Innovation, Value and Digital Enterprises

By Francisco J López Lubian

Recently, I have been invited to participate in the SAP CFO Summit in NYC as the keynote speaker, where I had the opportunity to discuss the role of the finance department in a digital economy with more than 30 CFOs from American companies. A recurrent issue was how to value the intangible assets associated to the digital world.

Everybody agreed: digital world matters and valuation matters.But do we know how to properly match digital world and valuation? Not always, according to recent experiences of digital enterprises in financial markets.

For example, let’s consider the IPO of Farfetch, the online giant of personal luxury goods. In its market debut on September 21^st, 2018, the price of the shares jumped to $27, with an intraday high of $30.6. One month later, the price was at $20.

Another case is the IPO of Snapchat, the company founded in 2011 by three Stanford students. In March 2017, the company launched an IPO with great expectations from the market. With an accounting value of $1.3 billion, a negative EBIT ($0.5 billion) and a negative Free Cash Flow (FCF) of $1.1 billion, Snapchat was valued at $20 billion, with a share price of $24. Just a few days after the IPO, the price of the share reached a peak of $29. Since then, the price started a continuous decline and, in October 2018, the share traded below $7.

This volatility in prices is not always related to declining values. On April 3^rd, 2018, Spotify launched a direct listing at a price per share of $165.9. Next day, the price closed at $140. On July 27^th, the price reached a peak of $195.7. And in late October 2018, the price went back to $155.

Something similar happened with another big tech IPO in 2018: Dropbox. With an initial price of $21 on March 22^nd, 2018, the price soared to $28.5 the next day. It reached a peak of $42.0 on June 18^th, and in late October the price was at around $24.

A similar trend can be found in operations of M&A. On October 28^th, 2018, IBM announced the acquisition of Red Hat to create a leading hybrid and multicloud provider. Nobody questioned the strategic rationale for this acquisition. A different issue was the “small detail” of the price. IBM paid in cash a premium of 63% on the market price of the shares, an amount many people considered a huge overvaluation of Red Hat.

For digital companies, market prices and initial valuations seem to be playing different games.

Why? Are digital companies living in a different world than the one assumed in traditional valuation methods? Are these traditional methods still valid to catch the economic value reflected in a digital world?  How can we know whether a market price of a digital company is a reasonable price?  How can digital companies be valued?

Since both digital world and valuation matter, it also matters to have reasonable answers to these questions. Let’s try shedding some light on these issues.

Innovation and digital world

To cope with the digital revolution, innovation is needed more than ever. Companies need to constantly innovate to keep pace with ever-changing consumer expectations. Innovation implies investment to be able to offer new products and services, using existing technologies or developing new ones.

These investments can be developed in-house and/or through the acquisition of existing companies. In any case, like in any investment decision, their economic sustainability needs to be analysed correctly. Economic sustainability implies economic feasibility and economic profitability as a way to create economic value.

In summary: in a digital world, innovation is crucial to survive and implies investments which need to be valued. To estimate a reasonable economic value, it is crucial to focus on valuation. Since we want to estimate reasonable values associated to innovation, let’s start by focusing on innovation.

The innovation map

Innovation is vital for any company in order to survive. But what do we mean by innovation? Do we have different types of innovation?

Any innovation includes three elements:

1. New products/services
2. New markets
3. New technologies

Based on these factors, we can categorize different types of innovations, as follows:

1. Incremental innovation: the emphasis is put on the development of new products/services, for existing markets and a given technology. For example, new versions of existing products.
2. Breakthrough innovation: the emphasis is placed on the development of new markets, for existing products/services and a given technology. For example, the extension of Fintech to Healthtech.
3. Disruptive innovation: the emphasis is laid on the development of new technologies, which generate new services/products and new markets. For example, the Internet.

Following these categories, any company can determine its innovation map, relating business and innovation, as shown in Figure 1.

Figure 1: The Innovation Map

Note that:

1. This innovation map can be applied to the present situation and/or a future (expected) situation, including one or different business.
2. The innovation map changes with time and market circumstances.
3. Types of innovation also change with time and market circumstances.
4. Disruptive innovation implies the development of new technologies.
5. Breakthrough and incremental innovations become disruptive by developing new technologies.

The innovation map can become a powerful tool to analyze and develop business strategies.

Linking Economic Value and Innovation

After focusing innovation, let’s examine some issues about economic value. Are traditional valuation models still valid to estimate the economic value of innovation?

As known, there are two ways to measure economic value. First, the extrinsic economic value, which is the economic value derived from what the market dictates. Second, the intrinsic economic value, where we try to determine the economic value based on business plans.

In terms of extrinsic (relative) economic value, the question is whether we have any reasonable comparable company which reflects the new situation we want to evaluate. How can we know if the extrinsic economic value is reasonable? By being convinced that the capital market is not over-/undervalued (for public companies) and by using information of companies, multiples and transactions which are comparable with the company we want to evaluate (in the case of private companies). Of course, the higher the degree of disruption in the innovation, the lower the probability of finding a useful comparable.

In terms of intrinsic (fundamental) economic value, the lack of operational flexibility in the traditional Discounted Cash Flow (DCF) approach can lead to an underestimation of the economic value associated with some investments, especially when a business model is based on the effective management of future risks and rewards based on innovation.

Operational flexibility reflects the fact that the future is not deterministic, as assumed in a traditional DCF approach, but probabilistic and open to different alternatives.

This is what happens in a digital world. In this case, the higher the degree of disruption in the expected innovation, the higher the importance of operational flexibility to create economic value.

How can we introduce the value of this operational flexibility in the traditional way (DCF) to measure economic value?

Basically, by^[1]:

1. Setting up different scenarios with different probabilities (probabilistic sensitivity analysis).
2. Transforming some of the variables from deterministic to probabilistic and forecasting a probabilistic DCF value based on simulations (like MonteCarlo).
3. Introducing the economic value of real options associated to the business model.

Keeping these facts in mind, we can determine how to link these valuation approaches to the innovation map, as shown in Figure 2.

Figure 2: The Innovation Map and Valuation

Therefore, in order to capture the expected economic value coming from innovation, we need to compute the economic value estimated through a traditional analysis of DCF in a situation of continuity, adding up a reasonable estimated value due to the operational flexibility.

^[1] See “Principles of Corporate Finance” Brealey, Myers & Allen. Mc Graw-Hill, 2015.