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A Corsair Valuation (NASDAQ:CRSR) – Post-IPO Update

In this blog post I take a shot at valuing Corsair (NASDAQ:CSRS) using a discounted cash flow valuation method. The calculation suggest an equity value ranging from US$1.62 to US$2.76B.

corsair logo

The Corsair Touch

Corsair Gaming Inc. is an American computer gaming components, peripherals, and systems company founded in 1994 as Corsair Microsystems by Andy Paul, John Beekley, and Don Lieberman. While originally selling processor cache and later system memory modules, soon Corsair started gravitating towards the DIY computer enthusiast market segment.

Over the past two decades Corsair has significantly diversified its product portfolio. Starting with flash memory and power supplies in 2006, Corsair is now a market leader in a wide range of product categories including computer chassis, gaming peripherals, cooling solutions, and streaming gear.

What enables Corsair to become so successful is what I’ll call the “Corsair Touch”. The Corsair Touch describes how Corsair enters a product category and finds a way to become successful. The Corsair Touch consists of a couple of key ingredients.

  1. Hire or develop experts who are technically proficient and deeply involved with the enthusiast community. The experts have a finger on the pulse when it comes to market trends. Not only can they anticipate new market trends, they also know how to integrate the new trends in future products. Corsair is rarely first to move with a new trend, but more often than not they make the right move.
  2. Enter any new market with a high-end product to win over the enthusiasts and establish a credible brand reputation. Then expand with more affordable offerings to gain market share. However, always stay clear of the low-end price-sensitive segment.
  3. Outsource most if not all manufacturing to lower-cost OEMs in Asia and avoid investing in fixed assets.
  4. Finally, leverage the world-class worldwide distribution and sales engine to push the products to the market

On August 21st, 2020, Corsair Gaming, Inc. filed its IPO prospectus with the SEC aiming to go public on the Nasdaq exchange under the symbol CRSR.

Gathering Information

There are four major value drivers to consider:

  1. Revenue, growth, and duration of growth
  2. Profitability and efficient use of assets
  3. Reinvestment in existing and growth assets
  4. Risk.

We can use the following documents to gather information about Corsair’s value drivers from 2005 to 2020:

corsair financial data

For reference I also collected data from publicly listed peers Logitech, Turtle Beach and Razer using the data service provider Finbox.

corsair comparables data

You can download the excel sheet here: https://hanweiconsulting.com/wp-content/uploads/2020/09/fcffsimpleginzu-corsair-v1.1.xlsx.

Revenue Growth

As mentioned in the opening paragraphs, Corsair has diversified its product portfolio away from the highly commoditized and volatile DRAM memory market. The company has successfully expanded into a wide range of computer components, accessories, and peripherals. You can see this expansion illustrated in a picture included in the IPO prospectus.

Between 2005 and 2010 Corsair is a nimble growth company focused on driving revenue through expanding the product portfolio and riding the organic growth of the PC DIY market. Between 2010 and 2015, the PC DIY market slows down, and Corsair identifies PC gaming as a market segment with above industry growth potential and more favorable margins.

After an unsuccessful IPO in 2010 and 2012, Corsair turns to Francisco Partners and obtains a $75 million strategic investment in the company. The investment is used to execute the growth strategy outlined in the 2010/2012 IPO prospectus:

  1. Achieve Leading Market Position in Each Product Family
  2. Increase Sales of Gaming Peripherals
  3. Leverage Our Scalable Operating and Business Model
  4. Build on Our Existing Infrastructure to Address Growing Opportunities in the Asia Pacific Region
  5. Selectively Pursue Complementary Acquisitions

In 4 years, Corsair doubled its revenue and becomes a $1 billion dollar company. Considering Corsair’s current position, it’s safe to say they absolutely succeeded in each of their strategic goals.

In 2017, Francisco Partners sold its stake in Corsair to EagleTree Capital. From the Press Release we note that the post-acquisition EagleTree aims to “[…] maintain the company’s focus on innovative products, to expand into new markets, and to pursue selective transactions”. This aligns with the growth strategy outlined in the 2020 IPO prospectus:

  1. Advance as the global leader in high-performance gaming and streaming gear.
  2. Continue to develop innovative, market-leading gaming and streaming gear.
  3. Expand into new gear and services that grow our market opportunity.
  4. Leverage our software platforms to sell more gear to existing customers.
  5. Strengthen relationships with end-users by increasing direct-to-consumer sales.
  6. Continue to grow market share globally.
  7. Selectively pursue complementary acquisitions.

The 7 strategies outlined boil down to 2 standard growth strategies: (1) organic growth through horizontal diversification, and (2) inorganic growth through M&A.

Profitability

Corsair operates a global, scalable, nimble business model utilizing the “Corsair Touch” to respond quickly to new market trends and demands. The facility in Taiwan assembles, tests, packages, and supplies the DRAM, liquid cooling products and pre-built gaming systems. All other Corsair products are produced at third-party, outsourced, factories located in China, Taiwan, and South-East Asia.

The outsourcing operations strategy allows Corsair to leverage the intense competition between suppliers and choose the best quality and best price. This helps maximize customer willingness to pay (increases price) and helps reduce cost, which combined allows Corsair to capture more value.

The DRAM business is still a significant part of Corsair’s overall business and has a big impact on profitability. DRAM is highly commoditized and operating profits are determined by volatility in market demand and supply, as well as timing of purchase. The gaming peripherals typically have a much higher gross margin in the range of 35-40% or higher.

Since 2007, Corsair has steadily increased gross margin by diversifying into higher-margin product categories. That said, Corsair’s gross margin of 24.2% is still well below industry peers Logitech and Turtle Beach’s 35% and higher gross margin. The same can be said about the operating margin. While positive, unlike its industry rival Razer, the operating margin fluctuates between 2% and 6%. This is also below industry peers Logitech and Turtle Beach. Expressed as a percentage of revenue, both Product Development (RD) and SG&A expenses are below the industry peers.

Reinvestment

Looking at the 2018 and 2019 cash flow statements, Corsair has every scent of an early growth company. The cash flow from operations is relatively low compared to the vast amount of cash for investment financed by debt. However, the picture changes if we factor out the recent three acquisitions of Elgato (2018, $46.6 million), Origin PC (2019, $13.8 million) and SCUF Gaming (2019, $136 million). In the 18 months spanning 2019 and the first half of 2020, Corsair spent $126+$10 million in cash on the three aforementioned companies representing 90% of all investment activities. This paints the picture of a company that is primarily looking at acquisitions to fuel future growth rather than reinvesting in existing assets in place.

This can be good or bad news.

It is good news if management believes the current assets in place and operations are well-tuned and ready to provide significant profits as they scale up further. In this case the existing core business becomes the cash cow to fuel the M&A inorganic growth. This offers a well-balanced short-term and long-term perspective for the company.

It is bad news if management believes the current assets in place have no future and the only growth can come from bringing outside products and people to guarantee the future of the company.

Risk

I use weighted average cost of capital (“WACC”) calculation to determine the risk. WACC has the following components: equity and debt.

Cost of Equity

To determine the cost of equity we use the following inputs:

  • Long-term Riskfree rate: US 10Y bond yield = 0.69% (Sept 10, from tradingeconomics.com)
  • Unlevered beta: 1.35 (Sept 10, from Damodaran‘s latest Valuation Spreadsheet)
  • Equity risk premium: 6.4275% (Sept 10, calculated using Damodaran‘s latest Valuation Spreadsheet and Corsair’s revenue per region)

Cost of Debt

To determine the cost of debt we use the following inputs:

  • Long-term Riskfree rate: US 10Y bond yield = 0.69% (Sept 10, from tradingeconomics.com)
  • Interest Coverage Ratio: 2.05, which results in an estimated synthetic rating of B2/B and associated estimated company default spread of 8.25% (Sept 10, from Damodaran‘s latest Valuation Spreadsheet)
  • Average maturity: 4 years (90% of debt is due in 2024)
  • Tax rate: 25% (United States corporate tax rate)

WACC

(in thousands)EquityDebt + Operating LeasesCapital
Market Value (*)$549,610$481,449$1,031,060
Weight in Cost of Capital54.32%46.69%100%
Cost of component14.95%6.71%11.10%
(*) market value of equity is determined by the total purchase price consideration of Eagletree’s acquisition of Corsair detailed on Page 72 in the IPO

The cost of capital is relatively high because the high debt-to-equity (increases relevered beta) and low interest coverage rate (lowers synthetic rating). The easiest way to improve the WACC is to use the proceeds of the IPO to lower the debt. This will not only provide additional free cash flow (less interested to be paid) but also increase debt capacity at more favorable interest rates.

The additional debt capacity can then be used as a source of finance for future acquisitions.

Initial Corsair Valuation

Using Damodaran’s model for DCF valuation, an initial Corsair valuation could look like this.

Revenue growth: 15% 2-5Y CAGR. High growth in the coming 5 years driven by continued aggressive expansion of the product portfolio both organically (new product launches in existing categories) and inorganic (acquire market leading companies).

Profitability: 15% EBIT in Year 10: leverage the lean business model to sell more of the same products with minimum overhead, focus on diversifying the portfolio with high-margin computer peripherals, and drive margin with aggressive direct-to-customer business.

