Valuing a Digital Transformation Project

Valuing a Digital Transformation Project

The definition of digital is fuzzy. Some view it as merely the upgraded term for what the IT function does. Others focus on digital marketing and sales, providing digital services to customers, or connecting devices. For a consumer goods company, i can identify at least 33 possibilities, including digital marketing, optimizing trade spending, improving sales force coverage, predictive maintenance, supply chain planning, and robotic process automation in the Back Office. Given the full scope of potential digital initiatives, it is no surprise that most companies are launching digital transformation projects. It’s not surprising that companies struggle with evaluating the myriad “digital” initiatives proposed. In this article, I provide my insights on valuing a Digital Transformation Project.

For valuing a digital transformation engagement, fundamental principle still applies: evaluate digital projects based on the cash flow expected to generate. While it sounds simple, getting it right requires some thoughtful strategic analysis. Ideally, all investment decisions should get examined against an alternative course of action. For digital engagements, the option may be to do zilch. But the do-nothing case doesn’t imply zero cash flows. The do-nothing or business-as-usual scenario is often the key to evaluating digital projects. 

For instance, post COVID19, brick, and mortar retailers are developing e-commerce because customers expect them. Thus, although the e-commerce project makes strategic sense, it appears to create a present negative value due to its additional costs with no added revenues. Here’s where the value of the base case comes in. If the retailer doesn’t develop the project, it will possibly lose market share and revenues. In this instance, the cash inflows are the delay of lost revenues, which could be substantial. So this project probably does have a present positive value. Ideally, the retailer would estimate market-share loss’s timing to decide on the best time to build the app. Perhaps delaying a year or two might maximize value if the retailer’s customer base isn’t clamoring yet. The retailer should also consider alternative features for the app and ways to build it. Should it start with something simple and low cost to roll out and then improve it over time? Or should it spend more upfront on a more feature-laden product? As you can see, there are many different cash flow scenarios to analyze when making this decision. 

Paths to Improved Performance 

Digital initiatives can improve a company’s performance in numerous ways. Analyzing the potential impact of digital helps frame the discussion as two opportunities or threats. 

The first—and the highest-profile manifestation of digital in the business press—is an application of digital tools that fundamentally disrupt an industry, requiring a major revamp of a company’s business model. The second kind of impact, less dramatic but also necessary, occurs when companies use digital to do the things they previously do, just better. Digital strategies can get applied in more mundane but also essential ways, including cost reduction, improved customer experience, new revenue sources, and better decision making. The line between the two applications can blur, such as when clothing retailers integrate their physical and online sales. The retailer is still selling clothes, but the customer’s experience has changed, and the retailer must substantially retool its business. 

New Business Models 

In some cases, digital disruption upends entire business models or creates entirely new businesses. The Internet transformed the way buyers research and buy airline tickets and hotel rooms, disintermediating many established travel agents. The start of video-streaming services has disrupted the business of conventional broadcast and cable TV channels. In some cases, digital has created enormous new businesses. Cloud computing services generated between $80 billion and $100 billion of revenues in 2019, up from less than $10 billion ten years earlier. The rise of cloud computing disrupted two other industries. First, the standardization of servers by leading players disrupted the manufacturers of mainframe and server computers. Second, it disrupted the IT services business that ran companies’ data centers. 

To evaluate these new companies, use the standard DCF approach. The fact that these businesses are usually growing fast and don’t earn profits early does not alter the valuation approach. Eventually, they will need to generate profits and cash flow and earn an attractive ROIC.

The critical point is that with high-growth companies, you must start to estimate revenues in the future when the market begins to stabilize, on the market’s potential size. It would be best if you assess ROIC based on an assessment of the business’s fundamental economics. An important consideration in estimating the ROIC of a new digital project is whether or not it will have network effects. The underlying concept is this: in certain situations, as a company, they can earn higher margins and return on capital because their product becomes more relevant with each new customer. In most industries, competition forces retreat to plausible levels. But in industries with network effects, competition is kept at bay by the low and decreasing unit returns by the market leader (hence the tag “winner take all”). 

