value in a digital world: dealing with innovation*

and January 22, 2018

The fast development and adoption of new technologies such as social media, mobile, cloud, the internet of things, artificial intelligence or 3-D printing is creating new human and business development opportunities. Digital revolution has reached a scale and level of impact that no business, industry, or government can ignore. The future of countries, business, and individuals will depend more than ever on whether they embrace digital technologies. These days, every company either is or must become a digital organization if it wants to survive and grow in the age of platforms and networks. Consequently, there has been a boom in acquisitions and restructuring in companies related to digital business. In some cases, one of the most controversial issues has been the rationality of the economic valuation of these operations, reflected in the final price. For example, the acquisition of WhatsApp for $19bn or the Snapchat IPO valuation of $25bn, to mention a few. This article intends to shed some light on this topic.

Consider this fact. A decade ago, the five most valuable companies on the Standard & Poor’s 500 Index were Exxon, GE, Microsoft, Gazprom, and Citigroup. Today, the ranking has radically changed. The index’s top five most valuable companies are in tech: Apple, Alphabet (parent company of Google), Amazon, Microsoft, and Facebook. This is certainly a new time and place—one dominated increasingly by horizontal digital platforms, virtual networks, and big data that span traditional industry verticals. And new companies such as Facebook, LinkedIn, Uber, and Airbnb have sprung up to take advantage of today’s new opportunity—to build horizontal platforms that leverage the assets of you and me and what we have (cars and homes), do (drive), and know (friends).

On the other hand, it is well known that in order to survive, any business—digital or not—needs to be economically sustainable. Economic sustainability implies to be economically feasible and profitable. It also implies to create economic value. And it is well known that for any business, the normal way to create economic value is to invest in assets that generate it.

So, valuation matters.

types of innovation

To cope with the digital revolution, innovation is needed more than ever. Companies need to constantly innovate to keep pace with ever-changing consumer demand. New product and service innovations can be categorized in three levels:

sustaining innovation

Also called incremental innovation, it represents small, yet significant improvements or upgrades to add or sustain value to existing products, services, and processes. Examples include a new version of a smartphone, new flavors, packaging improvements, and just-in-time or lean supply chain improvements. Most companies use incremental innovation to improve an existing product’s development efficiency, productivity, competitive differentiation, and to help maintain or improve a product’s market position.

breakthrough innovation

These are innovations that give consumers something unique or state-of-the-art technologically advanced. This innovation creates a significant competitive advantage for a while, but in a world of increasingly global competition, the advantage period is becoming shorter which requires constant breakthrough innovation. Examples of breakthrough innovations harnessing a new technology include the first iPod, the first iPhone, or Dyson, the world’s first bagless vacuum cleaner. Examples of breakthrough innovations harnessing a new business model include Microsoft Office 365, InnoCentive crowdsourcing model, and Zipcar business model.

radical innovation

Also called disruptive or transformational innovation, is an invention or change that has not been seen before that creates a new industry and transforms our society and life. This kind of innovation disrupts current markets, transforms the value proposition, and often eliminates existing industries or, at a minimum, totally transforms them. It involves harnessing new technology and a new business model simultaneously and as such, radical innovation is rare. When successfully accomplished, it typically provides vast benefits for society and business world. However, it also comes with a high degree of risk of resistance and failure. Examples include the telephone, automobile, television, microprocessor, and Internet. We can summarize these types of innovation as follows:

  • In sustaining/incremental innovation, we are dealing with an existing technology and an existing market, and the emphasis is on the development of new products and services.
  • In breakthrough innovation, we focus in new markets for some given technology and products/services.
  • In radical/disruptive innovation, we look for new technologies, new markets and the development of new products and services.

Figure 01 shows a graphical representation of these types of innovation, in relation to market and products/services development.

chart-01innovation and economic value

The classification of the company’s new products/services developments within the framework of sustaining, breakthrough, or disruptive, allows a company to develop an effective innovation portfolio by managing risks and rewards. Briefly, the typical revenue profile is:

  • sustaining: Immediately moderate, then its effects rapidly disappear.
  • breakthrough: Rapidly strong, then quickly dropping to a lower level.
  • radical: Longer gestation period leading to exponential growth.

Like any other economic model, the intrinsic approach to estimate the economic value does have limits. When we use the traditional Discounted Cash Flow (DCF) approach to estimate the economic value, we are assuming a very inflexible operational future, both in expected amounts and in timing. Expected Free Cash Flow (FCF) will occur in a deterministic future, in a given amount and in a given moment.

This lack of operational flexibility in the traditional DCF approach can lead to an underestimation of the economic value associated to some investments, especially when a business model is based on an effective management of future risks and rewards based on innovation. This is what happens in a digital world.

The higher the importance of innovation to become a survivor, the higher the importance of operational flexibility to create economic value. We can introduce the value of this operational flexibility in our traditional DCF approach in different ways:

  • Setting up different scenarios with different probabilities (probabilistic sensitivity analysis).
  • Transforming some of the variables from deterministic to probabilistic, and estimating a probabilistic economic value based on simulations.
  • Introducing the economic value of some real options associated to the business model.

Figure 02 shows the link between these valuation approaches and the innovation associated to different business models.

chart-02an example: the IPO of Snapchat

A recent example of a controversial valuation is Snapchat’s IPO valuation. Snapchat is both a mobile image messaging platform and a social network. It was launched in 2011 by former Stanford students Evan Spiegel, Bobby Murphy, and Reggie Brown, and it has over 178 million daily active users. Its primary source of revenues is advertising but it never made profits. Despite never making any profit, in March 2017, Snapchat’s parent company, Snap filed to go public with an initial price of $24 per share. Was Snapchat’s valuation at that time a huge flop?

In mid-December 2017, the price was around $14. Snapchat can be defined as a company offering incremental innovation. We can separate the price of its share in two components: the price coming from a traditional valuation based on DCF, and the price which should come from a valuation based on real options (RO) and probabilistic
cash flows.

Our estimation of the price based on a traditional DCF is not higher than $3 per share. As a real option, with a reasonable volatility of the underlying assets not higher than 50%, the price of the share would be around $8. Which lead us to an estimated price of around $11 per share. Any higher price would imply unreasonable assumptions, either in the traditional DCF price or in the RO component. This is consistent with the fact that, in last months, Snapchat has got only a few new users due to Facebook’s reaction, offering similar applications in Instagram and Facebook.