In recent years, we’ve seen some remarkable advances in digital technologies in cloud computing, data analytics, machine learning, and artificial intelligence, among others. These technologies have the potential to transform a wide range of businesses, especially in traditionally non-technology sectors.
For example, banks have made large investments in bringing analytics and automation to consumer portfolio investing. Retailers like Target have made substantial investments in artificial intelligence to predict sales and improve inventory stocking. Car companies like General Motors have made significant strides in developing autonomous driving technologies — and it is likely we will soon see self-driving GM cars on the road.
Motivated by the breadth of these digital transformations, we’ve done research exploring the how frequently they are occurring, what benefits they are creating, and what impact they are having on financial performance. In this work, we’ve tried to answer three specific questions:
First, how extensive is the adoption of digital technologies by non-tech firms?
To quantify the trend, we used textual analysis of annual reports and earnings conference calls for all publicly-listed non-technology companies, seeking to identify digital activity, such as a discussion relating to analytics, artificial intelligence, big data, cloud computing, digitization, and machine learning. We found that non-tech companies are going digital at a rapidly increasing pace. In 2017, nearly 22% of all listed non-technology companies report implementing some digital technologies in 2017, up from 4% in 2010. Notably, companies that go digital tend to be clustered in the financial services, retail, and manufacturing industries.
We find that firms that are larger, younger, hold more cash, and spend less on capital expenditures are also more likely to go digital. Companies with weaker performance are going digital sooner, perhaps as a possible response to competitive pressures.
Second, what are the benefits to going digital?
For one, investors seem to love it. Valuations of firms that go digital are 7% to 21% higher than peers. For example, Korn Ferry, an executive search and management consulting company that rolled out its Talent Analytics product in 2014, improved its valuation by over 60% (increase in market-to-book ratio from 1.21 to 1.94) in the same year.
Moreover, firms that go digital also receive higher valuations on their earnings. Their price-earnings ratio is 3% to 9% higher, and they receive 30% to 90% higher returns per dollar of incremental earnings than firms that don’t disclose digital activities. For instance, Caterpillar, a manufacturer of construction equipment, made significant investment in automated analytics and diagnostics in 2015 and saw its price-to-earnings ratio go from 15.0 to 18.8 that year, an increase of 25%. Furthermore, in the same year, the price response to an incremental dollar of Caterpillar’s earnings also increased substantially, by around 250%.
Early indications of success also lead investors to value digital activities more. In our analysis, we find that this happens when firms also experience high sales growth and when they are in industries where competitors have also made significant digital investments, as these firms face lower industry-wide fixed costs for engaging in digital adoption.
Interestingly, we find that the valuation benefits of going digital continue to increase over time, rising by 4% to 12% over the subsequent two years. This presents investors with an opportunity to earn profits based on disclosure by firms of their digital activities. We find that an investor can make a 5% risk-adjusted annual return (or alpha, in finance-speak) on a trading strategy that considers whether firms report digital activities.
The ability of investors to trade profitably on digital adoption also suggests that they don’t fully trust that managers will successfully implement it. To put it another way, the slow pace of increase in market valuation suggests that managers aren’t creating confidence about their digital activities. Our recommendation is to improve communicate with investors to get due credit for digital efforts sooner.
Third, how are companies faring in terms of their performance as they adopt digital technologies?
Surprisingly, we find little evidence of immediate improvement in financial performance for firms that go digital. We find positive performance benefits only in terms of asset turnover (a measure of efficiency of use of assets), which increases by 3% to 9% over three years relative to peers, following the disclosure of digital activities. Two examples in our data: Wyndham Destinations, a timeshare company that adopted data analytics to optimize the occupancy and pricing of its rental/exchange portfolios in 2013, saw its asset turnover go up 10% soon thereafter. Harley Davidson, a motorcycle manufacturer that introduced web-based crowdsourcing as an input for its marketing development in 2010, saw its asset turnover go up 20% soon thereafter.
However, we find no change in overall financial performance (measured by return on assets) and significant declines in operating margins and sales growth (lower by 14% to 42% and 10% to 30% respectively) when digital activities are disclosed.
These limited performance benefits could be due to several reasons.
One, the gains from digital activity take a long time to bear fruit and firms have to bear the costs in the interim. Many successful tech firms that undertook large digital investments like Amazon waited many years to become profitable.
Two, competitive forces may quickly erode the benefits to going digital. For instance, customers may benefit from better products but companies cannot sustain higher prices due to competition. This seems true for the restaurant industry, where digital ordering through apps is becoming ubiquitous.
Three, firms may not have the right management team to go digital. Notably, we find that non-tech firms that go digital with a technology executive among the top-5 senior executives perform better than firms without such executives by 60% in return-on-assets. Thus, it’s imperative to pay attention to having senior managers with the right tech acumen.
Digital adoption appears to be gathering pace across a wide spectrum of industries, and investors are rewarding the early movers even if immediate financial-performance benefits remain elusive. The risky nature of the digital investments highlights the need for companies to keep capital markets better informed about their digital activities and provide assurance that they have the right managers to execute the digital transformation.
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