Understanding Network Effect and Moats

While many companies chase trends, a select few build enduring dominance through a powerful, self-perpetuating force: the network effect. 

 But what exactly is this competitive advantage? A network effect is when the value of a product or service increases for both new and existing users as more customers join the network. These effects are about retention and defensibility, which are core factors in establishing moats.  

Morningstar’s Network Effect Moat Source report examines the concept of network effect and explains how it creates durable economic moats that are difficult for competitors to overcome. When network effects occur, they foster loyalty and reduce customer acquisition costs, paving the way for long-term profitability and sustainable competitive advantages. 

Being able to identify companies with this advantage is crucial when making decisions about client portfolio construction. Understand the different types of network effects, identify the key metrics for a proper network strength analysis, and get real-world examples of companies that have developed this competitive advantage.  

Download the full report here.  

Unlike traditional supply-side economies that focus on cost reduction through volume, the network effect is driven by demand. The value of the network can increase exponentially as the user base grows, while costs increase only linearly.

To better understand what a network effect is, it’s also helpful to know what it is not.  

A network effect is not when a product or service goes viral. Take for example the game Angry Birds which did grow quickly in popularity. Angry Birds grew fast but didn’t necessarily increase in value with each new user.  

The effect is also not the same as having a large user base without profitability. Twitter had a large user base but was never able to translate that into profitability. A network must be able to monetize its user base to qualify as a network effect moat source. 

Achieving critical mass is also essential to a network effect. Think back to the days of MySpace, one of the first social media platforms. A network must reach a point where its value exceeds that of the standalone product and competitors' offerings, which MySpace did not.

There are several different types of network effects which include:

A direct network effect occurs when an increased number of users directly adds value to all other users. The users are typically homogenous. 

A real-life example of this type of effect would be social networks and messaging apps like WhatsApp, where the service becomes more valuable as more contacts join the network.

An indirect network effect occurs when the value of the network increases for one type of user as another type of user joins, who then increase the network’s value further, attracting more users and creating a  flywheel.

The indirect effect often uses data to improve the product for everyone. For example, CrowdStrike uses data from one customer's security signals to improve threat detection for all customers.

Another type of network effect is the two-sided marketplace in which two distinct groups are connected, and the value for one group increases with the number of users in the other group. The advantages of this network include both direct and indirect effects. 

Uber and Lyft are both examples of e-commerce sites where more sellers (drivers) attract more buyers (riders) and vice versa. However, not all marketplaces are equal. 

For some, like Uber, the value of adding more supply(drivers) diminishes after a certain point (such as shorter wait times), which can weaken the network effect.

To determine if a network effect is strong, you must analyze specific user growth trends and engagement metrics. These include: 

• Acquisition: The ratio of organic versus paid users should increase over time, and paid customer acquisition costs should trend downward.  

• Engagement: User retention cohorts should improve over time, and "power user" curves should show an increasing number of highly engaged users.  

• Marketplace: It should take a shorter amount of time to match buyers and sellers—high match rates along with a more fragmented supply and demand base should also be present. 

• Economic: The company should demonstrate increasing pricing power through monetization efforts, like listings or subscription fees, and improving unit economics over time. 

The strength of the network, combined with the presence of other moat sources—including switching costs or intangible assets—determines whether a company earns a narrow or wide moat rating. 

Let's compare two popular websites in the online travel industry to better illustrate the relationship between network effect and moat rating.  

For example, Booking.com “owns” its inventory and has strong direct traffic and user retention—earning a wide moat.  

On the other hand, TripAdvisor operates as a metasearch platform with little supplier stickiness, making it vulnerable to competition. TripAdvisor has no moat. 

Another comparison can be made in the e-commerce space, though the businesses themselves are quite different.  

MercadoLibre, an online free marketplace dedicated to e-commerce and auctions, successfully demonstrated its network's value through increasing user engagement and building a complementary payments network. This company has a wide moat. 

Lyft, however, failed to achieve the critical mass or engagement levels of its competitor, Uber, demonstrating that a marketplace alone does not guarantee a network effect. Lyft has no moat.

The network effect is one of the most powerful competitive advantages a business can build. 

Companies that successfully cultivate this effect are positioned for long-term market leadership.  

By understanding the different types of network effects and performing a rigorous network strength analysis, you can identify companies with truly sustainable competitive advantages. These companies could be attractive opportunities to consider when making decisions about client portfolio construction. 

To help you identify and analyze companies with strong network effects, visit Morningstar Direct.