Reinvestment: 2.00x Sales-to-Capital in Year 10: continue the focus of reinvestment on growth assets rather than fixed assets, acquire the right companies to be #1 or #2 player in each entered product category or segment, continue the “Corsair Touch”.

Risk: 5.92% WACC in Year 10: similar to that of mature companies (riskfree rate + 4.5%)

Value of Equity ~ US $3.58B

Valuation Caveats

The initial valuation paints a positive picture of Corsair’s future, its projected cash flows and its value. In this section I want to add more personal side notes to this Corsair valuation and hopefully add perspective.

Revenue Growth

The revenue growth as projected in the Corsair valuation depends on the continued success in the existing product categories and the outstanding success of future product categories and acquisitions. The success essentially depends on the future success of the “Corsair Touch”.

For the “Corsair Touch” to be successful Corsair needs to continue to attract and retain industry experts, and those experts must continue to create value that Corsair customers are willing to pay a premium for. This value not only depends on Corsair but also on the rate of innovation of the OEMs and suppliers who produce the Corsair products. Since Corsair does little own manufacturing it needs a strong and integrated value chain. If the rate of innovation drops significantly and Corsair is no longer able to create products that customers are willing to pay a premium for, it risks being dragged into a price war with lower cost companies.

Additionally, a key strength of the “Corsair Touch” is the global, scalable, nimble business model. For this strength to help fuel growth, Corsair must be able to identify the product categories that have high synergy with the business model. The 2018 Elgato acquisition is a perfect example of this.

Elgato is a market leader in streaming equipment for PC gaming, had a limited high-margin product portfolio of mainstream plug and play equipment, and is operating in a hot and rapidly growing market. The combination “PC”, high-margin”, “plug and play”, “limited portfolio”, and “high growth” is a perfect fit for the “Corsair Touch” model and I have no doubts it will be a success.

Potential targets similar like Elgato could be:

  • Thrustmaster, leader in joysticks, game controllers and steering wheels
  • Hercules, leader in PC-DJ equipment and software
  • Fanatec, leader in sim racing hardware and equipment

SCUF Gaming is a different story as they produce highly customizable game controllers targeted at console gamers. While the high (gross) margin is a plus point, it remains to be seen how the “Corsair Touch” can be levered with these products. After all, Corsair is more known as a “PC Gaming” company and not as a general ‘Gaming” company like their competitor Razor. Also, the “Corsair Touch” does not really cater well to customized products.

Perhaps SCUF Gaming is a way for Corsair to establish itself as more than just a PC Gaming company and expand the product portfolio to all types of gaming. Including PC, console, handheld, mobile, and cloud gaming. That would certainly open up a lot of new avenues for expanding the product portfolio.

Profitability

The profitability case hinges on two main factors. One, leverage the “Corsair Touch” and charge a premium in high-margin product categories. Two, increase the direct-to-customer sales.

I already discussed the first point at length in the previous sections.

In July 2020 Corsair hired Kenji Gjovig as VP eCommerce. Coming from Albertsons Companies he joined to lead the direct to customer ecommerce business. It will be a tough job. As reported in the 2020 IPO prospectus, sales to Amazon accounted for 26.8% of net revenue for the six months ended June 30, 2020, increasing from 17.7% in 2017.

The big picture challenge for Corsair is that a lot of their business and products are “amazonable”. The online etailers that survive are those who can carve out a niche or offer a product/service that are “unamazonable”. Corsair must find a way how it can attract customers who are used to the ease of simply adding a Corsair product in their one-click Amazon check out. This can be done, but will not be easy and will not be cheap. An easy way out would be to offer lower prices through the online store, but not only does that impact the profitability, it also impacts the brand value. Offering exclusive products or customized products is another option, but that is incompatible with the “Corsair Touch” business model. High expenditure on advertising and marketing to lure people to the ecommerce platform is expensive and will eat into your margin. Offering better or more personal service compared to Amazon may seem easy to on paper but very quickly becomes expensive. Especially for a company selling worldwide.

Reinvestment

The reinvestment is targeted mostly at M&A. A key challenge with M&A is that for attractive businesses there are usually multiple bidders and multiple bidders often result in a Winner’s Curse. The Winner’s Curse is a tendency for the winning bid in an auction to exceed the intrinsic value of an item. Similarly, many companies who do M&A end up overpaying for acquisitions.

Overpaying for an acquisition basically means you have overestimated the value (value transfer and value creation) of the acquisition. Reasons for this can be overestimating the synergies (“dreams”), underestimating the cost of capital (minimizing the risk premium), exaggerating the residual growth rate in the calculation of the terminal value, and using multiples of “comparables” which are not really similar or simply inflated.

M&A is really difficult and Corsair will need not only a clear acquisition strategy, a strong negotiation strategy (“BATNA, be able to walk away”), but most importantly key people who can identify potential targets and accurately evaluate the value it can create for the business after acquisition.

It is difficult to judge whether Corsair management is doing things right from outside. However, we can look at the transactions detailed in the 2020 IPO prospectus. Specifically, we can look at the goodwill mentioned. Goodwill is the price paid for future cash flow and is calculated as the acquisition price minus the book value of the assets.

  • Elgato (2018): $23.133 million net assets, $23.487 million goodwill
  • Origin PC (2019): $1.499 million net assets, $12.270 million goodwill
  • SCUF Gaming (2019): $63.670 million net assets, $72.642 million goodwill

The obvious standout here is SCUF Gaming as Corsair paid more in goodwill than net assets. In 2019 SCUF Gaming reported net sales of $68.3 million, gross profit of $26.5 million and operating loss of $2 million.

Terminal Value

The terminal value captures the value of a business beyond the forecasted cashflow period. The terminal value often comprises a large portion of the total value of the business. My model uses the perpetuity method which assumes a business will continue to generate cashflows at a constant rate forever.

The obvious caveat is of course that we do not know if Corsair will continue to generate revenues beyond year 10. Perhaps with the rise of cloud gaming or other technologies we soon will not need any of the products Corsair is selling.

My assumption is that Corsair will continue to shift its product portfolio towards new categories and markets and hence I am okay using the perpetuity method in this Corsair valuation.

Corsair Valuation: Sensitivity Analysis

Last step of the Corsair valuation is to do perform a simple sensitivity analysis. In the past I used Crystal Ball to perform my sensitivity analysis but recently I have switched to the ModelRisk excel plugin.

Inputs:

  • CAGR 2-5Y: lognormal distribution (mu=10%, sigma=5%)
  • Profitability: triangle distribution (min=5%, mode=12.5%, max=20%)
  • Sales to Capital ratio: triangle distribution (min=1.5, mode=2.0, max=2.5)

Outputs:

  • Mean value of equity ~ $2.29B
  • 25% percentile: $1.62B
  • 50% percentile: $2.15B
  • 75% percentile: $2.76B

Corsair Valuation: Post-IPO Update

On September 23, 2020, Corsair Gaming was listed on the Nasdaq raising $238 million by offering 14 million shares at $17. The share price dropped on opening day by over 16% to $14.24.

I updated my valuation work sheet with the additional data such as outstanding shares and re-ran the simulation. You can find the information below:

Worksheet download: https://hanweiconsulting.com/wp-content/uploads/2020/09/fcffsimpleginzu-corsair-v1.2.xlsx

Simulation:

As of Sept 24, 2020, Corsair sits around the 15% percentile.

Disclaimer: For all intents and purposes, the content and information below is for entertainment purposes only and should not be considered investment advice.

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Markets Aren’t Crashing? (S&P 500 Valuation)

Why aren’t markets around the world crashing to historical lows amidst the global pandemic? In this blog post I take a closer look at the factors driving market valuation and discuss whether the markets are delusional or rational.

On February 19, the S&P 500 index reached a new all-time high of 3386.15. One month later, on March 23, the same index stood 34% lower at 2237.40. All gains since January 2017 wiped out due to the COVID-19 induced fear and uncertainty. Today, April 29, the S&P 500 sits around 2800, still down from it’s peak right before the crisis but far from the market crash everyone seems to be talking about.

The question on some people’s minds seems to be: when will the market eventually crash? Other people claim the earnings headwind is already priced in. Using the DCF method, I value the S&P 500 index and look at the data to try and make sense of this question. I cover three main inputs to value the S&P 500:

  • Equity risk premium: is the implied equity risk premium unusually low or high?
  • Earnings forecast: is the expected growth in future cash flows reasonable?
  • Payout ratio: are the expected returns reasonable?
Valuing the S&P 500 market index
Valuing the S&P 500 market index

Implied Equity Risk Premium

The equity risk premium is the price of risk in equity markets. It can be understood as the premium investors demand for investing in an equity asset. The riskier an asset, the higher the associated risk premium will be.

Although no asset is truly risk free, we could argue that government bonds from first world countries like United States or Germany are risk free in practice because their governments will never default. Similarly, you’ll find that the risk premium for well-established firms in mature markets will be lower than the premium for startups in developing markets.

In valuation and corporate finance, the equity risk premium is an essential input for calculating the cost of equity and cost of capital. Traditional methods employ a backwards looking historical equity risk premium. In modern valuation we prefer to use a forward-looking implied equity risk premium.

The implied risk premium is estimated using current market data such as market capitalization and risk-free rate, and most recently available company earnings reports. In this blog post I outline how to perform the calculation using tools provided by the online data service Finbox.