For instance, Microsoft Office was the standard used by most companies. As market Office users expanded, it became attractive for new customers to use Office for specific 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 DVD or download was so low. Thus the Office became one of the most profitable products of all time. Even such a successful package may get disrupted by competition as office computing moves to the cloud. Such network effects are not the usual case. 

Valuing A Digital Transformation Project

More exceptional investors again may have gone overboard with the number of “unicorns,” typically defined as start-up companies with values above $1 billion (usually still private) and negative profits. In 2019, as some unicorns went public or tried to, there was a renewed realization that not all these companies could earn extraordinary returns from network effects, and values fell considerably. It’s unlikely that companies offering analytics services, selling e-cigarettes, or renting out short-term office space will achieve long-term network effects. 

Cost Reduction 

Many digital initiatives can help companies reduce their operating costs. Predictive maintenance of factory equipment reduces both maintenance costs and lost production from downtime. Another example is the grandly named robotic process automation (RPA). RPA doesn’t refer to physical robots, but rather to software that automates processes like accounts-payable processing. As these robots become more sophisticated, they can take on even more difficult tasks, handling exceptions in addition to plain-vanilla accounts payable. 

The economics of cost reduction is not simple. You might get tempted to estimate the present value by simply discounting the expected savings and subtracting the investments required. But it would help if you also examined the second-order effects. Are your competitors pursuing the same initiatives? In a competitive industry like the chemicals business, those cost reductions might get passed through to customers as price reductions. In a situation like this, where the present value of cost reduction efforts is zero because the gains get transferred to customers, the alternative case becomes essential. If your competitors are pursuing digital initiatives to reduce costs and you are not, then you need to reduce your prices in line with your competitors. The alternative to digital action would decline in cash flows due to lower prices without decreasing costs. Therefore the present value of the initiative may become positive again once you compare your work to the right base case. In practice, whether the savings get passed on to customers will vary by industry, but it’s critical to think carefully through the alternative situation. 

Improved Customer Experience 

Consumers have benefited tremendously from the digital actions of companies serving them. Many retailers have -become “omnichannel,” giving consumers a high degree of flexibility. -Consumers can purchase an item of clothing in a store or online, to get shipped to the buyer’s home or a local store. 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 customer experience can add value to the business in a variety of ways. 

As is the case with applying digital solutions to reduce costs, it’s critical to think through the competitive effects of investing in digital to gain a superior customer experience. Does the improved customer service lead to a higher market share because your customer service is better than your competitors? Or does it maintain your market share or avoid losing market share because your competitors are doing the same thing? In many situations, customers expect improved customer experience and are unwilling to pay extra for it. The cost to ship online orders often makes these sales unprofitable, while in-store purchases may be declining, leading to lower margins due to higher fixed costs. Even so, retailers have no choice but to provide the omnichannel services despite lower profitability. If they don’t, they’ll lose even more revenues and profits.

Better Decision Making 

Finally, some executives pair the trove of data generated and new advanced analytics techniques to enable managers to make better decisions about a broad range of activities, including how they fund marketing, utilize assets, and retain customers. Advanced analytics to improve decision making can generate additional revenues, reduce costs, or both. In many cases, the benefits may get diluted because competitors take similar actions, but the investment in analytics still may create value by maintaining competitive parity. 

Closing Thoughts 

As executives and investors alike grapple with understanding the competitive implications of digital technologies in all their forms, it bears remembering that these topics and the management responses to them will likely be fluid for some time to come. As new as these topics may seem, existing valuation principles can help with framing initial responses and surfacing techniques for dealing with such challenges as they evolve. Companies will also do well if they concentrate on the specific areas that will have the most significant impact on the factors that create value.

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