that the probability of large winnings at any particular future point obviously diminishes enormously and becomes very slight after a few coin tosses. It is famous for the contradiction of the expected total return and the relatively small amount that any reasonable person would be willing to wager on that return. A number of mathematicians have attempted to resolve this contradiction - economist and quant Paul Samuelson having been one of them - but their efforts at refutation have been unsatisfying.

Recent articles have related the Petersburg Paradox to investor expectations for stocks with high and persistent earnings growth. An extremely smart and interesting article was published way back in 1957 by David Durand (The Journal of Finance, Vol 12, No 3, Sep 1957, pp 348-363). Durand explored the problem of valuation for growth stocks including the then relatively new approach of using multiple discount rates at various break points in time. The growth numbers are quaint - annual growth at numbers like 5 and 6.5% - chickenfeed compared to growth rates of modern high tech companies.

Durand related the question of pricing long growth periods to the Petersburg Paradox, addressing the infinity problem and the need to truncate the infinite series at some point. This has a parallel to the problem of valuing current growth companies where it is necessary to consider not only forecasts for future earnings growth rates but also the length of waiting time before cash flows and dividends appear. There's also the question of the interest rate used for discounting, which is now virtually nil but has been very significant at times in the past.

The Adam Smith Model happens to dovetail nicely with the distant outcomes of the Petersburg Paradox coin flip game. The further away the payout is from the present the larger the rewards become when you finally throw heads. It's just that in the case of fast growing but not yet profitable companies, you more or less defer the chance of hitting heads early in order to let the reward build exponentially and have the promise of hitting a very large summative outcome in the future. That's where the thinking of investors in Amazon, Tesla, and Netflix must come from, and it's more or less rational if their estimate of the payoff and the time necessary to achieve it are reasonably accurate. It has been pretty accurate in the case of Apple.

There's just one more thing, of course. What if the estimate of Adam Smith value proves to be outright wrong? What if a tough new competitor with a better technology or improved business model appears? What if competition already in place proves to be more formidable than assumed? Even with Amazon these risks must be taken into account, but with Tesla they should be major concerns, and with Netflix they should be very major concerns.

There could also be exogenous risks such as a major rise in interest rates which would wreck the denominator and greatly reduce the value of a distant payoff. That high denominator, by the way, was what drove price earnings ratios in the 1970s down to the single digits. Returns even a few out years were so heavily discounted that no one wanted to look that far into the future. This sort of thinking served to greatly diminish the appeal of growth stocks.

Innovative companies don't always work out. I thought about that a lot around the year 2000, when I attached a 95% probability to my belief that the investing world had lost its collective mind but reserved a 5% probability I was the one who just didn't get it. The odd thing is that some of the new model dot.coms did, in fact, contribute quite a bit to the general welfare. They made all sorts of businesses more efficient, and at the same time made basic communication for everyone cheaper, faster, and better. This is presumably a good thing. In the end, however, it didn't work out well for shareholders who held on long term.

But there's another question. Did their temporarily outrageous valuations represent a magical mechanism for pulling forward a proper reward for founders and the most nimble shareholders despite the fact that the companies themselves were destined to never ultimately earn any money? In a just version of Adam Smith's invisible handsome reward was certainly owed to the founders and early owners who contributed so much to human well being but the mechanism by which they received it is somewhat murky,

So what if that deferred payoff never comes?

Schopenhauer asked a similar question in his Studies in Pessimism, except that he asked it about death, not a sudden gush of cash flow. Calm down, Schopenhauer argued. Why fear death? If you knew it wasn't the end of things, that you would wake up tomorrow morning feeling fine, you wouldn't worry about it much. What about waking up next week? What about next year? What about five or ten years out? What about a thousand years before you wake up? Ten thousand? What about... never? Would it make a difference?

Schopenhauer's courage in the face of non-being is reflected in the large number of investors who seem unworried about the possible absence of cash returns many years into the future. Once you take the Schopenhauer premise, it doesn't matter if the payoff never arrives. The stock is going up today in anticipation of it. That's all that really matters. Shareholders are happy. You can always cash out at your convenience. What is the future anyway but a dwindling infinite series?

It's really more like heaven than death. Both of my grandmothers believed strongly in its existence, although I can't imagine what they really thought it would be like. It probably didn't matter. In both cases, it sustained them over the course of long and productive lives which they lived with great confidence of a wonderful if not precisely defined eternity. Ignorance was bliss.

A business is its customers. Is it as simple as that? The value of a business is the value of the services provided to its present and prospective customers discounted for the distance in time to monetization of those customers but discounted to reflect the possibility of various things that could happen to reduce or wipe out that future payoff. Both new and rapid growth businesses generally defer that payout further into the future than most businesses, especially if the discounting factor is relatively low.

This model produces huge winners and abject losers. We marvel at the winners when we see them without considering survivor bias. We discard the losers even if they have played a major part in the evolution of the economic world and traded at high prices in optimistic moments along the way. In retrospect we wonder why they once traded at such high prices.

In very young industries such as biotechs, the outcome often leaves losers by the way side and rewards just one or two competitors. One way of thinking about this is that at the outset many such companies own a similar probability of surviving but one or two end up "owning" most of the customers and the cash flow bonanza that will eventually come with them. The probability of winning gradually shrinks for most but rises for the winners. For that reason, my daughter's approach of buying a basket of these companies is probably the best way for investors to participate.

This approach may also be very helpful in evaluating growth companies which are not new but remain at some distance from giving investors serious cash rewards. Here the method for selecting a basket of winners draws upon the kind of broad-brush estimates and calculations used in selecting a basket of small biotechs. If looking closely at Amazon, Tesla, and Netflix doesn't help much, it's important to make and constantly update estimates bearing upon the scale and strength of their "ownership" of customers as well as rough estimates of risks. This broad and approximate approach is how Adam Smith would probably have looked at valuation of companies if he was as interested in profits as we sometimes assume him to have been.

Disclosure: I am/we are long JNJ, BDX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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How Adam Smith Might Have Valued Amazon, Netflix, Tesla, And Tiny Biotechs - Seeking Alpha

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