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How Are Businesses Creating Value in the New Economy:
“The first sign we don’t know what we are doing is an obsession with numbers.” ~ Johann Wolfgang von Goethe
Here is what we might call a number problem. Say you are interested in new media stocks. The year is 1993, and you come across an upstart Internet company – for the moment, let’s call it XYZ Corporation.
It is based in Dulles, Virginia, and has just 124 employees. It has net income of $4.3 million from annual revenues of $31.6 million. Its market capitalization? A mere 168 million.
Few people pay any attention to XYZ, and no wonder. “Nothing grows under big trees,” someone once said. XYZ is in the shade of some giant tress, any of which has the resources to easily oust XYZ from its precarious perch. One of those trees is a company we’ll call ABC Corporation.
ABC is a New York- based multi-media giant with revenues of $13.1 billion, net income of $86 million a year, and a market capitalization of $10.9 billion.
So there you are, back in 1993, and the question before you is this: Which company are you going to invest in? The right pick – as you probably have guessed – would have been XYZ, better known as America Online Inc.
By the beginning of the year 2000, seven years later, AOL had grown into the world’s premier on-line server, with a market value of $169.6 billion. It made a profit of $1 billion in 1999 on revenues of $5.7 billion.
Meanwhile, ABC, otherwise known as Time Warner, Inc., the big tree whose shade failed to stunt AOL’s growth, had a market cap of $93 billion on January 1, 2000. Revenues at the end of the third quarter of 1999 were $23.5 billion with net income at $1.2 billion.
If you had invested $1,000 in AOL at the opening of trading in January 1993, it would have grown to a hefty $332,057 by year-end 1999. Meanwhile, the same amount invested in Time Warner – a company at that time with almost 500 times the sales of AOL and 24 times the net income – would be worth $4,944.
This means that when, just 10 days into the new millennium, AOL and Time Warner announced their intention to merge, AOL was destined to be the dominant partner in the huge new company.
Next question: How could you have been prescient enough back in 1993 to choose little America Online over the powerhouse called Time Warner? What could you have known about AOL that might have clued you in on where to put your money?
You might have invested in the company form the beginning if you had identified and understood the value of all the assets that made up its business – not just he bricks and mortar and the financial assets represented on the balance sheet, but the intangible assets that traditional accounting pretty much ignores.
In that case, you might have known about an intangible asset by the name of Stephen M. Case, who, together with the company’s president and chief operating officer, Robert W. Pittman, devised the business model that would define and dominate the fledgling on-line industry. You might have understood his intention to create extraordinary wealth on the back of another intangible AOL asset, its small, but uncommonly loyal customer base – now grown to more than 22 million subscribers.
As The New York Times put it following the merger, “Mr. Case worked for 15 years, through obscurity and ridicule, to achieve his vision that chatting on a computer screen would become as important a communications medium as the telephone or television.”
But how could you have known from the start about Steve Case and the genius of his vision? Who or what could have pointed you to AOL as a company that would introduce radically new ways of doing business in the years ahead?
You certainly would not have found the key in books on management, or in strategic-planning manuals, or even in The Wall Street Journal. Nor would you have found all the information you needed about AOL’s value-creating potential on its balance sheet. You still won’t for that matter.
Leadership, one of the key factors in determining the future prospects of a company, is invisible on its balance sheet. So are many of the other assets that are essential to the creation of value in the New Economy. In fact, for an organization to succeed today and in the years ahead, it is going to have to create value in totally different ways, using assets that are not even captured by our current accounting systems.
The advent of the New Economy has made a new approach to value creation mandatory. Today’s business world has been transformed by globalization, breakthrough technologies, and new levels of competition in which old rules of business are constantly breached. These are the hallmarks of the New Economy, and they leave companies with no choice but to develop new business models attuned to the new reality. Old ways of managing and measuring assets no longer suffice.
This book is intended to be a guide to creating value in the New Economy. It points to the innovative strategies and processes that leading organizations have adopted to make the most of their assets. And it provides a tool – the Value Dynamics Framework – to help managers exploit all their assets.
As it stands, companies give short shrift to a whole range of assets that don’t appear on the balance sheet, which is dominated by physical and financial assets. Value Dynamics adds three more categories of assets that are driving wealth creation in the New Economy: Employee and supplier assets, customer assets, and organization assets. As you will see in later chapters, the Value Dynamics Framework also lists the individual assets within each category. Just as scientists are breaking the code of life with their discovery of DNA, so the companies we describe there are starting to identify the building blocks of economic value – or, as our book title puts it, they are Cracking the Value Code.
AOL isn’t the only company that has pioneered new ways of creating value today. Another is the Dell Computer Corporation.
