Ever wondered how Value Hackers like Alibaba, Amazon, Apple, Google, Facebook or Microsoft grow so fast and are so cost effective? Stock markets recognize their strong economic fundamentals, so their billionaire market valuations are rising exponentially. For example, Amazon market cap have grown fivefold in less than five years. The secret behind such amazing economics is something called an ‘exponential flywheel’. If you have a flywheel in your value game you will enjoy exponential revenue growth, low marginal costs, increasing returns to scale, and massive cash-flow generation. Hence the fact that growth tends to become a perpetual state in the digital era: constant reinvention of the company’s value game, and cash flow to finance that infinite transformation.
Growth and return on invested capital (ROIC) drive cash flows and are the fundamental ingredients of the intrinsic value of any company. Many business executives grew up in a world in which they had to make trade-offs between growth and profitability. But in the digital era, things are radically different. Growth is now correlated with profitability and increasing returns to scale, as opposed to what existed in the traditional strategy and economic playbooks. Therefore, turning digital technology into value requires to define a business strategy devised to activate those exponential flywheels that mutually reinforce the growth and return to scale. Exponential growth happens in domains that are ruled by network effects and value-driven cost structures.
The drivers of value
Companies are facing the challenges of understanding the exponential economics behind a digital transformation because the massive application of new technology is changing the fundamentals of economic value and affecting the majority of existing business models.
So let’s start with the basics of value in the digital era. A company’s cash flow and, ultimately, its intrinsic value stem from its long term growth in revenues and from its returns on invested capital (ROIC) relative to its cost of capital. Economically, the overriding principle of value capture is to generate cash flows at rates of return that exceed the cost of capital raised from the company’s investors.
We can use a ‘value tree’ to analyze the connections and relationships between the true drivers of intrinsic value, growth and ROIC, and the potential impact of any digital transformation strategy. Every company will have its own strategy, but ‘Exponential Growth’ and ‘Increasing Returns to Scale’ can ensure that both concepts systematically reflect how digital can improve the fundamentals of economic value along any digital transformation journey.
Revenue growth is the mother of all exponential flywheels and a genuine hallmark of Value Hackers, due to their distinctive capacity to build lasting relationships with millions of customers and monetize them in numerous ways. The best way to set and fuel an exponential growth engine of revenues is by means of a multi-sided network of customers, products and services, and channels. Such connections generate the required ‘network effects‘ to grow in an exponential way, since the value of a network is directly proportional to the square of the number of connected nodes. Thereby, the maximum network effect is generated when a firm is able to build a multi-sided network that properly connects a community of fans, a system of complementary products and services, and an omnipresent grid of channels and touch-points.
Increasing Returns to Scale
Growth at all costs is not the right way to do it, therefore every dollar of both capital and operational expenditure must be a value driver, intended to generate a positive return. A company’s cost structure can either make or break a value game since growing exponentially is just as important as doing so healthily. Increasing returns to scale are the result of value-driven cost structures that are designed to maximize the compounding effect of the three key profitability drivers of any company: assets turnover, profit margin, and leverage. For that matter, the design principles of such value-driven structures should be focused on augmenting the utilization of key assets, restructuring the productivity drivers, and leveraging assets from third parties.
The combination of revenue growth and return on invested capital (ROIC) relative to its cost is what drives company’s intrinsic value. The faster companies can increase their revenues and obtain profits at attractive rates of return, the more value they capture. Therefore, the strategic challenge is to sustain exponential growth and high returns to scale. This is precisely what select Value Hackers have steadily achieved during recent years, and, therefore, stock markets value them in terms of hundreds of billions of dollars.
Achieving such economics for your value game is like turning a giant, heavy flywheel. Pushing with great effort, you get the flywheel to complete one entire turn of investment, growth, monetization, profitability and return. If you don’t stop and you keep pushing, the flywheel moves a bit faster, turn after turn. Then at some point, everything connects seamlessly, and the flywheel flies forward with almost unstoppable momentum. Once you get flywheel inertia, you get the power of strategic compounding. Each turn of value capture builds upon the previous one, which compounds one upon another. This is how you build sustainable economics. If you have a flywheel, you will enjoy exponential economics of growth and return in a sustainable way.
One of the most successful Value Hackers to use the flywheel is Amazon. Jeff Bezos and his executive team grabbed the flywheel concept and deployed it to articulate the momentum machine that drove the company at its best. For Amazon, the exponential growth engine starts with the customer experience. A truly singular customer experience drives traffic to Amazon’s shops, and this drives supply in the form of sellers that put their products on Amazon. This effect creates a greater selection of products, which improves the shopping experience. At the same time the exponential growth allows Amazon to lower their marginal cost structure and reduce prices, and hence, the customer experience improves further.
The exponential flywheel means an end of decades of trade-offs between growth and profitability. In his landmark 1996 article on business strategy, Michael Porter stated that “Among all other influences, the desire to grow has perhaps the most perverse effect on strategy. Trade-offs and limits appear to constrain growth.” But in the digital era, things are radically different, since growth and return are in fact correlated through scalability.
Capital markets reward companies with exponential revenue growth and higher returns above their cost of capital. Thus, these new economic fundamentals explain why companies such Apple, Amazon and Microsoft have become part of an exclusive club: $1 trillion market-value companies.
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