Global Trend

Given the prevailing fuzzy definitions of the term “digital,” it is not surprising that business leaders are often unsure how to evaluate the myriad technology-enabled initiatives being proposed to them and determine how much value they may create. In a 2018 McKinsey & Company survey of 1,733 managers, about 80% 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 those benefits.

Like the McKinsey consultants, the Trends editors find that this inability to identify and measure sustainable competitive advantage typically occurs because companies lose sight of the business fundamentals when seeking to achieve digital transformation.   These business fundamentals simply involve, evaluating digital projects and strategies based on the cash flows they are expected to generate and comparing those to realistic “do nothing” base-case scenarios. 

In the case of digital projects, the do-nothing case may not mean net-zero change; it typically means 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 real “base case” over the relevant time horizon 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.”

Unfortunately, for reasons of psychological comfort and even self-preservation, business leaders are typically reluctant to build and share business-as-usual projections that show declines in profits and cash flows. Yet such declines are what most often happens when companies avoid change. Companies must be realistic about the potential for declining base cases. And, 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.

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. They 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.

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 most traditional travel agents; it was 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. As a result, cloud computing itself has become an enormous business with $150 billion spent on cloud services and infrastructure during the first half of 2019, alone. 

To value these new opportunities, business leaders should use the standard discounted cash flow (or DCF) 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. 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 eventually 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 (creating a “winner take all” environment) and the inconvenience to customers of switching to new suppliers (called 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, an 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.

On the other hand, 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 how efficiently their 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.

However, this 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.

Notably, 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 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. Furthermore, 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 a 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?

Beyond cost-saving and enhanced customer experience, 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.

Finally, companies are increasingly recognizing that some of the most exciting opportunities for gaining digital competitive advantage relate to better decision making.  That is, 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.

McKinsey cites the case of a consumer packaged goods company.  The company was able to reduce the number of people required to design planograms. A planogram is a model of how a consumer packaged goods 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 the performance.

The investment in advanced analytics also helped the company increase total customer spending on its merchandise 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.  This is highly desirable as benefits may be diluted because competitors take similar actions; but even in those cases, the investment in analytics still may create value by maintaining competitive parity.

What’s the bottom line?

With the proliferation of cutting-edge technologies, executives must avoid getting too caught up in discussions about how technologies work.  In the process, they lose sight of how the specific solution can impact cashflow across time.  They inevitably find that the time-tested principles of project evaluation and selection still apply.

Given this trend, we offer the following forecasts for your consideration.

First, in the 2020s, the base-case scenario for a company’s business will increasingly take into account portions of the digital value chain that go beyond its own walls.  

For at least two decades, companies have devoted a great deal of effort to supply chain optimization. In fact, the increasing vulnerabilities of extended global supply chains have become a significant factor driving “reshoring.” Increasingly, the ability to share data with peers as well as upstream and downstream partners, including consumers, will become a competitive factor.  Some of this capability will hinge on technology, but far more will depend on relationships.  In any case, trends that impact a company’s access to data and its ability to effectively use that data will determine where the business is headed.  

Second, individual companies will find it difficult to capture value from some of the most radically important digital opportunities impacting consumers. 

Consider an idea we discussed earlier: sharing real-time context data among nearby autonomous automobiles.  This will greatly improve safety while reducing commute times and fuel costs.  However, to make it truly valuable, all vehicles will need to have this feature, thus eliminating the competitive advantage for the innovator.   Such opportunities are likely to be pioneered by component manufacturers and regulators for whom improving the entire “competitive eco-system” is a win.  And,

Third, even as the Fifth Techno-Economic Revolution creates an amazing new world of possibilities, the fundamental rules of business valuation will remain unchanged.  

Just like the laws of physics, the laws of finance are immutable. Time horizons, hurdle rates, and cash-flow assumptions are the key variables.  As before, boardrooms will bear witness to many "experts" who’ll say “it’s different this time.”  But, they will all be wrong!

References

1. McKinsey Quarterly. October 20, 2020.Liz Ericson and Tim Koller. Why ‘digital’ is no different when it comes to valuation.

2. McKinsey Quarterly. October 2018.Hortense de la Boutetière, Alberto Montagner, and Angelika Reich.  Unlocking success in digital Transformations.

3. McKinsey Quarterly. April 24, 2019. Five moves to make during a digital transformation.

4. Measuring and Managing the Value of Companies. Tim Koller, Mark Goedhart and McKinsey & Company, Inc.  (New York, NY; Wiley Finance)