Why ‘digital’ is no different when it comes to valuation

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Whether tech-enabled or old-school, proposed projects and initiatives need to be assessed according to the cash flows they generate. The trick is getting the base case right.

Ask any dozen business leaders how they define “digital,” and you will probably get just as many different answers. For some, digital is just an upgraded term for what their IT function does. For others, digital refers to the use of online tools and technologies to make process changes, or performance improvements, or to pursue organizational transformation. For still others, it’s an excuse to question the how and the why of their core business.

Our colleagues examined how a typical consumer-packaged-goods (CPG) company defined the term and identified at least 33 types of digital initiatives—digital marketing, optimization of sales-force coverage, predictive maintenance, supply-chain planning, and robotic process automation in the back office, to name a few.

Given the prevailing fuzzy definition of digital, it is not surprising that business leaders are often unsure how to evaluate the myriad technology-enabled initiatives being proposed to them and how much value they may create. In a 2018 survey of 1,733 managers, about eight in ten said their organizations were pursuing digital initiatives. But only 14 percent of the managers said they had realized significant performance improvements from these efforts, and only 3 percent said they had successfully sustained any changes.

Our advice to these business leaders? Don’t get tripped up by digital labels. Follow the same principles that apply to all investment decisions. That is, evaluate digital projects and strategies based on the cash flows they are expected to gen­erate, making sure to factor in “do nothing” or base-case scenarios as well as the overarching objectives of the digital project or strategy being proposed.

While that approach sounds simple, getting it right requires some thoughtful strategic analysis.

Don’t skip the base case

Which of the following (if either) would be more valu­able to the organization: investing in a new e-commerce site or investing in some automation software that could improve the company’s procurement processes? Executives often argue that such digital-investment decisions can be difficult to make for a range of reasons, including the following:

  • The benefits from these initiatives often do not materialize right away and can have front-loaded or “shadow costs”—as a result of, say, building a new digital business while maintaining the core business.
  • Proposed digital initiatives cannot be meaning­fully compared against “traditional” ones.
  • The value of a specific feature (interest-free credit, for example) can be difficult to disentangle from its context.
  • The link back to the core business decision underpinning the digital strategy or initiative is obfuscated.
  • Executives are wary of experiencing “death by 1,000 pilots that do not scale.”

The decision-making default, then, has been to lean in on those opportunities where, for instance, the potential improvements seem to be most visible or where the project owners are shouting the loudest. As the impact metrics shared earlier reveal, this approach creates uneven results.

Ideally, all investment decisions should be analyzed against an alternative course of action. For digital projects, the alternative may be to do nothing. But especially in the case of digital projects, the do-nothing case may not mean net-zero change; it may actually mean a steady (or accelerating) erosion of value. Consider the decision many banks have faced over the years about whether to invest in mobile-banking apps: if all of a bank’s competitors have mobile apps and the bank doesn’t invest in one, its market share will likely fall over time as it loses customers or fails to attract new ones. Therefore, the base case is not stable profits and cash flows; instead, it is a decline in profits and cash flows—along with a reputation for being a stale brand.

For reasons of comfort and even self-preservation, business leaders are often reluctant to build and share business-as-usual projections that show declines in profits and cash flows. Yet such declines are what most often happen when companies avoid change. Companies must be realistic about the potential for declining base cases. By developing an honest base case and a full range of cash-flow scenarios, business leaders can more meaningfully compare digital initiatives and strategies against other investments that may be competing for scarce resources. This approach may also prompt companies to think more strategically about how, when, and how much to invest in digital projects, given how quickly customers’ expectations are changing.

By developing an honest base case and a full range of cash-flow scenarios, business leaders can more meaningfully compare digital initiatives and strategies against other investments.

Examine potential impact from digital

Building a realistic base case can provide the data needed to vet the potential impact of a digital strategy or initiative. It is also important, however, to identify the type of impact that digital strategies and initiatives may have and frame investment discussions accordingly. There can be some overlap but companies’ digital initiatives typically fall into one of two categories.

