Valuation of digital transformation

Published December 16, 2021, 5:36 AM

by Reynaldo C. Lugtu, Jr.

Which of the following would be more valuable to the organization: (1) investing in a new e-commerce site or (2) investing in some automation software that could improve the company’s procurement processes?

This is a question I pose to business leaders when they pursue digital transformation. The common answer is investing in a new e-commerce platform because it is revenue generating. In fact, this was supported by a 2020 study commissioned by Epson which revealed that nearly three quarters (74%) of the respondents have embarked on the digital transformation journey that mainly focused on the marketing and sales as well as customer interaction and servicing parts of their businesses.

This is the problem when business executives evaluate the impact of digital transformation. In a 2018 McKinsey survey of 1,733 managers pursuing digital initiatives, only 14 percent of them managers said they had realized significant performance improvements from these efforts, and only 3 percent said they had successfully sustained any changes.

Executives often argue that such digital-investment decisions can be difficult to evaluate because the benefits from these initiatives often do not materialize right away and can have front-loaded or “shadow costs”—because of, say, building a new digital business while maintaining the core business. Another reason, as highlighted by McKinsey, is that proposed digital initiatives cannot be meaning­fully compared against “traditional” ones.

So how can we evaluate the financial impact of digital transformation and its attendant digital projects? The trick is to assess digital initiatives based on the cash flows they generate. But getting the right base case is crucial.

Just like any investment decision, digital initiatives should be analyzed against an alternative course of action; and for digital projects, the alternative may be to do nothing.A do-nothing scenario may not mean net-zero change; but may lead to a steady or accelerated erosion of value.

Therefore, the base case of doing nothing is not stable profits and cash flows, but the decline in profits and cash flows. There may be other intangible effects including decline in reputation and brand image.

This is why building a realistic base case can provide the data needed to evaluate the potential impact of a digital strategy or initiative. But this is easier said than done. Optimism and overestimation bias may come into play.

Take the curious case of two initial public offerings (IPOs) in the US in 2017, as mentioned in Applicoinc.com.

Blue Apron, a tech-enabled fresh ingredient and recipe delivery service, was considered a tech company while private, raising money as a start-up from Silicon Valley venture capitalists at valuations that were typical for other tech companies and receiving lots of hype and praise from the traditional tech press.But when Blue Apron IPO’d in 2017, the company traded at a revenue multiple of about 1, with a market cap just under $1 billion dollars. Rather than being valued like a tech company, it turns out that public markets value the company much the same way they would a typical chain of grocery stores. Blue Apron is a grocery store with a tech enabled user interface and delivery mechanism.

On the other hand, CarGurus, an automotive research and shopping website that assists users in comparing local listings for used and new cars and contacting sellers, was valued at a revenue multiple greater than ten in 2017. Its revenue was about $143 million for the first half of 2017, compared to Blue Apron’s nearly $500 million.

What’s the difference? CarGurus is a platform – a new business model call product marketplace, whereas Blue Apron is a grocery store with a tech enabled user interface and delivery mechanism.

This tale presents two digital initiatives that require different approaches to valuation.

First 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. This is where we apply an honest base case and a full range of cash-flow scenarios, to meaningfully compare digital initiatives against other investments that may be competing for scarce resources.

The second is the application of digital tools and technologies to fundamentally disrupt an industry, requiring a major revamp of a company’s business model which may even cannibalize the company’s core strengths. This is where we start from the future when evaluating the digital initiatives, rather than the present where markets may not exist yet. New business models look at the fundamental economics of the business, but also consider whether the new digital business will engender network effects.

So, the valuation of digital transformation initiatives not only require fundamental business case analysis but also a keen understanding of new business models. As there is much talk about the need to create new business models during this time of the pandemic, educating yourself on the differences in digital technologies and digital transformation initiatives will come in handy.

The author is the Founder &CEO of Hungry Workhorse Consulting, a digital and culture transformation consulting firm. He is the Chairman of the Information and Communication Technology Committee of the FinancialExecutives Institute of the Philippines (FINEX). He is a Fellow at the US-based Institute for Digital Transformation.He teaches strategic management in the MBA Program of De La Salle University. The author may be emailed at [email protected]

 
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