Historical Perspective

Since my first blog post on how to use Finbox to estimate the implied equity risk premium, I’ve been tracking the implied equity risk premium of a variety of major indices. Below you can find the updated visualization.

As you see in the chart above, the implied equity risk premium for the S&P 500 decreased from near 8% at the end of March to 5.5% at the end of April. I discussed a variety of elements influencing the equity risk premium calculation in times of crisis in a follow-up blog post earlier this month. If you’re interested, I would definitely recommend going through that blog post.

According to Damodaran’s research, historically the equity risk premium for the S&P 500 averages around 4.5%. This is substantially lower than today’s 5.5% to 6.0%. If we consider only the years since the 2007-2008 financial crisis, the historical risk premium hovers around 5% to 6%. Today’s risk premium falls within this range perfectly.

Future Cash Flows

An crucial input to value the S&P 500 is the expected future growth of cash flows. There are a variety of methods to determine this input. You can rely your own expertise to estimate the growth every year. Of course, you can also rely on the forecasts of the managers of the firms you’re tracking. You can also ask analysts to provide estimates. You can use a top-down approach and estimate the growth for the index as a whole, or a bottom-up approach by estimating the growth of each company in the index to derive the overall growth of the index.

In my blog post titled Finbox Implied Equity Risk Premium Follow-Up I outline a particular method of estimating the growth of future cash flows using Finbox. There are two key inputs:

  1. For each company in the index, the expected growth in net income in the first year
  2. For each company in the index, the expected compound annual growth rate of net income for the next five years

The growth estimates are provided by industry analysts and aggregated by Finbox. In the charts below you can find the estimates over time.

index 1y net income growth tracker finbox
index 5y cagr tracker finbox

As you can see, the analyst estimates are slower to adjust to the crisis than the market. One would hope that is the case! The market can be irrational and emotional, but we need analysts to help us make sense of the situation and provide careful, well-founded and rational insight.

Since about a week or so, we see that the analysts have started putting a figure to the impact of the virus. Estimates for Western markets range from near -20% (Europe and UK) to -10% (United States). For China and Japan, the situation is slightly different, and in particular the Chinese situation is an interesting topic (which I will cover in a future blog post).

The bottom-up analyst outlook for the next 5 years remains relatively stable for all markets. The forecast slightly more favorable for the US and European companies and hovers around 4-5% CAGR.

Sustainable Payout Ratio

The last input we need for our discounted cash flow model is the expected return of the excess cash flows generated by the firm to the shareholders. This topic addresses the dividend decision in corporate finance. Simply put, it poses the question whether the excess returns will be reinvested in the firm or returned to the shareholders.

In theory, a company aims to maximize shareholder wealth. If the company has interesting and highly profitable projects lined up, then reinvesting excess returns into those projects is preferred. However, if the company has no interesting projects then the company should return the cash to the shareholders such that the shareholders can invest it in other companies that may have interesting projects.

There are two ways companies can return cash to the shareholder: dividends and buybacks. Each method has its advantages and disadvantages, and it’s up to the management of the company to determine what’s best for their situation. Collectively, we can capture the returns to the shareholders as a Payout Ratio. The payout ratio for the S&P 500 currently sits around 88%. That means for every $100 in net earnings, S&P 500 firms return $88 to the shareholders.

In this discounted cash flow model, we employ a sustainable payout ratio based on the stable growth rate after year 5 and the trailing twelve months return on equity.

We can argue at length whether it is reasonable to assume companies will eventually return to the shareholder every dollar they can’t reinvest (and whether the cash that gets reinvested actually creates value for the shareholder), but what we all assume is that the payout ratio is a decision made by the company management. The management is accountable to the shareholders, and this dynamic ensures the payout ratio will be reasonable considering the company’s performance. If the payout ratio would be impacted by external forces, e.g. government mandating a maximum payout ratio of 70%, then the value of the index would drop very rapidly.

Bringing It All Together

Let’s bring together the different inputs.

  • At 5.5%, the implied equity risk premium for the S&P 500 is higher than the historical equity risk premium for US equity markets, but sits right in the middle if we consider the risk premium since 2008.
  • At -9.52% for the next year, the Finbox aggregated analyst earnings forecasts for the S&P 500 firms are quite downbeat. This reflects a major impact of the coronavirus on supply and demand.
  • The sustainable payout ratio assumes companies will return excess returns to shareholders if management does not have interesting projects to invest in

Based on the findings above, it certainly looks like investors are making a reasonable attempt at valuing the market. The equity risk premium implies investors don’t find stocks any riskier than they were pre-crisis. The earnings forecasts that drive the discounted cash flow model are not implying a straight up catastrophe, but are definitely downbeat. Lastly, the payout ratio implies investors expect firms will return cash to the shareholders reasonably.

Of course, the above is merely my opinion. Perhaps you find equity risk greatly underestimated, or find the analyst forecast too positive considering the circumstances, or expect payouts to substantially change in the coming years. In the table below I’ve added a couple of scenarios to value the S&P 500 with different assumptions.

Equity
Risk Premium		Y1 Growth
Forecast		5Y CAGR
Forecast		Sustainable
Payout Ratio		S&P 500
Valuation
5.41%-9.52%4.64%95.89%2863.32
7%-9.52%4.64%95.89%2190.51
5.41%-20%4.64%95.89%2834.18
5.41%-9.52%1.00%95.89%2439.10
5.41%-9.52%4.64%75.00%2285.78
Alternating assumptions that drive different S&P 500 valuation

Also, you can use the excel document below to experiment yourself. It contains the latest data on April 29, 2020, as provided by Finbox API. Simply adjust the assumptions on the last sheet and see how the intrinsic value estimate changes.

200429_sp500_v2Download

(PS: the answer to the question whether markets today are delusional or rational is of course that they are both and neither at the same time *wink*)

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Finbox Implied Equity Risk Premium Follow-Up

In this post, I want to follow up on the method to estimate the implied equity risk premium using the Finbox API function with an updated methodology, comparison with other market indices, and briefly discussing Damodaran’s numbers.

If you haven’t read my previous posts on the topic, feel free to check them out first:

  • Implied Equity Risk Premium Estimate Using Finbox (link)
  • S&P 500 Intrinsic Valuation Using Finbox (link)

Updated Methodology: Incorporating Net Income Growth Forecast

A key input for computing the implied equity risk premium is the earnings growth forecast for the next five years. The earnings growth serves as a base to estimate the potential dividends and buybacks firms can employ to return value to the shareholder in the coming years. The next five year growth is not a number you can find in a whitepaper or datasheet; it’s called a forecast for a reason.

In my previous article I proposed using Finbox’ Net Income Forecast CAGR 5Y (ni_proj_cagr_5y) as input for the earnings growth. The net income forecast is based on a bottom up estimate of growth for each of the S&P 500 firms. In total Finbox reports 6,283 estimates (April 4, 2020).

Finbox also offers a Net Income Growth Forecast (ni_proj_growth) metric which provides a forecast for the earnings growth in the next year. Incorporating this data in the model helps fine-tune the Year 1 growth. When discounting a series of cash flows, getting the “early money” right is important.

I kept the Year 5 earnings estimate consistent as to not dismiss the 5Y CAGR forecast input. For years 2 through 4, I split the difference between year 1 and 5 equally. The resulting calculation looks as follows:

Implied equity risk premium calculation on April 4, 2020
Implied equity risk premium calculation on April 4, 2020

The difference between the old methodology and new methodology is not that big: 6.64% (old) versus 6.61% (new).

Using Alternative Indices: STOXX 50, FTSE 250, CSI 100, S&P 100, Russell 1000

A question that comes up all the time when discussing the implied equity risk premium is: Why use the S&P 500 to calculate the risk premium? Why not any other index? What makes the S&P 500 so special that we can use it as the foundation to calculate the cost of equity in finance?

Implied equity risk premium tracker using the old methodology
Implied equity risk premium tracker using the old methodology

As Damodaran puts it in the 2020 edition of his paper on the equity risk premium: “Given its long history and wide following, the S&P 500 is a logical index to use to try out the implied equity risk premium measure”. In the section titled “Extensions of Implied Equity Risk Premium” (p110), Damodaran further expands on the topic of computing the equity risk premiums.

Out of curiosity, I used the same method on a couple of other well-known market indices. Below you can find the implied equity risk premiums as calculated on April 4, 2020.

  • CSI 100 (CN): 8.78% (RMB 21T total market cap)
  • FTSE 250 (UK): 8.81% (GBP 289B total market cap)
  • S&P 100 (US): 6.73% (USD 15.32T total market cap)
  • S&P 500 (US): 6.61% (USD 22.69T total market cap)
  • STOXX 50 (EU): 8.41% (EUR 2.35T total market cap)
  • Russell 1000 (US): 6.29% (USD 25.28T total market cap)

We can note two things.

First, the difference between the US stock market indices (S&P 100, S&P 500, Russell 1000) is not that large: 6.29% to 6.73% in favor of the larger market index. This can be explained by assuming the forward-looking estimate of the equity risk premium for small cap firms is -0.32% and for the large cap firms 0.12%.

Second, the difference between the US stock market indices and other indices is quite large (>2%).

This can potentially be explained by difference in risk-taking culture as “many companies and individuals in Europe have a cultural suspicion of risk-taking, entrepreneurialism and ‘Anglo-Saxon’ capital markets.“ Simply put, if you’re more risk averse you will demand a higher premium for investing in a more risky asset.