The first category is the application of digital tools and technologies to fundamentally disrupt an industry, requiring a major revamp of a company’s business model or a spooling up of new businesses, some of which may even cannibalize the company’s core strengths. The second (less dramatic but still critical) category is when companies use digital to simply do the things they already do, only better—in service to, for instance, cost reduction, improved customer experience, new sources of revenue, and better decision making.

New business models

In some cases, the use of digital tools and technol­ogies can upend entire business models or create entirely new businesses. Look no further than the way the internet has changed the way consumers research and purchase airline tickets and hotel rooms, disintermediating many traditional travel agents—one of the original cases of industry reinvention. The introduction of video-streaming services has disrupted the economics of traditional broadcast and cable TV channels. And the rise of cloud computing not only has reshaped how compa­nies are transforming themselves but also has entirely disrupted two other industries: man­u­fac­turers of mainframe and server computers, and businesses that ran companies’ data centers. Cloud computing itself has become an enormous business: $150 billion was spent on cloud services and infrastructure over the first half of 2019.

To value these new opportunities, business leaders should use the standard discounted cash flow approach. The fact that these businesses often grow fast and do not earn profits early on should not affect the valuation approach. Investors can cer­tainly be patient at times, as Amazon saw for decades with its retail business, but digital initiatives will eventually need to generate profits and cash flow and earn an attractive return on invested capital.

With high-growth companies, business leaders must start from the future rather than the present—markets may not exist yet, so scenario planning is critical.1 A look at the fundamental economics of the business can help managers build a realistic estimate of returns, but another important consider­ation is whether the new digital business will engender network effects. That is, as companies grow, they can earn higher margins and return on capital because their product becomes more valu­able with each new customer. In most industries, competition forces returns back to reasonable levels. But in industries with network effects, competition is kept at bay by the low and decreasing unit costs of the market leader (hence the industry tag “winner take all”) and the inconvenience to customers of switching to new suppliers (the “lock-in effect”).

Companies like Amazon, Apple, and Google have leveraged their payment, single-sign-on, and connectivity products to create incremental value from each new user. Microsoft’s Office software provides another good, if tried-and-true, example of network effects. It has long been the workplace standard for word processing, creating spreadsheets, and generating graphics. As the installed base of Office users expanded, it became ever-more attrac­tive for new customers to use Office for these tasks, because they could share documents, calcu­la­tions, and images with so many others. As the customer base grew, margins were very high because the incremental cost of providing software through DVDs or downloads was so low.

Cost reduction

Many digital initiatives help companies reduce operating costs. One mining company saved more than $360 million per year from process-automation software that gave managers more insight into what exactly was happening in the field, enabling managers to make adjustments on the fly. Meanwhile, several fossil-fuel power generators learned that they could improve their plants’ heat rates (how efficiently the plants use fuel) by up to 3 percent by using sensors and actuators for remote monitoring and automated operations, and by employing smart valves that self-report and repair leakages.

Understanding the economics of cost reduction is not as straightforward as it may seem. Business leaders might be tempted to estimate present value by simply discounting the expected savings and subtracting the investments required. But business leaders must also examine the second-order effects.

In a competitive industry like chemicals, for instance, cost reductions might simply be passed through to customers as price reductions, and the present value of the chemicals company’s cost-reduction efforts would seem to be zero. But a look at the alter­native case reveals something different: if competitors are pursuing digital initiatives to reduce costs and your company is not, you will still have to reduce your prices in line with those of your competitors. The alternative to the digital initiative would be a decline in cash flows because of lower prices without reduced costs. The present value of the initiative may turn positive again once the business leader compares the initiative with the right base case.

Improved customer experience

Consumers have benefited tremendously from companies’ digital innovations, particularly regarding the purchasing experience. A customer can buy an item of clothing in a physical store or online, to be shipped to the buyer’s home, or to a local store, or to any one of thousands of pickup points. If a local store doesn’t have the right size for in-store shoppers, customers can order it on the spot and have it delivered to their homes. A cus­tomer who decides to return an item can return it to any store or mail it back, regardless of how it was purchased. Consumers can also track in real time the progress of shipments heading their way.

