The valuation of innovation

So here's a problem: what is the value of an innovation to a financial services firm? What is the value of a breakthrough versus incremental? And how can you guess it in advance so that you can win the money?

In my team, these are questions we wrestle with every day. The fact of the matter is that without a reasonable justification for doing innovation, noone wants to hand over the money. And that's money you need to have if you want keep innovating.

Ideally, one wants a justification in terms of the net effect on firm value. Wouldn't it be great to say that if we spend X on innovation, the share price will go up by Y%?

Actually, a study exists that tries to do that, reported in the March issue of the Journal of Marketing. "Innovation's Effect on Firm Value and Risk" is a scholarly article full of statistical stuff (and behind a paywall), but the headlines are these:

1. Breakthrough innovation provides windfall gains to firms, but may cause financial distress
2. Incremental innovation provides ordinary profits to firms
3. On average across sectors and markets, a breakthrough innovation increases the market value of a firm by 0.0847%. For a firm with an average market value of $4.9 billion, that translates to a windfall of about $4.2 million (NPV)

Here are my key takeaways. Firstly, doing incremental is going to pay the bills, as I've said on this blog on multiple occasions. You want to pay the bills otherwise, sooner or later, you're going to get shut down. But incremental isn't going to drive all that much direct growth.

Secondly, breakthroughs do give you the growth, but they aren't, on average, the transformational tickets to the future that innovators would like them to be. You'd have to do quite a lot of serial breakthrough to make a substantive dent in the fortunes of my bank, for example. But does anyone really have the appetite for risk that that would entail?

Anyway, those are estimates across industries. Trying to get something a bit better for the banking industry is challenging, so we've begun looking at specific innovations from our own history.

We have a scoring system that we use to evaluate potential ideas in 16 dimensions. The answers to these questions are weighted based on the priorities that our business units give us for various strategic questions. And out the end comes a number.

We went back and scored a basket of historical innovations, and then correlated that number with the actual returns from the innovation. It turns out our score, coupled with cost data, is quite a good predictor of the returns one might expect from an innovation, be it breakthrough or otherwise.

But we're still interested in the performance of financial services firms in general in the presence of innovation. Does anyone have any pointers to a study or other data?

Comments

[FredericBaud]

Breakthrough innovations could in fact be priced as real options, i.e. their value is not so much based on their expected return than on the volatility of the outcome. Which means that doing breakthrough innovations has value not so much from the gains that you expect, but from the possibilities you may, or may not pursue thanks to them.

[Taylor Davidson]

Unfortunately I do not have any data or studies on innovation in financial services.

But the broader point: the incremental v. breakthrough is a common point of debate, yet it's not an either/or question. Both types of change are valuable at different times and places in an organization. Recognizing what type of innovation can be done and needs to be done is the more important step.

[Mark Tomlinson]

I agree with Frederic - Real Options appear to be the key to calculating ROI for innovation projects (vs NPV). We have developed a tool which uses this to optimise portfolios of "big bet" R&D investments in our own business.

[Dave Birch]

Doesn't the scientific evaluation depend somewhat on what constitutes innovation? I'm sure it's true that "Secondly, breakthroughs do give you the growth, but they aren't, on average, the transformational tickets to the future that innovators would like them to be" but that may be because we are in an industry that considers cutting the corner off of a credit card to be a breakthrough innovation.

There's also a timescale issue: I'm sure banks considered securitisation of debt to be a fantastically successful breakthrough product right up to the moment that it cost them hundreds of billions of dollars.

I think you've touched on the issue before, but in essence most innovations deliver small returns because they are incremental: banks just don't do things that aren't incremental, do they?