A second possible explanation is selection bias. Collectively, US companies are global leaders operating in a relatively free and open market with strong access to capital. The premium investors demand for a stake in a US company operating in this business environment is simply lower than for the same stake in any other market.

A third way to look at the difference is to consider that the markets may be overpriced (if the implied premium is too low) or underpriced (if the implied premium is too high). One could argue that the US and European equity market should be of equivalent risk, and therefore conclude that the European equity is underpriced (and may present an interesting investment opportunity).

Equity Risk Premium: Damodaran Versus Finbox API

Every month Damodaran updates the Implied Equity Risk Premium on his personal website. The Implied ERP on April 1, 2020, is 6.02%. Why are his numbers lower than the implied equity risk premium as computed using the Finbox API?

Damodaran's monthly implied equity risk premium update
Damodaran’s monthly implied equity risk premium update

Before we get into the number crunching, let’s state the obvious and say that these are extraordinary times of economic uncertainty due to (1) the global coronavirus pandemic and (2) associated economics of stoppage, (3) the credit & funding market dislocations, and (4) the oil price wars.

Historically, the US equity risk premium averages around 4.5% (source: Damodaran’s Implied ERP (annual) from 1960 to Current) with peaks over 7% only occurring a handful of times in March 2009 (7.68%), April 2009 (7.01%), October 2011 (7.64%), January 2012 (7.32%), February 2012 (7.04%), and June 2012 (7.28%) (Source: Damodaran’s Implied ERP by month for previous months). The increased risk premiums were marked by market crashes: the financial crisis of 2007-08 and the European sovereign debt crisis of 2010.

Damodaran historical implied premium for US equity market between 1960 and 2019
Historical implied premium for US equity market between 1960 and 2019 (source: Damodaran)

Returning to the number crunching, a key difference between the two methods is the choice of inputs.

InputDamodaranFinbox API
Cash flowDividend + buybacksDividend + buybacks – stock issuances
GrowthTop down forecastBottom up forecast
Payout RatioSustainableSustainable
Difference in inputs to compute implied equity risk premium

In particular, the growth forecast is different. Damodaran’s analyst-acquired bottom-up estimate is 6.42% whereas the top-down estimate is 3.18%. Bottom-up estimates tend to over-estimate the growth as analysts focus in on specific firms and may not fully take into account the macro-environment. Sadly, there are no top-down estimates available through the Finbox API so the bottom-up forecast (weighted by net income) is the only option we have.

Also, the timing of the computation plays a role. Between March 12, 2020, and April 4, 2020, we tracked the implied equity risk premium using the old methodology resulting in an average of 6.75%, with minimum of 6.29% and maximum of 7.49%. Damodaran’s 6.52% falls within the range we’re seeing using Finbox.

Lastly, one of the limitations of the implied equity risk premium during a crisis is that while the index level and risk free rate are current, the earnings and cash flow numbers are stale. The trailing twelve months earnings will eventually come down as firms release their Q1 and Q2 reports. The index level has already “priced in” lower earnings whereas our model may not.

One way to work around this problem is to make the earnings growth forecast as current as possible. While Finbox updates the metric at least once a day for the most recent changes in analyst forecasts, they are still dependent on timely analyst forecasts.

Another workaround is by manual intervention and overriding the Finbox input with your own estimate of earnings growth. Matching Damodaran’s inputs (dividends + buybacks as cash flow choice, Year 1 earnings growth of -30%, 5Y CAGR of 1.47%, Adjusted expected cash payout of 87.86%) yields a lower, covid-adjusted implied equity risk premium of 5.54%.

Covid-adjusted implied equity risk premium using Finbox API

At the end of the day, it’s up to everyone to determine which method they feel most comfortable with.

DateIERPS&P 500RiskfreeMarket CapEarningsDividendsBuybacksIssuancesCash to EquityNet Cash to EquityY1 Growth FC
5Y CAGR FC
Sust. Payout
7/55.32% $2,848.42
0.68%
 $25,858,786
$124.80
$48.17
$72.40
$8.85
$120.57
$111.72
-6.49%
6.51%
94.83%
5/55.37% $2,842.74
0.63%
 $25,754,934
$125.34
$47.29
$70.34
$9.15
$117.63
$108.47
-6.62%
6.48%
95.25%
2/55.45% $2,830.71
0.64%
 $25,663,832
$135.88
$47.49
$65.61
$9.05
$113.11
$104.05
-10.50%
4.90%
95.56%
28/45.35% $2,878.48
0.65%
 $26,110,130
$136.92
$48.12
$65.03
$9.11
$113.15
$104.03
-9.52%
4.64%
95.51%
25/45.45% $2,836.74
0.60%
 $25,755,891
$136.89
$47.80
$64.75
$9.07
$112.55
$103.48
-9.55%
4.64%
95.90%
24/45.55% $2,797.80
0.59%
 $25,424,113
$137.47
$48.08
$64.85
$9.15
$112.93
$103.78
-9.65%
4.62%
95.90%
23/45.61%
 $2,799.31
0.61%
 $25,423,785
$139.59
$49.97
$66.09
$9.19
$116.06
$106.87
-10.23%
4.58%
95.88%
22/45.76% $2,736.56
0.57%
 $24,842,817
$139.60
$50.18
$66.35
$9.19
$116.53
$107.34
-1.77%
4.42%
96.15%
18/45.49%
 $2,874.56
0.66%
 $26,187,071
$140.75
$50.82
$66.58
$9.20
$117.40
$108.20
-1.68%
4.41%
95.59%
15/44.76%
 $2,846.06
0.75%
 $31,096,085
$119.08
$48.06
$67.69
$7.90
$115.74
$107.84
0.61%
4.81%
95.08%
14/44.75%
 $2,761.63
0.77%
 $31,096,085
$115.55
$46.63
$65.68
$7.67
$112.31
$104.65
0.61%
4.81%
94.89%
10/45.20%
 $2,789.92
0.73%
 $28,441,035
$127.63
$51.51
$72.55
$8.47
$124.05
$115.59
0.61%
4.81%
95.18%
9/45.20%
 $2,749.98
0.74%
 $28,446,945
$125.78
$50.61
$71.06
$8.26
$121.67
$113.41
0.61%
4.82%
95.07%
8/45.42%
 $2,659.41
0.72%
 $27,412,696
$126.25
$50.80
$71.42
$8.29
$122.22
$113.93

0.64%
4.82%
95.27%
7/45.86%
 $2,663.68
0.69%
 $25,399,347
$136.64
$54.91
$77.43
$8.96
$132.34
$123.38
0.64%
4.81%
95.48%
4/46.61%
 $2,488.65
0.59%
 $22,688,946
$143.37
$57.54
$81.08
$9.37
$138.62
$129.25
0.62%
4.81%
96.12%
3/4
6.66%
 $2,526.90
0.62%
 $22,539,572
$146.55
$58.81
$82.87
$9.58
$141.68
$132.10
4.81%
95.89%
2/4
6.69%
 $2,470.50
0.59%
 $22,533,323
$143.32
$57.52
$81.04
$9.37
$138.56
$129.19
4.81%
96.11%
1/4
6.50%
 $2,584.59
0.67%
 $23,562,438
$143.39
$57.54
$81.08
$9.37
$138.63
$129.25
5.36%
95.60%
31/36.38%
 $2,626.65
0.71%
 $23,917,050
$143.56
$57.58
$81.18
$9.39
$138.76
$129.37
5.36%
95.32%
28/36.55%$2,531.370.68%$23,376,274$142.19$57.04$80.68$9.31$137.72$128.415.37%95.51%
27/36.29%$2,630.07 0.85%$23,968,209
$143.51$57.57$81.43$9.39$139.00$129.605.37%94.39%
26/36.68%$2,475.560.86%$22,600,960$143.38$57.46$81.36$9.38$138.82$129.445.37%94.46%
25/3
7.13%$2,447.330.86%$21,340,638$150.09$60.32$85.59$9.89$145.91$136.025.64%94.33%
24/3
7.49%$2,237.400.76%$21,103,134$142.92$57.44$81.50$9.42$138.94$129.525.64%94.99%
21/37.18%$2,304.920.89%$21,160,519$142.92$57.44$81.50$9.42$138.94$129.525.64%94.13%
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S&P 500 Intrinsic Valuation Using Finbox

In the previous blog post we used the Finbox API service to calculate the implied equity risk premium of the S&P 500. Using the Finbox API service we can also do an intrinsic valuation of the S&P 500.

Background

We live in extraordinary and challenging times. The novel Coronavirus (SARS-CoV-2) and related disease (COVID-19) has been spreading around the world for almost three months now. People around the world are urged or forced to stay at home to help governments and communities get the virus under control. The coronavirus will undoubtedly have a lasting impact on our lives.

The virus has already made severe impact on businesses around the world. First, when the Hubei province in China shut down, many global supply chains were also shut down. Now, as more people around the world are no longer able to go to work, many businesses are suffering from a steep decline in demand. For example, the tourism and airline industries have come to a complete halt as people stay at home. A lot of businesses may go under and a lot of people may lose their jobs. And without people earning money to spend, businesses will see a further decline in sales.

