Why It’s So Hard to Predict the Size of New Markets  

7 May 2019:

Every executive has two types of investment war stories. The first type is underestimating an opportunity, which leads to a “fish that got away” story like how Blockbuster could have bought Netflix. The second type is overestimating an opportunity, like how Eddie Lampert bought Sears for $11 billion only to see it land in bankruptcy over a decade later.

One would think we would be better at conducting “size of prize” analyses. But we’re not. An investment firm turned to a well-known consulting firm to size the prize for one of their portfolio companies. That consulting firm concluded the business had already realized half of the total market opportunity. The business then proceeded to double in size within a year — with no signs of slowing down. So the investment firm sought a second opinion. By looking at the opportunity through the eyes of superconsumers — the most passionate, profitable, and prescient consumers — it was clear that this company was creating a new category, not just a new product. This showed the business had only captured a tiny fraction of the opportunity. The investment firm realized they had something far more valuable.

At the core of under- or overestimation are a few common errors. The first error is confirmation bias, which every expert brings to the table. The second and third errors are “sins of omission,” which are both related to treating this as a purely theoretical math exercise. You must factor in consumer passion, otherwise the size of prize will be too low. But you must also factor in practical application (e.g., how would you actually realize the size of prize), otherwise the size of prize will be too high.

The first error of confirmation bias is unhelpfully baked into the most common approach to this task, which is finding a “comp” (or comparable example) as an analogy. Investment bankers like comps because they provide a quick shorthand at looking at potential EBITDA multiples of other transactions. This is similar to what a real estate agent does to help value your house before you sell it. But what happens when the comps chosen are single-family homes, and your property is a luxury condo that happen to be in the same zip code? When valuing businesses, this happens way more often than we realize — and it’s especially common when the company being evaluated is truly disruptive and is blurring the lines between multiple categories.

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Source: Harvard Business Review

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