The definition of digital transformation is vague and not well established. Some of my colleagues looked at consumer packaged goods and noticed at least 33 digital projects, including digital marketing, optimization of trade expenditure, optimization of sales force coverage, predictive maintenance, and robotic process automation in the back office.
My advice to businesses is to go back to the basics when assessing digital opportunities: to analyse digital ventures on the basis of the cash flow they are supposed to produce. All investment decisions should be analysed against alternate courses of action. The alternative for digital ventures could be to do nothing. But the do-nothing scenario doesn’t mean zero cash flow. In reality, do-nothing is often the key to evaluating digital ventures.
Banks have faced this obstacle a number of times. In the 1970s and 1980s, banks introduced automatic teller machines. Banks set up online banking in the 2000s. In the 2010s, banks created mobile banking applications. It seems clear that the banks wanted to incorporate all of these inventions. But these advances probably did not produce new sales, since they were anticipated by consumers. Here’s where the value of the base case comes from. If the bank does not develop a mobile app, it is likely to lose market share and sales over time. In this situation, cash inflows are intended to stop missed earnings, which may be significant.
In order to analyse the possible effects of emerging technologies, we usually look at two types of digital shifts. The first is the use of digital technology to radically change the market, requiring a significant overhaul of the business model of a company. The second type of effect, which is less drastic, happens when businesses actually use digital technology to do the things they already do, only better.
An example of where digital revolution has overturned entire business models and produced completely new industries is how the Internet has changed the way customers search and buy airline tickets and hotel rooms, disconnecting many conventional travel agents. Using the traditional discounted cash flow strategy to value these new businesses. The fact that these companies frequently grow quickly and don’t make money early does not influence the valuation approach. For high-growth businesses, you need to start estimating sales in the future as the economy starts to stabilise. You will need to estimate ROIC on the basis of a fundamental economics evaluation. Once you have built a business profile that is closer to maturity, you can predict cash flows between now and then.
Using digital simply to do what you already do, but even better, falls into four types: cost savings, enhanced customer experience, new sources of revenue, and better decision-making.
Let’s just break them down.
Reduction of costs. One mining company saved more than $360 million a year from process automation in the field, giving managers more insight into what was going on, allowing managers to make changes and predict what was required. Understanding the cost-cutting economy is not as easy as it would seem. You will need to look at the second-order impacts. Are the same policies being pursued by your competitors? If so, the current benefit of cost reduction programmes tends to be zero, as savings are passed on to consumers. This is where the alternative case becomes relevant. If you do not follow cost-cutting measures, you will always have to lower your prices in line with your rivals. The alternative to the digital initiative will be to reduce cash flows. As a result, the present value of the initiative could turn positive again.
Improved service to the client. Consumers have benefited greatly from digital technology. One of the leading manufacturers of agricultural products has developed a seamless online ordering, monitoring and query management process. This raised the company’s customer satisfaction score by 24 percentage points and improved the performance by 20 per cent. As in the case of cost reductions, it is crucial to consider the competitive results. Is enhanced customer service leading to higher market share because your customer service is better than that of your competitors? Or do you retain your market share or do you stop losing market share because your rivals are doing the same thing?
New sources of income. Some businesses have been able to generate new sources of revenue through digital initiatives. Imagine that you’re sitting at home in a hurry to get some ice cream, but don’t want to go out to the nearest grocery store. Ben & Jerry’s has set up centralised ice cream freezers in the United Kingdom, where the distribution company picks up the ice cream and delivers it to the customer within a limited period of time. These centralised freezers produce 10 times the amount of convenience store freezers.
Better decision-making. Finally, some executives are using modern sophisticated analytical methods to make smarter decisions. The manufacturer of high-tech hardware has introduced an automated approach to increase prices for thousands of product configurations, with weekly alerts of up to 200,000 price points for up to 20,000 items.