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Businesses understand the power of digital innovations to reshape industries and markets. Yet, time and again, they have struggled to innovate with new and disruptive technologies.

Clayton Christensen and others argue that an incumbent’s failure has little to do with the newness or complexity of the technology. Rather, it is often their acute focus on the needs of the most important customers that places stringent limits on what they can and cannot pursue. Our research implicates another important stakeholder, the firm’s investors, who may keep businesses tethered to existing technologies. In theory, investor incentives align with what is good for the firm. In practice, we find important differences.

Investors affect innovation investments

In our research, we first examined the drivers of firms’ investments in digital innovation and their subsequent market valuations. How investors value a firm matters a great deal in determining which firms are able to succeed with digital innovations. When investors value firms for their growth potential rather than current profits — as is the case with startups and tech giants — they are not only more likely to invest in digital innovation, but also obtain higher market valuations. In contrast, when investors expect current-period profits — such as from industry incumbents — they are not only less likely to invest in digital innovations, but obtain significantly lower market valuations when they try to become digital leaders.

As of Aug 7 2018, Tesla’s market capitalization (USD 64.75B) exceeded that of BMW (USD 64.36B), despite BMW’s comparable production levels and deliveries of electric cars and significantly higher profits (net income of 10.3B for BMW versus -2.7B for Tesla as of June 30, 2018). Despite that, investors hailed Tesla’s technological innovation efforts, and expressed far greater optimism regarding Tesla’s future growth. Similarly, despite healthy profits and publicly committing to and investing billions of dollars in technologies similar to those pioneered by Tesla, both GM and Ford have struggled mightily to ignite investor enthusiasm for their stocks.

Or consider General Electric.  Once the darling of digital innovation, GE is rapidly curtailing its ambition to transform itself into a digital powerhouse. Just four short years ago, GE CEO Jeff Immelt declared that “If you went to bed last night as an industrial company, you’re going to wake up this morning as a software and analytics company.” But by 2017, a frustrated Immelt had to leave GE, remarking that “…in our core businesses, earnings have tripled during my tenure, we have record-high market share, financial performance has outpaced that of our peers…we have paid more in dividends than during the previous 110 years of GE history combined; nonetheless, our P/E ratio has gone from 40 to 17… and the stock price has underperformed. Thus it is with transformation.” Investors seemingly just weren’t looking for radical innovation from GE. Incumbent firms struggle when they stray too far from investor expectations.

Our research shows that these are not isolated examples. We found that the market rewarded “growth” companies for investment in digital technology, but actively punished more mature, steadily profitable firms for the same.

We started by modeling companies’ trajectory, based on their performance 1984 to 1996, and breaking down those estimates based on how much of the company’s valuation was based on current profits vs. their potential for future growth. We found that firms that were valued for future growth had the greatest propensity for digital innovation while the high-profit firms had the lowest propensity for digital innovation. We measured digital innovation based on the number of digital patents the firm had secured from 1998 to 2010.

Finally, we examined the consequences of digital innovation for firms that derived their market valuations largely based on current profitability. To do this, we compared the market valuations between 1998-2010 of companies that were similar in terms of their digital status (leader or laggard) and their growth trajectory (based on our model estimate). The trajectory-contingent matching allows us to get beyond simple correlations to explore the causal relationship between  digital innovation, investor expectations, and firm performance. Whereas the digital leaders in the high-growth group were rewarded for their digital investment by the stock market with higher valuations, the digital leaders among the high-profit group were punished with much lower stock market valuations. In effect, the financial markets were heavily discounting the digital ventures of these firms.

Succeeding despite investor constraints

Our large-scale empirical study provides strong evidence of the constraining role of investors and financial markets in shaping the innovation choices of firms. Even in the face of significant increase in digital innovation and its demonstrated impact on a range of outcomes, our findings show why incumbent firms find it difficult to move away from existing sources of value to pursue new digital innovations.

Notwithstanding the allocative efficiency of capital markets, the implications for firms that are valued for growth is that managers of these firms must recognize the opportunity of digital innovation and create capabilities to exploit this opportunity. Conversely, there are risks to digital innovation for firms that are valued more for their current period fundamentals rather than for future growth prospects. Financial markets tend to punish the digital leaders in this group for forays that are necessarily complex strategies whose benefits are realized over longer periods of time.

Managers in established firms should therefore try to reset market expectations through proactive and carefully calibrated communications to investors before they pursue digital innovations. Alternatively, these firms should think of structures and arrangements (e.g. spin-offs) that are better aligned with the expectations of the financial markets to pursue digital innovations.

from HBR.org https://ift.tt/2Le86k3