Using digitization to improve the customer experience can add value to the business in a variety of ways. In some cases, it can lead to reduced costs. An electricity-distribution company fully redesigned its customer interfaces in a “digital first” way that made a priority of customers’ online interactions. As a result, customer satisfaction rose 25 percentage points, employee satisfaction increased by ten percentage points, and customer-service costs fell 40 percent.

As is the case with applying digital solutions to reduce costs, it is critical to think through the competitive effects of investing in digital to gain a superior customer experience. In many situations, customers have come to expect an improved customer experience and are unwilling to pay extra for it. Meanwhile, providing omnichannel services can be expensive for retailers: the cost to ship online orders often makes these sales unprofitable, especially as shipping is expected to be free and fast (same day, in some cases). Meanwhile, in-store sales may be declining as a result of the omnichannel services, leading to lower margins, as some costs are fixed.

Even so, retailers have little choice but to provide omnichannel services despite lower profitability. If they don’t, they stand to lose even more revenues and profits. When vetting digital initiatives in this category, business leaders should ask themselves: Does the improved customer service lead to higher market share because the company’s cus­tomer service is better than that of competitors? Or does it maintain the company’s market share or avoid losing market share because competitors are doing the same thing?

In many situations, customers have come to expect an improved customer experience and are unwilling to pay extra for it.

New sources of revenue

Some companies have been able to create new revenue sources through digital initiatives. In these cases, the economic analysis versus the base case is more straightforward because, at least for a while, the company (and maybe its competitors) are making the pie bigger for the whole industry.

For instance, an ice-cream manufacturer set up centralized freezers in the United Kingdom, where a delivery company picks up the ice cream and delivers it to customers within a short time period. This service has generated more than ten times the volume of convenience-store freezers—and mostly additional sales, because without the convenient delivery, customers might simply skip the ice cream. In another case, an industrial-equipment manufacturer created a data-driven service business that collects soil samples and analyzes weather patterns to help farmers optimize crop yields. Sensors in tractors and other machinery provide data for predictive maintenance, automated sprinkler systems synchronize with weather data, and an open-software platform lets third parties build new service apps.

Such new sources of revenue can create value because they don’t involve just keeping up with the competition. In both examples, digital innovations created an overall increase in the revenue pool for the industry—even for the “same old product”—whether in overall consumption of ice cream or over­all demand for precision-farming services.

Valuation seventh edition

Valuation: Measuring and Managing the Value of Companies, 7th edition

Better decision making

Some executives are using advanced analytics to make better decisions about a broad range of business activities. Doing so can generate additional revenues, reduce costs, or both. For instance, a consumer-products company used advanced ana­lytics to improve the design of its planograms. A planogram is a model of how a CPG company allocates its limited space on retail shelves. It describes which products will be included and how to display them. The analytics program revealed to the company’s decision makers that they could dramatically improve the effectiveness of their product placements. They were able to gain these insights by continually comparing and contrasting alternative product mixes, without waiting for weeks of physical-store receipts to hint at performance.

At the same time, the company was able to reduce the number of people required to design the plano­grams from ten to just two, driving down costs.

In this case, the investment in advanced analytics helped the company increase total customer spending by getting customers to upgrade to more profitable products. And because the change involved only choices within the company’s product mix, the improvement created value without necessarily inviting a competitive response. In other cases, the benefits may be diluted because competitors take similar actions, but the investment in analytics still may create value by maintaining competitive parity.

In our experience, it’s easy for executives to get caught up in discussions about how technologies work, and then try become fluent in them—for instance, asking what knowledge graphs are, and how exactly do machines learn, and so on. More important, though, is to focus on identifying which decisions create (or destroy) the most value in their organizations and then consider the application of advanced analytics toward those discussions. The ultimate goal is to gain better insights and even prescriptive answers on how to operate.

As executives and investors seek to understand the competitive implications of digital technologies, it bears remembering that these topics and the management responses to them will likely be fluid for some time to come. It is also worth remem­bering that even when definitions seem fuzzy, the principles of valuation are not. They are steadfast and reliable, and they can help business leaders drown out the noise and distinguish value-creating opportunities from value-destroying ones.

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