Stock markets around the world have also dropped significantly. The Dow Jones dropped more than 35% from 29,551 points on February 12, 2020, to 19,174 points on March 20, 2020. Similarly the S&P 500 Index fell almost 32% from 3386 points on February 19, 2020, to 2305 points on March 20, 2020. The German DAX Index fell over 38% from 13,789 points on February 19, 2020, to 8,442 on March 18, 2020. Fueled by an oil price war, we’re looking at the “fastest bear market” ever.

(source: schwab.com)

From February 26, 2020, NYU Stern professor Mr. Aswath Damodaran began covering the impact of the virus on the markets on his blog and YouTube channel:

  • 26/02: A Viral Market Meltdown: Fear or Fundamentals? (blog, youtube)
  • 09/03: A Viral Market Meltdown Part II: Clues in the Debris! (blog, youtube)
  • 16/03: A Viral Market Meltdown III: Pricing or Value? Trading or Investing? (blog, youtube)
  • 23/03: A Viral Market Meltdown IV: Investing for a post-virus Economy (blog, youtube)
  • 31/03: A Viral Market Meltdown V: Back to Basics! (blog, youtube)
  • 08/04: A Viral Market Meltdown VI: The Price of Risk (blog, youtube)
  • 24/04: A Viral Market Update VII: Mayhem with Multiples (blog, youtube)
  • 13/05: A Viral Market Update VIII: A Crisis Test – Value vs Growth, Active vs Passive, Small Cap vs Large! (blog, youtube)
  • 04/06: A Viral Market Update IX: A Do-it-Yourself S&P 500 Valuation (blog, youtube)
  • 19/06: A Viral Market Update X: A Corporate Life Cycle Perspective (blog, youtube)
  • 02/07: A Viral Market Update XI: The Flexibility Premium (blog, youtube)
  • 23/07: A Viral Market Update XII: The Resilience of Private Risk Capital (blog, youtube)
  • 20/08: A Viral Market Update XIII: The Strong (FANGAM) get Stronger! (blog, youtube)
  • 05/11: A Viral Market Update XIV: A Wrap on the COVID market, premature or not! (blog, youtube)
Damodaran S&P 500 intrinsic valuation

In the third blog post, Damodaran provided an updated intrinsic valuation of the S&P 500 index ranging between $2,547.91 (20%) to $2,986.04 (80%).

Using the same Finbox tools we used in our previous blog post, we can also do an intrinsic valuation of the S&P 500.

Data Gathering

To value the S&P 500 index we need the following data inputs:

  • Long-term risk-free rate: 10Y US bond yield (Wikipedia)
  • Company information (Finbox API)
    • Current market capitalization (marketcap)
    • Dividends paid LTM (total_div_paid_cf)
    • Stock buybacks LTM (common_rep)
    • Stock issues LTM (common_issues)
    • Net income LTM (ni)
    • Book value of equity FY (total_equity)
S&P500 company data provided by Finbox.com API service
S&P500 company data provided by Finbox.com API service

To estimate the current value of the S&P 500, we want to use the most up to date information available. That’s why for most metrics we use the last twelve months data points.

Dividend and Buyback Computation

After gathering the raw data, we normalize by weighing the current S&P 500 index against the S&P 500 total market capitalization.

From S&P 500 raw data to index unit adjusted data points

At the moment of writing, March 23, 2020, the index units adjusted data points are:

  • Earnings: $142.92
  • Dividends: $57.44
  • Buybacks: $81.50
  • Issuances: $138.94
  • Cash to Equity: $138.95 (dividends + buybacks)
  • Net Cash to Equity: $129.52 (dividends + buybacks – issuances)

S&P 500 Valuation Inputs

  • Base Earnings: $142.52
  • Base Net Cash Yield: $129.52
  • Expected Y1 earnings growth: PERT distribution (min -25%, mode -5%, max 5%)
  • Expected Y2 to Y5 earnings growth: triangle distribution (min 4%, 7%, 10%)
  • Expected long term riskfree rate: triangle distribution (min -0.51%, mode 0.89%, max 1.5%)
  • Sustainable payout ratio in Y5: 1-g/ROE
  • Equity risk premium: triangle distribution (min 5%, mode 7.18%, max 9%)

S&P 500 Intrinsic Valuation

In the chart below you can find a histogram plot of the S&P 500 intrinsic value. It ranges from $2,001.58 (25%) to $2,425.66 (75%) with a mean of $2,211.15.

S&P 500 intrinsic valuation
S&P 500 intrinsic valuation (March 23, 2020)
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Implied Equity Risk Premium Estimate Using Finbox

We can estimate the implied equity risk premium used for estimating the cost of equity in corporate finance and valuation using the Finbox API service.

Equity Risk Premium

Simply put, the equity risk premium is the price of risk in equity markets. It captures the premium investors demand to invest in equity over a risk-free safe haven investment such as treasury bills. It can also be understood as the expected return on equity compared to the expected return on risk-free assets. Estimating the premium plays an important role in estimating the cost of equity and cost of capital in corporate finance and valuation.

Most equity risk premium estimates are backwards looking historical risk premium estimates based on the historical performance of stocks. As Damodaran points out in his lengthy paper on equity risk premiums (Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2019 Edition), historical risk premiums carry an inherent bias towards the user’s preference of time window, type of average, and the chosen risk-free rate. Even for the most data-rich estimates, the standard error is still significant and thus the statistical value low.

Comparison of historical equity risk premium estimates (Mr. Aswath Damodaran)
Comparison of historical equity risk premium estimates (Mr. Aswath Damodaran)

The implied equity risk premium is a forward-looking method of estimating equity risk premiums. The idea is as follows:

“If you know the price paid for an asset and have estimates of the expected cash flows on the asset, you can estimate the IRR of these cash flows. If you paid the price, this is what you have priced the asset to earn (as an expected return). If you assume that stocks are correctly priced in the aggregate and you can estimate the expected cashflows from buying stocks, you can estimate the expected rate of return on stocks by finding that discount rate that makes the present value equal to the price paid.”

Mr. Aswath Damodaran
Example of an implied equity risk premium calculation by Mr. Damodaran
Example of an implied equity risk premium calculation by Mr. Damodaran

Every month Damodaran updates the Implied ERP on his NYU Stern website. I urge you to read through the many teaching materials available on his website to get a better understanding of the mechanics of the implied equity risk premium.

Finbox Inc

Finbox Inc ( https://finbox.com/ ) is a Chicago-based online toolbox for investment and financial professionals that covers over 95,000 companies worldwide through their partnership with Standard & Poor’s Market Intelligence. I found this platform late 2018 and signed up for a membership in June 2019. I personally use their powerful stock screener to identify potential investment targets and pull relevant financial data into excel spreadsheets using their Excel spreadsheet add-on. Here you can find a complete list of supported API metrics.

For the purpose of estimating the implied equity risk premium, I use Finbox’ API services primarily to pull in data of the companies included in the S&P 500.

Data Gathering

To estimate the implied equity risk premium of a mature market, we need the following data inputs:

  • Mature market index: S&P 500 (Yahoo Finance)
  • Long-term risk-free rate: 10Y US bond yield (Wikipedia)
  • Company information (Finbox API)
    • Current market capitalization (marketcap)
    • Dividends paid LTM (total_div_paid_cf)
    • Stock buybacks LTM (common_rep)
    • Stock issues LTM (common_issues)
    • Net income LTM (ni)
    • Book value of equity FY (total_equity)
S&P500 company data provided by Finbox.com API service
S&P500 company data provided by Finbox.com API service

To estimate the current premium, we want to use the most up to date information available. That’s why for most metrics we use the last twelve months data points.

Dividend and Buyback Computation

After gathering the raw data, we normalize by weighing the current S&P 500 index against the S&P 500 total market capitalization.

From raw data to index unit adjusted data points

At the moment of writing, March 22, 2020, the index units adjusted data points are:

  • Earnings: $142.92
  • Dividends: $57.44
  • Buybacks: $81.50
  • Issuances: $138.94
  • Cash to Equity: $138.95 (dividends + buybacks)
  • Net Cash to Equity: $129.52 (dividends + buybacks – issuances)

Estimating Implied Equity Risk Premium

To estimate the intrinsic value of the S&P500 index, we only need a couple of inputs:

  • Current level of the index
  • Expected earnings growth for the next 5 years (top-down analyst forecast provided by Finbox)
  • Expected earnings growth in terminal year (equal to the long-term risk-free rate)
  • Expected returns to equity for the next 5 years (net cash to equity)
  • Expected returns to equity in terminal year (sustainable payout ratio)
  • Discount rate (implied equity risk premium)

The current level of the index is a single data point anyone can find in a matter of seconds.

The expected growth in earnings is a bit more difficult as we’re trying to predict future cash flows. In Damodaran’s worksheets you’ll find several options to determine your choice of growth rate though he seems to prefer a top-down analyst forecast of the S&P 500 index level. Following this idea, I rely on Finbox’ Net Income Forecast CAGR 5Y (ni_proj_cagr_5y) as main growth input.

Net income growth forecast by finbox as foundation for expected growth
Net income growth forecast by Finbox API

The forecast data is sourced from Standard & Poor’s aggregate of forecasts by various brokers and equity research institutions. Finbox’ Data Explorer allows you to check how many analysts contribute to the forecast of a specific stock. For example, Apple’s net income forecast is based on 73 estimates. While not all companies are covered equally (or accurately for that matter), the sample size of total estimates for all S&P 500 companies should give us a solid base as growth input.