Back in the late 1980s, Dell, based in the Austin, Texas, suburb of Round Rock, laid the groundwork for huge success by adopting its “Be Direct” business model. It called for the company to serve customers directly over toll-free phone lines. Only after a personal computer was sold were the parts for that machine ordered. The “direct” model eliminated dealers and inventories as well, and passed the savings on to Dell customers.
As a result, the company was able to seize a hefty share of the market for personal computers – for a while at least. Then its rivals in computer manufacturing cloned key parts of the Dell model, and its market share began to drop.
But Dell found another way to out-innovate its competitors, it reinvented itself as the hub of a system of suppliers intimately linked by long-term contracts and information networks. And it took advantage of new technology to establish a strong presence on the World Wide Web. So successful are Dell’s Web-based sales and customer service operations that they now account for almost 30 percent of its new business. The company has no traditional distribution network standing between itself and its customers.
These days, a Dell customer may be served by a telephone or on-line order taker who actually works for Matrix Marketing, a division of Cincinnati Bell, Inc. (Cincinnati, Ohio). The Matrix employee hands the order to a coordinator who actually works for Roadway Express, Inc. (Akron, Ohio). The coordinator, in turn, may pass the order along to the Dell factory in Austin, Texas, Limerick, Ireland, or Panang, Malaysia. Meanwhile, Roadway directs parts suppliers such as Selectron, which furnishes motherboards, and Maxtor, which makes hard drives, to replenish stocks in Austin, Limerick or Panang. And it tells United Parcel Service of America, Inc. (Atlanta, Georgia), to ship the finished computer to the Dell customer.
But here is our question: How does Dell Computer create value for itself and its investors? When it relies on outsiders to handle so many aspects of its operations, what does the company actually do?
Answer: Dell makes the most of its suppliers. That means that its future depends to a great extent upon its skill in selecting and managing other people’s organizations — an intangible asset that is not exactly a line item on an income statement or balance sheet. Has doing less of the work itself hurt Dell? Hardly. The company, which maintains offices in 32 countries, is a nonstop money-making machine. Its sales for the year ending October 1999 reached $23.6 billion – up 41 percent form the previous year. Net income climbed by 25 percent to $1.7 billion. Among Fortune Magazine’s “100 Fastest Growing Companies” for that year, Dell was the leader in return on stockholders’ equity with a three-year annual return on investment of 186 percent.
Of course, Dell’s competitors have not stood still. Its chief rival, Compaq Computer Corporation, is no in the midst of a major reorganization, and is repositioning itself with a new management at the helm. But Dell still prevails in the stock market. Its market capitalization at year -end 1999 was $130.8 billion, nearly three times that of Compaq.
Another question: How does the giant clothing retailer Gap Inc. create value? It’s obvious, you say?
Gap Inc., a California corporation based in San Francisco, is a fast-growing retailer, the biggest in the United States, with more than 2,900 stores, 110,000 employees, and sales of some $10.8 billion through October, 1999. And it creates value with its unpretentious, comfortable clothes.
But The Gap is also a way of doing business. Virtually every aspect of its operations is dictated from headquarters. That includes the design of its stores, the design and presentation of its clothes, the attire of its salespeople, the hours it is open, even the bodyforms it uses.
But if you ask Millard S. “Mickey” Drexler, president and Chief executive officer, to define his company, you are likely to get a different answer. He asks why a clothing store can’t be more like other global brands, such as AOL and Disney. “We are limited,” he once declared, “only by our imagination.”
You won’t find many brands like AOL and Disney in the clothing business, one of the most mature around. Usually, fashion houses streak across the firmament on the inspiration of a single creative mind, then fizzle. Drexler thinks his company can be an exception. He sees it as a stable planet in the brand firmament, and he is well on the way to making it so.
Here is the thing about brands: They must be of a dependable and consistent quality. The Gap is surely that. “Growth without quality,” Drexler likes to say, “Is nothing more than a shortcut to failure.”
Brands must also be accessible and new Gap outlets are popping up everywhere. In the first 10 months of 1999, Gap Inc. opened 380 stores, a 20 percent increase in the number of outlets over the previous year. Brands must be in the public eye – promoted incessantly through advertisements, on the Internet, through the buzz. The Gap spent about 4.4 percent of its sales on advertising in 1998, up from 1.7 percent of sales in 1997.
Clearly the company has made the scene.
Drexler views the company these days as a “portfolio of brands.” He has been busily leveraging the original Gap brand by adding line extension. Among them: GapKids, BabyGap and Gap Scents. His most recent addition is GapBody, shops that sell everything from candles to boxer shorts.
Drexler is onto something. By year-end 1999, the Gap had a market value of $39.1 billion. During the past decade, Gap Inc.’s annual return to investors has averages 38.l8 percent. That is better than Coca-Cola’s record of 35.5 percent, the Gillette Company’s 29.4 percent, and Disney’s 21.6 percent.
