Are internet domains an asset class? If so, what is the risk-return profile like?
In an effort to answer these questions, MIT researcher Thies Lindenthal has taken the very important step of creating a price index for domain names. With an index, one can benchmark. More exciting though is that this index may (like PMIs, for example) serve as a leading indicator — for internet companies like Google, that is.
Creating such an index is no easy task. The value of domain names is difficult to model and transactions, when the rights to domains are sold, are relatively infrequent.
The new pioneers
What makes one domain name more valuable than another anyway? Lindenthal invites us to draw a parallel to how real estate of the non-virtual type is valued:
Theoretically, Alonso- Muth-Mills models of urban layouts (Alonso, 1964; Mills, 1972; Muth, 1969) explain differences in land rents by differences in the distance to jobs or amenities. Applying this reasoning to domains, the price of a domain is hypothesized to depend on its ‘proximity’ to potential users. Since a voyage on the world wide web usually begins with the user entering the domain name of the desired website into her web browser, distance to the user can be seen as the effort a user is required to make to correctly remember and type a domain name. An appealing domain name like Apple.com is easy to recall and quickly entered. In this sense, an intuitive domain name is like a convenient down-town address linked to excellent transportation systems. Long or cryptic domain names are more burdensome, which is comparable to a longer commute to a location somewhere in the outskirts.
Differences in ‘location’ fuel a heated race for the shortest and most memorizable domain names…
Concerning that race for the most desirable location on the interweb, Lindenthal draws a parallel between the land rushes of 19th century America and the first-come-first-served policy of domain name registration. Thank goodness all we have to do to register a name is pay a few dollars a year rather than risk typhoid, cholera, snakebite, exhausation, a broken leg, and all those other things you can die of on Oregon Trail.
For those that do register names, this record of ownership has to be regularly renewed otherwise it reverts back to the ether. The ‘churn’ of names is largely due to such expirations, and the rest is by way of transactions between parties.
Dataset
To construct his index Lindenthal needed that transaction data, or at least a big enough pool of it that it could be representative enough of the market as a whole. What he got was access to the database of Sedo.com — the largest domain marketplace in the world when based on completed transactions.
Here’s a graph of transactions over the period of time that Lindenthal’s initial index covered (there are 200,170 in total):
Methodology
Domain names present a particular challenge when trying to construct an index of their value when one considers that no two names can be exactly the same. Furthermore:
Taking the average of transaction prices gives a first indication of price developments in the market for domains but does not control for quality differences in the domains sold. If there is a time period in which many high-quality domains are sold, the average transaction price will increase, regardless of any true trend in prices. Median based indices are less sensitive to extreme values but suffer from the same systematic shortcoming of disregarding the characteristics of the underlying transactions. Putting it differently, one is comparing apples to oranges.
To make sure one is only dealing with apples, and not any rogue citrus fruits, a methodology could be employed that only looks at repeat sales, so that it could be ascertained how much the value of a domain has gone up or down over time and construct an index purely from those.
However, that would mean just dealing with the little red bars in the above graph — too few data points. So what Lindenthal has done is use a neat trick whereby he expands the universe by separating the part of the index estimation that deals with the Second Level Domains (that’s the “apple” in www.apple.com) from that which deals with the Top Level Domain (e.g. com, net, org).
The IDNX
Here’s what the IDNX looks when plotted with the Nasdaq and US online advertising revenues:
The correlation between the series led Lindenthal to conclude:
The strong correlations of domain prices with the high tech economy and online advertisement revenues are re-assuring in two ways. First, they show that domain name buyers and sellers make economically motivated price decisions. Domain markets are not a cloud-cuckoo-land where dreamers trade esoteric goods at imaginary prices. Second, finding a link that is expected to be present based on economic reasoning confirms that the domain name index ‘makes sense’.
Here, however, is the bit we find the most exciting…
From a theoretical point of view, prices for Internet domain names should be the discounted future cash flows that can be generated by owning this domain. Domain prices are therefore forward looking, giving a indication of not only the current profits but include expectations about future opportunities as well. These expectations cover small and large Internet ventures as long as they share similar business models. This suggests that the domain name index can serve as a fever curve for the well-being of the Internet economy, considering also small enterprises that are currently excluded by stock-price based indices.
We like forward-looking indicators.
In addition to that, FT Alphaville spies a new derivative in the making.
Here’s the latest read, by the way (last datapoint for December 2011):
Tiny uptick… Google investors, this one is for you.
Related links:
IDNX homepage (pretty graphs available)
Valuable Words: Pricing Internet Domain Names – Thies Lindenthal
Could Domain Names Predict the Next Recession? – Fox Business
How Much Would You Pay For Your Next .COM? - ReadWrite Enterprise