As terminal growth rate we choose the risk-free rate (US 10Y gov’t bond yield).

To estimate expected returns, I slightly diverge from Damodaran’s preferred choice and opt to include dividends, stock buybacks as well as stock issuances (Net Cash to Equity). I feel it’s a more fair representation of return to all shareholders (existing and new). To estimate the returns between year 1 and year 5, I draw upon what Damodaran calls the sustainable payout level. The sustainable payout is computed using the stable growth rate and the trailing 12-month ROE and equal to 1 – g/ ROE. The payout ratio is adjusted over the next 5 years in linear increments to this value.

Once all this is set up, we’re ready to solve for the equity risk premium using Excel’s built-in Goal Seek function.

Example of estimating the implied equity risk premium using excel goal seek function
Example of estimating the implied equity risk premium using excel goal seek function

On March 22, 2020, my estimate for the implied equity risk premium is 7.18%. For your reference, you can compare this number with the implied equity risk premium published by Damodaran on his website at any time (5.77% for March 2020).

Conclusive Thoughts and Spreadsheets

I don’t think there’s a fundamental difference between the method for estimating the implied equity risk premium outlined in this blog post and the method used by Damodaran. However, the API service provided by Finbox facilitates gathering relevant data. Also, it offers a larger sample size of analysts for the top-down S&P 500 earnings growth forecast. Lastly, with the latest updated company and analyst information we can calculate the implied equity risk premium on a daily basis.

The value of this “instant” data point remains to be seen. Does it really matter to have the absolute latest information? Is having today’s estimate more useful than relying on Damodaran’s monthly ERP update? I’m not entirely sure so I’ll leave that up to you to decide. In case you’re also a Finbox user, I will link my spreadsheets below, so you open them and play around with them yourself.

To end this blog post, I would like to express my gratitude to Mr. Aswath Damodaran for his generous attitude towards teaching and sharing information. I don’t have the opportunity to join his classes at NYU Stern, but I do have access to his study materials and classroom via the online videos and webcasts. I highly recommend you to check those out if you want to learn more about corporate finance and valuation. While you’re at it, also check out his YouTube channel and blog for more content and insights.

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Business Theory of Disruptive Innovation

The theory of disruptive innovation, introduced by Joseph L. Bower and Clayton M. Christensen in 1995 , deals with the question how an organization can drive growth through innovation. The theory of disruptive innovation builds on the jobs to be done and aims to help organizations focus on innovation-driven growth

While the theory extends much further than described in this post, I find it particularly helpful when evaluating new opportunities. Although the theory will help you understand how to appropriately allocate the organization’s resources, I feel the topic fits the Opportunity question as outlined in the Strategic Blueprint Structure better.

innovation in business
Innovation in business

Consumption vs Non-Consumption

A first important topic in the theory of disruption of innovation is recognizing there are different type of consumers and non-consumers. Whereas traditional businesses think of a market as the amount of people buying a specific product or service, it’s more useful to think of your market as everyone who needs to get a certain job done. From that perspective, you can separate four types of people

  • Consumers: people who are using your product or service to get the job done
  • Non-consumers (A): people who are not able to use your product or service, but would like to if they had the means to acquire or hire
  • Non-consumers (B): people who refuse to use your product or service because it does not meet their needs or desires
  • Non-consumers (C): people who have no idea your product or service exists and are currently using a different product to get the job done

Note that while we recognize a distinct difference between the groups, they do share certain characteristics. For example, the group of consumers, non-consumers (A), and non-consumers (B) have in common that they all know about your product. They are either a customer already, or feel your offer either over-serves or under-serves them. Similarly, the group of all non-consumers share the fact they’re not using your offer, however they all have a different reason.

The theory of disruptive innovation states that organizations benefit most when they compete against non-consumption. This seems logical as the group of non-consumers would typically be much larger than the group of consumers. However, in day-to-day operations we often get caught up in trying to sell more or newer to those people who are already buying our solutions.

The terms under- and over-served will return later in the post but for clarity purposes let’s define them as follows:

Under-served customers are people for whom the product offer does not meet the desired performance while over-served customers are people for whom the product provides too much performance. Product or service performance, in this context, is measured against the set of specific attributes and values a customer is willing to pay for. You can read more about this topic here: Attributes and Values: Business Strategy Core.

Sustaining and Efficiency Innovation

In his theory of disruptive innovation, Clayton Christensen distinguishes three type of innovation in business: sustaining, efficiency and disruptive innovation. The fundamental difference between both types of innovation is easily understood. Simply put, sustaining innovation is making a good product better while efficiency innovation is making the same product using fewer resources.

Product Development Sustaining InnovationEfficiency InnovationDisruptive Innovation
Capital Required++++—+++++
Free Cash Flow—++++—
Jobs Created++++—+++++

The key difference between the different types of innovation lies in the capital requirements and its uses, and its impact on the free cash flow.

Product Development (“Empowering Innovation”)

When a new product is developed for a certain job to be done, it demands a lot of capital. In fact, often starting the business requires much more capital than is available to the founders of the business. That’s why we would get a bank loan or venture capital firms to invest in our business. Both the bank and the investor help us obtain the capital required to start the business. Christensen refers to this phase as “empowering innovation” because it creates jobs for people who build, distribute, sell and service these products.

Sustaining Innovation

Once a product is in the market and establishes itself as a profitable business, a big driver to engage in sustaining innovation is the rivalry that takes place in the marketplace. Different firms will try and compete for the same customers by improving their offer vis-à-vis your offer. While significant re-investment in the business is of course necessary to survive in the marketplace, the amount of capital necessary for the re-investment is not that large. You can usually rely on the same people who made the product to also improve its attributes and performance. You can often use the same facilities and factories although maintenance and upgrading may be needed. Your inventories will not drastically expand either since people who buy the new product are not also buying the old product.

Efficiency Innovation

At a certain point, the sustaining innovation will reach a point of diminishing returns. The product improvements are not significant enough to convince customer to buy the new product. This will hamper the revenue growth potential and it is at this moment the financial folks will step in. The focus shifts from re-investing to improve the product, to re-investing to improve the gross, operating and net margins. The idea is that by improving the margins the business generates more free cash flow, which then can be reinvested in new projects or opportunities. The financial folks have plenty of efficiency measures at their disposal to determine what’s the best way to improve margins, but usually it boils down to either outsourcing operations to a business with lower operating costs.

“Efficiency innovations pay off really quickly. Empowering innovations take five or more years to pay off. So, they invest in efficiency innovations, and more capital comes out.”

Clayton Christensen, 2013 (source)

Clayton Christensen is very specific in his criticism of efficiency innovation. While jokingly referring to the “invention of the spreadsheet” as the root cause of the demise of economies, fundamentally the criticism is that companies get used to the short-term profits of efficiency innovation. In addition, instead of using those profits to invest in innovation businesses choose to re-invest further in the efficiency optimization practices in order to realize even more profit. The efficiency cycle repeats itself, until there’s no more efficiency to squeeze.

Disruptive Innovation

Disruptive innovation is similar to empowering innovation in the sense that disruptive innovation also ends with a new product or service offered on the market. However, the disruptive innovation theory distinguishes two types of innovation as particularly powerful: low-end disruptive innovation and new market disruptive innovation.

Low-End Disruptive Innovation

low-end disruptive innovation
Low-end disruptive innovation

Low-end disruptive innovation begins with offering low-cost products to over-served customers using a lower cost business model than established players. As the product improves over time through sustaining innovation, the product will eventually over-serve the initial customers. However, you’ll find that up-market there are now under-served customers with greater performance demands you can serve with the lower-cost business model.

A couple of clarifications are necessary.

The term “performance” refers to the specific offering level of the set of attributes or values offered by your product or service. The performance evaluation of a product is entirely dependent on the customer needs and desires. The better the value offered by your product matches the performance demanded from the customer, the less likely the customer will switch to a different solution.

The term “over-served” indicates that the performance demanded by the customer is lower than the value that is offered by the product. Thus, the customer is paying for things they don’t really need, and the customer may prefer a lower quality but cheaper solution.

Generally, fueled by rivalry and associated drive for sustaining innovation, the performance offered by the market increases at a much faster pace than the performance demands by the customer base. This causes companies to look for market segments that are willing to pay more for higher product performance. This is called going “up-market”.

Not only are the customers in this segment willing to pay more, generally the profit margins are also higher in the up-market segments. So, companies find it natural to dispose of their lower-margin business and prefer the higher-margin new customers. However, the more up-market you go, the more you find yourself catering to a niche market with niche demands.

The disruption takes place every time the low-cost business model enters a new market. The disrupting company is able to take on the incumbents thanks to the cost advantages inherent to its low-cost business model. It can repeat this every time it moves up-market as incumbents are usually slow to adapt to new business models.

Notice how the low-end disruption model appears cyclical in nature. As the low-cost business models improve the product performance and moves up-market it will eventually over-served certain customers. Those over-served customers will eventually be looking for cheaper alternatives. New low-cost disruptive businesses can then take their piece of the market.

New Market Disruptive Innovation

new market disruptive innovation
New market disruptive innovation

New market disruptive innovation focuses on under-served or non-served customers (non-consumption). Typically, this requires a low-cost business model combined with a new value chain as non-consumption performance demands are different from existing customers.