Back to our question: How does Gap Inc. create value? Answer: The company is exploiting its portfolio of brands, an intangible asset, to generate new value for its customers and wealth for its investors and other stakeholders. But it isn’t getting much help in managing its brand from traditional management, measurement, or reporting systems. Brands, you see, don’t show up on the balance sheet.
Our last and most important question: How do you create value in the New Economy? The answer, as our examples suggest, is more profound and more complex than you might suspect. That is why we have written this book. Today, more than ever, the question of how to create value occupies the waking hours of the world’s business leaders, investors, academic researchers, and economists, al of whom recognize that the old answers no longer work.
In the pages that follow, we offer a new way of thinking about value – and new ways of creating value in the new millennium. We propose a fundamental shift in the way business id done, as well as in the management theories and practices that support it. We start with the most basic of questions: What’s a business anyway? And we reply: A business is its assets – all of its assets.
These assets are tangible and intangible, measured and unmeasured, owned and unowned. And even though not all of them appear on a company’s balance sheet, they drive business success in the New Economy.
Businesses assemble their assets in combinations specific to them. That is, they use their assets to build unique business models.
It is the business model that ultimately determines whether an organization creates or destroys value and in what ways. Or, in our parlance, business models determine whether a company actually succeeds in cracking the value code.
Traditional economics saw wealth flowing primarily from an organization’s land, capital, labor and entrepreneurship. Land, and then capital, were seen as the scarcest resources. Labor was the abundant brute force used by owners of land and capital to exploit their resources, rather than a source of knowledge and innovation.
It is clear that this formulation fails to encompass all the sources of wealth in today’s business environment. We believe, and offer evidence to show, that traditional approaches to management and measurement are no longer adequate. Change now comes too fast and from too many directions.
In this book we seek to answer questions that confront all of us in the New Economy: How do we create value for our organizations? What new strategies and capabilities are required for us to create value and manage risk? What assets are most important in the New Economy?
When a company like Dell, for example, out sources almost everything from sales of manufacturing to research and development, its drivers of long-term value creation can hardly be judged simply in terms of traditional tangible assets. Intangible assets count heavily. The quality of its supplier relationships and the channels (especially the Internet) that it uses to communicate with those customers.
Where do we find evidence of how value is created in the New Economy? The financial markets. Investors have increasingly come to understand that it is often the assets hidden below the surface of financial statements that drive stock prices.
That isn’t to say that investors – especially professional ones – no longer value companies based on current and future cash flows. They still use that yardstick, but with a difference. Today, investors take a broader view of what is driving cash flows, including non-balance sheet assets and the ways a company exploits them. Lacking consistent ways to categorize and accurately measure the intangible drivers of value, many investors are forced to rely on what amounts to little more than informed guesswork.
ABOUT THE BOOK
The New Economy is more than hype and high-flying stocks. It is real and it is something that no company can afford to ignore. Why? Because today’s economy is different from anything we have dealt with before. The New Economy is founded upon the forces of new technologies, globalization, and the increasing importance of intangible assets, such as brands, relationship, and knowledge. Organizations are creating value in new ways, using combinations of tangible and intangible assets theretofore unrecognized.
This book marks the beginning of a journey with a single destination: understand the drives of value creation. And it offers a new set of principles called Value Dynamics. Based on a three-year study of 10,000 companies by premier consulting firm Arthur Andersen, Value Dynamics offers new insight into what companies should do to create value in the new millennium.
In today’s superheated economies, businesses are in a race to discover the underlying code of value creation. The authors of this book argue that assets (both tangible and intangible) are the basic building blocks of value, the “economic DNA” of businesses. Value Dynamics offers a way to map the unique value-creating characteristics of individual assets and combinations of assets.
What does this mean for you and your organization? Simply this: Every company must embrace a new model of how to create value in the New Economy. Value Dynamics begins that journey.
ABOUT THE AUTHORS
Richard E.S. Boulton, Barry D. Libert, and Steve M. Samek are partners at Arthur Andersen. Richard Boulton, Worldwide Managing Partner – Strategy and Planning, is responsible for the firm’s global service offerings (assurance, tax consulting, and corporate finance), as well as the firm’s Web-based knowledge businesses. Barry Libert is a worldwide lecturer and consultant on value creation and its impact on business models, corporate investment, and technology strategies in the New Economy. Steve Samek, Managing Partner of the firm’s U.S. operations, is responsible for almost 40,000 professionals who serve more than 20,000 companies in all industries and sits on the firm’s Board of Partners.
CRACKING THE VALUE CODE: How Successful Businesses are Creating Wealth in the New Economy is available wherever books are sold, online or off. Published by HarperBusiness, an imprint of HarperCollins Publishers. ISBN: 0-06-662063d-5.