Assessing the Value of Digital Transformation

The following post is an answer to a question recently asked in my Quora session: “What role does digital transformation have on a company and its value?” To read all of my answers, visit the session here.

The concept of digital transformation is fuzzy, to say the least. When some of my colleagues examined how consumer packaged-goods companies define the term, they found at least 33 types of digital initiatives fell under its umbrella, including digital marketing, optimization of trade spending, predictive maintenance, and robotic process automation in the back office.

When assessing digital opportunities, my advice is to go back to the fundamentals: evaluate projects based on the cash flow they are expected to generate. All investment decisions should be compared to an alternative course of action. For digital projects, the alternative may be to do nothing. But the do-nothing case doesn’t mean zero cash flow. In fact, the do-nothing case is often the key to estimating the value of a digital project. 

Banks have faced this challenge several times. In the 1970s and 1980s, they introduced automated teller machines. In the 2000s, they set up online banking. In the 2010s, they developed mobile-banking apps. It seems obvious that banks needed to introduce all of these innovations—but these investments probably didn’t generate new revenues, because customers came to expect them as core services. This is where the importance of the base case comes in. If the bank doesn’t build a mobile app, it will likely lose market share and revenue over time. In this case, the cash inflows are the avoidance of lost revenues, which could be substantial.

When assessing digital opportunities, go back to the fundamentals: evaluate projects based on the cash flow they are expected to generate

To analyze the potential impact of digital transformation, we typically look at two categories of projects. The first is the application of digital technologies to fundamentally disrupt an industry, requiring a major revamping of a company’s business model. Consider how the Internet changed consumers’ approach to the research and purchasing of airline tickets and hotel rooms, disintermediating many traditional travel agents. To value such new businesses, use the standard discounted cash flow approach (you can find a detailed explanation in my book, Valuation). The fact that these businesses are often growing rapidly and don’t earn profits early on does not affect the valuation approach. With high-growth companies, you must start in the future to estimate revenues when the market begins to stabilize (see my earlier blog on valuing unicorns. You also have to estimate the return on invested capital (ROIC) based on an assessment of the fundamental economics. Once you have developed a profile of the company as it gets closer to maturity, you can estimate the cash flows between now and then.

The second, less dramatic kind of digital transformation entails companies using digital solutions to simply do the things they already do, only better. These types of initiatives fall into four groups:

Cost reduction. Understanding the economics of cost reduction is not as straightforward as it may seem. You also must examine the second-order effects. Are your competitors pursuing the same initiatives? If so, the present value of the cost-reduction efforts appears to be zero because the savings are passed on to customers. Here, the alternative case becomes important: If you don’t pursue digital initiatives to reduce costs, you will still have to reduce your prices in line with your competitors. The alternative to the digital project would be a decline in cash flows, so the present value of the initiative may turn positive.

Improved customer service. As is the case with reducing costs, it is critical to think through the competitive effects. Does the improved customer service lead to higher market share because your service draws customers away from competitors? Or does it merely maintain your market share or avoids the loss of market share because your competitors are doing the same thing?

New revenue sources. Many companies have been able to generate new revenues through digital initiatives. As just one example, an ice cream company in the United Kingdom has set up centralized freezers where a delivery firm picks up the ice cream and delivers it to customers. These centralized freezers generate ten times the sales volume of convenience store freezers.

Better decision-making. Some executives are using advanced analytics techniques to improve the quality of their decisions. For example, a maker of high-tech hardware implemented an automated solution to improve pricing for thousands of product configurations, with weekly updates of up to 200,000 price points for 20,000 products.

It matters what type of digital transformation you undertake. Creating an entirely new business model and improving current operations have very different implications. To understand the value of each initiative, examine its economics based on cash flows, with special consideration for what would happen if you don’t pursue it.

I’m a core leader of McKinsey and Co.’s Strategy and Corporate Finance practice. To learn more about the impact of coronavirus on a company’s value, check out my book Valuation: Measuring and Managing the Value of Companies, 7th Edition, co-authored with Marc Goedhart and David Wessels. You can order your copy here.

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