The term “performance” refers to the specific offering level of the set of attributes or values offered by your product or service. The performance evaluation of a product is entirely dependent on the customer needs and desires. The better the value offered by your product matches the performance demanded from the customer, the less likely the customer will switch to a different solution.

The term “under-served” indicates that the performance demanded by the customer is higher than the value that is offered by the product.

Often, this under-served market is interpreted as a low-end market segment with cheap customers. This is wrong. The customers in this segment are misunderstood as cheap because they are not willing to pay for the attributes offered by the company, regardless how low the price is. Their willingness to pay is low because they don’t value those specific attributes. They value different attributes; attributes which the company isn’t offering.

For an existing business to venture in new market disruption, it’s often required to establish an entirely new team separate from the current team. Everything is different: the customers, their needs, the profit-formula, the value and supply chain, the volumes, and so on.

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Attributes and Values: Business Strategy Core

The core of each business strategy centers around identifying and addressing those attributes and values your customers care about most.

In the Strategic Blueprint for Business World Domination I outlined three fundamental questions for each business that wants to achieve sustainable growth. In this post we continue expanding on the opportunity question. When you figured out the raison d’etre of your business – the job to be done – and have carefully considered the business macro- and micro-environment, it’s time to move forward with the business strategy.

business strategy
Fundament of business

Business Strategy Definition

In a blog post I wrote one year ago I used the following definition of business strategy.

“Thus, we can propose the following definition: a business strategy defines the unique set of specific attributes the firm chooses to focus on aiming to achieve superior long-term return on invested capital.”

While the definition above still holds true, I’d like to expand on that definition and be more specific.

“A business strategy sets out to identify the existing and potential attributes or values of a product or service, choose those attributes and values your target customers are willing to pay for, and focus on achieving market-leading performance on those specific attributes and values.”

Notice there are four important aspects of the business strategy.

  1. Identification all the existing and potentially new attributes that your target customer may or may not care about
  2. Championing of those attributes you believe the customer values most and therefore is willing to pay for
  3. Satisfying those attributes your customer deems as a minimum requirement but isn’t necessarily willing to pay for
  4. Eliminating those attributes your customers don’t value at all

The identification process is rooted in the job-to-be-done analysis. The better you understand what your customer is trying to get done, the more specific you’ll be identifying the attributes. Note that we mention both the attributes your customers care and those they don’t care about as both are significant. In strategy formulation it’s important to not only know what you want to do but equally important to know what you don’t want to do.

Eventually you should have a list that comprises of three distinct types of attributes: the ones that you absolutely need to get right (champion), the ones you need to have (satisfy), and the ones you shouldn’t have (eliminate).

Categories of Attributes and Values

We can identify two broad categories of attributes and values and further segment into five distinct categories.

  • Functional Attributes
    • Attributes related to quality (how well does it get the job done?)
    • Attributes related to reliability (how long can it perform at the right quality?)
    • Attributes related to convenience (is it easy to acquire or hire?)
  • Emotional Attributes
    • Attributes related to personal needs or desires
  • Social Attributes
    • Attributes related to social needs or desires

Generally, the functional attributes are the most important to any product.

When thinking about attributes and values related to the business strategy formulation, it’s useful to link two related topics. First, the Blue Ocean Strategy and second the relationship between Value and Price in marketing strategy.

Blue Ocean Strategy

Blue Ocean

Blue Ocean Strategy is a business theory and published book written by W. Chan Kim and Renée Mauborgne, both professors at INSEAD. The theory asserts that business should systematically focus on unexplored new market areas (blue oceans) rather than endlessly compete in existing markets and industries (red oceans).

Red oceans are red because they feature cutthroat competition between companies targeting the same customers with similar products. The companies fight for market share by constantly trying to outperform their rivals. As more companies enter the market space, the prospects for profits and growth come under pressure. The cutthroat nature of the rivalry makes the market blood red.

Blue oceans are blue because they untainted by competition. They are in fact unexplored markets. The demand is created rather than competed over. Neither the total market size nor the profit formula is set in stone, meaning there’s plenty of room for growth and profit.

business attributes blue ocean value innovation

The cornerstone of Blue Ocean Strategy is Value Innovation. Value innovation is the simultaneous pursuit of differentiation and low cost, creating a leap in value for both buyers and the company. The point of value innovation is to make the competition irrelevant by reducing the total cost as well as increase the overall value. Cost savings can be achieved by eliminating and reducing the attributes an industry is currently competing on while value is lifted by creating attributes the industry has never offered.

This is very much aligned with the process outlined above. Cost savings are essentially a satisfying the identified attributes the customer doesn’t really care about but deems a minimum requirement. Satisfying doesn’t mean matching the industry standard, but in fact matching the customer expectation. Value lifting is championing the new potential attributes that the customer cares a lot about.

On the Blue Ocean Strategy website, you can find plenty of useful tools to help you explore the framework. One tool I find particularly useful is the Strategy Canvas which visually captures the difference between current market landscape and the future prospect of your business strategy.

Value and Price

In a blog post titled Value and Price Dynamic, I covered the dynamic between three distinct perspectives:

  1. The firm’s perspective on the value offered
  2. The customer’s perspective on the value perceived
  3. The firm’s perspective on the price

Whether a customer is willing to pay for your product or service depends on whether they believe to capture a significant amount of value. That value is the difference between the value perceived by the customer and the price to pay. The higher the customer incentive to purchase (CIP), the more likely the customer is to purchase.

From a company perspective, the goal is to maximize the value perceived while minimizing the cost. This can be achieved by following the process of Value Innovation as proposed in the Blue Ocean Strategy or by following the steps outlined earlier in the post.

  1. Identification of attributes will help you understand what the customer perceives as valuable and what they perceive as not valuable
  2. Championing attributes ensures that the customer will perceive your product as more valuable than competitor products as you offer the best performance
  3. Satisfying attributes ensures that the customer isn’t paying for things they don’t inherently find valuable while avoiding removing attributes they deem a necessity. These are crucial attributes because including them doesn’t add much value but excluding lowers the value significantly
  4. Eliminating attributes ensures that the value gap between the firm’s offered and customer’s perceived value is low, and reduces the overall cost

Economic Moat

As the business is increasingly proficient at identifying, championing, satisfying, and eliminating those attributes and values the customer cares and doesn’t care about, two things will happen. First, your product or service value proposition becomes increasingly unique in the marketplace and more difficult for competitors to copy. Second, you become increasingly more proficient at optimizing the total cost ownership of the specific set of attributes that makes your product unique. This makes it difficult for a competitor to copy your product with a lower cost.

With the right business strategy and the right execution, inevitably your business will develop inimitable sustained competitive advantages and economic moat.

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Jobs To Be Done: Business Raison d’Etre

Addressing the jobs that need to be done is true raison d’être for every business, product or service. Knowing what’s the job to be done implies truly understanding the customer and their needs or desires.

In the Strategic Blueprint for Business World Domination I outlined three fundamental questions for each business that wants to achieve sustainable growth. In this post we expand on the first question: the opportunity question.

jobs to be done

Jobs To Be Done

While academics and business leaders have discussed the topic of business fundamentals for decades and likely centuries, I have not come across any theory as simple yet complete as Clayton Christensen’s Jobs to be done.

The Jobs theory links the customer and product by the underlying action, the job that needs to get done. A job usually includes a functional aspect but can also be emotional of nature. The customer who needs to get a job done goes on the market to “hire” a product or service that gets the job done. On the market there are usually a plethora of products or services that get the job done. What gets “hired” to do the job will depend on the customer preference in terms of price, quality, reliability, convenience, or any other factor.

Just like with any other job, your product or service can get “fired” from the job if the performance does not meet the customer’s standard or expectation. Your product or service can get fired after the first-time use or after years of use, if a competitor develops a better offer.

Example 1: McDonald’s Breakfast Milkshakes

mcdonalds breakfast milkshake

One of the most famous examples to demonstrate the thought process behind the jobs to be done is Clayton Christensen’s McDonald’s Milkshakes story.

The case sounds simple: how can McDonald’s improve their breakfast milkshake to increase sales and profit?

This should be particularly straight-forward considering McDonald’s is one of the most successful marketing companies in America. They have all the groundwork done. For each product on their menu, they compiled a detailed profile of the target customer and their likely purchasing behavior. Based on the work of the marketing department, the research and development could then enhance the product on all dimensions of performance of the product. Alas, there was no improvement in sales or profits.

Clayton and team then tried another approach. They camped out at one of the restaurants and made meticulous notes whenever someone bought a milkshake. It turned out that about half the milkshakes were sold before 8.30AM, that it was the only thing the customer bought, that they were always alone, and always got in the car and drove off with it.

So, that begs the question: what job are they hiring this milkshake to do that early in the morning?

The job to done was very simple. All customers have a long commute ahead of them and they needed something to do whilst driving so they wouldn’t fall asleep. Furthermore, they knew that they’d be hungry at 10:30AM if they didn’t eat something before. The milkshake offers exactly the features that get the job done. First, due to the drink’s high viscosity it takes quite some time to empty the cup. And second, thanks to its ingredients you weren’t hungry until lunch time.

Are there no competing products for this job? Sure!

