When Facebook acquired the messaging service WhatsApp for billion in the spring of 2014, the question on everyone’s mind was, does the service really merit a valuation of almost 20 times projected revenues?
WhatApp’s valuation may be extreme, but huge gaps between revenues and valuation are increasingly common. Cloud-based sharing service Dropbox received venture capital funding at a valuation of billion, or 40 times revenues. Airbnb.com raised funding at a valuation of billion, which would make it worth nearly 20 times its revenues — and worth more than Hyatt Hotels or Wyndham Worldwide. Taxi-replacement service Uber is currently raising funding and is expected to see a valuation of billion, estimated to be more than 15 times revenues. Most recently, Alibaba’s IPO raised funds at a value approximately 10 times revenues.
These companies represent a new trend in the types of business that investors prefer. Leaders of more traditional companies are left wondering why these upstarts merit such high valuations. Are they more profitable? Do they see faster growth? Do they have higher return on assets and lower marginal costs?
Our answer is yes — to all of the above.
In collaboration with Deloitte, we examined 40 years of financial data for the S&P 500 companies to see how valuations trends have evolved along with business models and emerging technologies. Our research led to three key findings.
1. There are four business models.
To begin, we searched for a simple way to characterize the different types of business that were engaging the hearts and minds, and pocket books, of investors. Because today’s highly valued, fast growing businesses can be found in almost every industry, we quickly moved past standard industrial classifications and developed a new framework based on business model, which is the principal way an organization invests its capital to generate and capture value.
The four models are:
- Asset Builders: These companies build, develop, and lease physical assets to make, market, distribute, and sell physical things. Examples include Ford, Wal-Mart, and FedEx.
- Service Providers: These companies hire employees who provide services to customers or produce billable hours for which they charge. Examples include United Healthcare, Accenture, and JP Morgan.
- Technology Creators: These companies develop and sell intellectual property such as software, analytics, pharmaceuticals, and biotechnology. Examples include Microsoft, Oracle, and Amgen.
- Network Orchestrators. These companies create a network of peers in which the participants interact and share in the value creation. They may sell products or services, build relationships, share advice, give reviews, collaborate, co-create and more. Examples include eBay, Red Hat, and Visa, Uber, Tripadvisor, and Alibaba.
We applied this business model framework to our dataset, the S&P 500 Index companies from 1972 to present, in order to see how the four models performed over time. Two different researchers categorized each company into its dominant business model, giving consideration to several factors: The company’s description of itself in annual reports; the revenue generated by different business units; capital allocation patterns such as R&D or COGS expenditure; and market perceptions including news articles and analyst reports.
Although most companies operate in several business model categories, we assigned to each company the most advanced business model that it uses for a significant portion of its business, or that it is making strong efforts to develop. For example, although most of Nike’s business is manufacturing and selling shoes, which we classify as Asset Building, Nike has also developed the Nike+ ecosystem, which connects these physical goods to the Internet where users track activities and share progress with their friends. For this reason, we classified Nike as a Network Orchestrator.
2. Network Orchestrators create more value.
Our business model classification and analysis yielded some surprising results. Network Orchestrators outperform companies with other business models on several key dimensions. These advantages include higher valuations relative to their revenue, faster growth, and larger profit margins.
Let’s look at the numbers in detail. Our analysis indicates that as of 2013, Network Orchestrators receive valuations two to four times higher, on average, than companies with the other business models. Further, trend data over the past decade indicates that this valuation gap is widening over time. We call this degree to which a business model drives the gap between revenues and valuation “the multiplier effect.”
A company’s price to revenue ratio – what we call its “multiplier” — is calculated based on its market valuation and revenues, two numbers that are difficult to manipulate with accounting. Market valuations reflect investor expectations for future cash flows, and indeed we found that companies with the highest multipliers outperform less valued companies on revenue growth, profitability, and Return on Assets for more than a decade.
When we looked beyond the impact of business model on price-to-revenue ratio, we also found that Network Orchestrators outperform companies with other business models on both compound annual growth rate and profit margin. We believe this occurs because the value creation performed by the network on behalf of the organization reduces the company’s marginal cost, as described in Jeremy Rifkin’s The Zero Marginal Cost Society. For example, TripAdvisor.com benefits from its customer’s reviews and AirBnb leverages its network’s housing assets.
3. Few companies operate as Network Orchestrators.
Fewer than 5% of companies are Network Orchestrators despite the positive impact of this business model on multiple performance measures. Why? We see several reasons.
First, today’s network-based business models require new technologies and competencies. Most corporate leaders are skilled at building, owning, and managing their own physical assets or people. Network Orchestrators, however, rely on intangibles such as knowledge (Gerson Lehrman Group) or relationships (Facebook), or other people’s assets (Uber) as well as new “non-management” and “non-ownership” competencies related to facilitating a network of individuals and their individual assets and relationships.
Second, Generally Accepted Accounting Principles (GAAP) categorize some assets as “assets” (plant property and equipment), others as expenses (people, training, and intellectual property) and ignores others (customers, sentiment, and networks) altogether, frequently resulting in the under-allocation of capital to intangible assets. This is especially problematic given that, today, intangible assets make up approximately 80% of corporate market value.
Third, standard industry designations result in siloed thinking, leaving empty space where new business models can enter. For example, think back to the early 1990s. Most traditional retailers were slow to move into the online space because they didn’t consider themselves “technology companies.” The online market was left open, and in came a slew of new players such as Amazon, eBay, and Zappos, who gobbled up market share and changed the retail game. Today, the power of networks is creating a new cross-industry transformation. Consider what Uber and Lyft are doing to the taxi industry or how Airbnb is affecting the hotel industry.
Finally, business models are tightly integrated into all parts of a company, and are therefore daunting to change. Changing business model requires changing capital allocation, but Research by McKinsey & Company shows that most companies follow the same allocation patterns year after year, despite dramatic changes in the business environment.
These factors make it difficult for executives and board members to cash in on the value offered by new business models.
Networks are sources of information, capabilities, and assets that lie in and around every organization. Most networks, however, lie dormant and untapped. To become a Network Orchestrator and create more value and better performance, leaders must connect to and activate their networks, tapping into new sources of value, both tangible (Airbnb’s network of lodgings) and intangible (the expertise of Apple’s Developer Network). We recommend that all leaders and boards consider the steps below:
- Assess your business model. Understand which business models currently exist within your organization and also the preferences and biases of the leadership team members who have created these models through capital allocation.
- Inventory your network assets. Take stock of your dormant network assets including customers, employees, partners, suppliers, distributors, and investors, and determine which have the greatest potential.
- Reallocate your capital to networks. Divert at least 5% to 10% of investment capital to activating your networks. Take an experimental approach to early allocation and expect ongoing adaptation. This could be accomplished organically, or through acquisition or partnership.
- Add network KPIs. Add to your standard financial metrics new network-oriented indicators such as number of participants, their sentiment, and level of engagement. These KPIs will provide direction for your network adaptation.
The bottom line: begin your evolution today and create the multiplier effect in your own organization. Activate your dormant networks by reaching out to your customers, employees, partners, suppliers, employees, and investors and figure out how you can co-create value with them.
Take this assessement on digitalgrader.com to determine your business model and learn how to build and leverage your network assets.
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