  • Banana: gone in 2 minutes and what to do with the peel?
  • Donuts: crumb all over your clothes and makes your fingers gooey
  • Bagels: too dry without condiments, too dangerous to put on the cheese cream while driving
  • Coffee: it can easily spill if you drive over a bump in the road

While all the products listed above are genuine substitutes or even competitors of the breakfast milkshake, none quite meet the needs of the customers on the product attributes or performance dimensions they care about.

Example 2: Google Ads

google ads

In the age of the world wide web, small domestic businesses sell to customers around the world in a global marketplace dominated by multi-national corporations. An important job to get done for any business, small or large, is to attract new customers. While large corporations usually have the advantage of deep pockets and strong brand recognition, small businesses are limited and must carefully deploy its communications to the right target customer.

The job to get done is to help small businesses reach the right customer within their advertising budgets. The job requirements include:

  • Clear and transparent link between advertisement spent and resulting sales increase
  • Highest probability of reaching the target customer so that no dollar is spent on customers that are not interested in the product
  • Total advertising cost that is bearable for a small business

Traditional advertising channels include direct mail, broadcast television, magazines, newspapers, radio, and billboards. To use any of these channels you need to hire an advertising agency that helps you publish your communications in the relevant media. The advertisement agencies are usually expensive to work with, implying a large up-front cost. Furthermore, this up-front cost does not include the ad placement cost. Furthermore, the channels have very limited advertisement space available meaning there’s competition will drive up the cost for the placement. In other words, this service is not viable for “hiring” to get the job done.

On the other hand, Google Ads offers exactly the features a small business requires to reach potential new customers around the world. Not only are you able to specify very detailed what type of customer you’re after in which region (down to city level), you can link the marketing campaign to your online web store to measure traffic and resulting sales, and to top it all off you can start from a measly budget of US $5 per day.

Imagine going to an advertising agency thirty years ago and telling them you’re a small American business trying to sell to vegan aspiring athletes in their early twenties from Latin America, and are willing to spend $5 per day. What do you think would’ve been the response?

From Jobs to Business Strategy Formulation

To get a full perspective on all aspects relating to the job to be done, you can ask the following questions:

  • What is the job to be done?
  • Are we able to get that job done?
  • Are others already getting that job done?
  • How are they getting the job done?
  • Can we get the job done better?

Once you understand the job to be done, the relevant and important performance dimensions, and potential competing products and services, you’re ready to take the next step and formulate your business strategy.

For those who would like to learn more about Clayton Christensen and the jobs to be done, I highly recommend watching his talk at Google from 2016.

Clayton Christensen: “Where does Growth come from?” | Talks at Google
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Strategic Blueprint for Business World Domination

The strategic blueprint for business world domination is a framework to help you plan your business. Whether you’re running a small business or a multinational corporation, as a business leader it’s your responsibility to figure out how to grow sustainably. There are hundreds or even thousands of books and papers covering the topic of how to approach that challenge and this series of posts are not any different. Over the next couple of weeks and months I aim to cover a big picture strategic blueprint or framework that can help you figure out how to achieve business world domination.

Strategic Blueprint Structure

The strategic blueprint consists of 3 fundamental pillars or questions. The three questions form the essence of deciding what business you’re in, how to get the business going, and how to create a prosperous organization.

  1. What are the opportunities?
  2. How do we make it happen?
  3. How do we ensure good execution?
Blueprint for business world domination

Opportunities

The opportunity question is the first step in starting a business. It challenges you not only to choose an industry, market, or segment, but also clearly define what it is that makes you stand out against existing and potential competitors. The question fundamentally demands you to clearly state or outline what it is you’re trying to get done.

Many entrepreneurs and business leaders tend to skip or fast-forward the process of answering the opportunity question. An entrepreneur might find it more useful to just get started and figure out the details later, while a business leader running a successful company may think they’re merely stating the obvious. In both cases it feels natural to skip straight to the second question and start working to get it done.

However, I urge the reader to spend enough time on the opportunity question. A careful study of the business environment and thoroughly thought out business strategy enables you to focus on the things that matter the most to your business. Improper analysis and planning will come back to haunt you when it’s time to allocate the company’s limited resources.

Relevant blog posts:

  • Jobs To Be Done: Business Raison d’Etre (link)
  • Attributes and Values: Business Strategy Core (link)
  • Business Theory of Disruption Innovation (link)

Resources and Capabilities

The second question primarily deals with allocating the organization’s available resources. Traditionally we think of resources as primarily the people, technology, cash, equipment, and so on. However, it may be useful to expand this to also include the capabilities of the organization and its people.

Traditionally, when a firm expands its business scope beyond its initial product or service, a firm is organized in a single corporate unit and multiple business units. To a varying degree the business units operate independent from each other, but are linked by resources shared by the corporate. However, in today’s fast-changing and sometimes volatile marketplace, the rigidity of a corporate backbone may be too restrictive.

With this in mind, from the perspective of organizational structure I follow the idea of authors Andrew Yeung and Dave Ulrich set out in their book Reinventing the Organization: How Companies Can Deliver Radically Greater Value in Fast-Changing Markets and make a strict distinction between the corporate substrate and the business teams. While the business teams are entirely independent in striving to win in their respective markets employing the available resources, the corporate substrate ensures the teams align. You could say the substrate is the glue that binds everything together. It acts and reacts on inputs from the business teams, provides a rigid structure on the short-term but inevitably changes over the long term.

The key challenge of the resource and capabilities question is to find the right balance between business teams in the marketplace and a corporate substrate that both provides a strong structure and the ability to change over time.

Good Execution

The third and last question deals with the long-term prosperity of the organization. It challenges the business leader to think about the governance processes and leadership needed to help the firm expand the business scope.

Governance processes includes developing and nurturing the right organizational culture, motivate and hold people responsible for their job performance, encourage and support the generation of new ideas as well as foster them, attract and retain talents, the sharing of information with peers and partners, and the collaboration across the entire organization ecosphere.

The leadership challenge boils down to four words: learn, grow, change, and create.

In the coming weeks and months, I hope to provide more context with each of the topics. I will add the links to the relevant blog posts in the sections above.

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Investment Decision (5): Sensitivity Analysis

sensitivity analysis

In this post we will cover the topic of sensitivity analysis and uncertainty related to expected return of an investment.

Uncertainty

When evaluating an investment, it’s important to do as much data gathering and analysis as possible. Good analysis will help you have a greater understanding of the associated costs and returns. However, even the most well-prepared analysis must face the uncertainty of the future. No matter how large your spreadsheet is, no one can predict the future with certainty.

Uncertainty means that some of your assumptions regarding costs, reinvestment, expenses, returns, etc. may be over- or under-estimated. No. It is almost certain your assumption will be wrong. But if we’re certain that we’ll be wrong, how can we make a useful evaluation?

With uncertainty or sensitivity analysis we can use statistical models to tell us which of the parameters in our model will have the biggest impact on the investment evaluation. Furthermore, statistical analysis will help us have a better understanding of the variance in outcomes

What-If Scenario

Simply put, sensitivity analysis is nothing more than setting up several “What-if” scenarios, testing those assumptions and see how they impact the outcome of the evaluation. For example:

  • What if the revenue is 15% lower than expected?
  • What is the impact if our margin is 5 base points lower than expected?
  • What happens if we’re only able to raise 60% of the funds we need?

Defining a what if scenario allows you to reconsider your assumptions. It’s likely that you have a gut feeling which of the parameters will influence your evaluation most. But to increase confidence you can run the numbers.

There are many ways to do sensitivity analysis. For small projects, simply running the numbers manually in an excel sheet will work just fine. For larger projects you may want to consider professional software.

Below you can find one example of a basic sensitivity analysis and a more advanced sensitivity analysis.

Sensitivity Analysis Example (Basic)

basic sensitivity analysis

For the basic sensitivity analysis, I use an example of an equity valuation of a Singaporean mobile app. For this project, it was important to make assumptions about all related costs on an annual basis. The result was an equity valuation using the discounted cash flow model.

In my base model, the valuation of the project was approximately SG $35.6M.

To do sensitivity analysis, I described 10 additional scenarios varying one or more of the eight different parameters. I ran the numbers for each scenario and laid them out in a separate excel sheet. As you can see, the equity valuation now ranges between SG -$8.5M and SG $35.6M with an average value of SG $18.8M.

Sensitivity Analysis Example (Advanced)

basic sensitivity analysis

For the advanced sensitivity analysis, I use a share valuation of AMD I made in February 2019. This share valuation is a lot less detailed than the equity valuation for the Singaporean app as I use only three value drivers: growth rate, operating margin and re-investment rate.

  • Growth rate: expected average annual revenue growth for the next 5 years, then converging to inflation rate by year 10.
  • Operating margin: targeted pre-tax operating margin, converging from the current margin to target margin by year 10
  • Sales to capital ratio: the required reinvestment cost to support the revenue growth

The share valuation is based on the current value of the company and number of outstanding shares.

Using Oracle Crystal Ball we create assumptions for each of the three parameters by determining the distribution and its factors. Then we run 1,000 to 20,000 trials. The software will use random values for the three parameters and calculate the share value.

As output, we get an expected distribution of share value as well as the associated statistical information. In addition, Crystal Ball also provides additional information on which of the three parameters impact the valuation most. In this case, operating margin is the dominant parameter.