92  Valuation of ESG and Digital Initiatives
Here’s where the importance of the base case comes in. If the bank 
doesn’t build a mobile app, it will likely lose market share and revenues 
over time. In this case, the cash inflows are the avoidance of lost revenues, 
which could be substantial. So this project likely does have a positive pres-
ent value.
Ideally, the bank would estimate the timing of market-share loss to de-
cide on the best time to build the app. Perhaps delaying a year or two might 
maximize value if the bank’s customer base isn’t clamoring for it yet. The 
bank should also consider alternative features for the app and ways to build 
it. Should it start with something simple and low cost to roll out and then 
improve it over time? Or should it spend more up front on a more feature-
laden product? As you can see, there are many different cash flow scenarios 
to analyze when making this decision.
Paths to Improved Performance
Digital initiatives can improve a company’s performance in numerous ways. 
To analyze the potential impact of digital, it helps to frame the discussion as 
two opportunities or threats. The first—and the highest-profile manifestation 
of digital in the business press—is an application of digital tools that fun-
damentally disrupts an industry, requiring a major revamp of a company’s 
business model.
The second kind of impact, less dramatic but also important, occurs when 
companies use digital to simply do the things they already do, only better. 
Digital strategies can be applied in more mundane but also important ways in-
cluding cost reduction, improved customer experience, new revenue sources, 
and better decision making. The line between the two applications can blur, 
such as when clothing retailers integrate their physical and online sales. The 
retailer is still selling clothes, but the customer’s experience has changed, and 
the retailer must substantially retool its business.
New Business Models  In some cases, digital disruption upends entire busi-
ness models or creates entirely new businesses. The Internet changed the way 
consumers research and purchase airline tickets and hotel rooms, disinterme-
diating many traditional travel agents. The introduction of video-streaming 
services has disrupted the economics of traditional broadcast and cable TV 
channels. In some cases, digital has created enormous new businesses. Cloud 
computing services generated between $80 billion and $100 billion of reve-
nues in 2019, up from less than $10 billion ten years earlier. The rise of cloud 
computing disrupted two other industries. First, the standardization of serv-
ers by leading players disrupted the manufacturers of mainframe and server 
computers. Second, it disrupted the IT services business that ran companies’ 
data centers.

Digital Initiatives  93
To value these new businesses, use the standard DCF approach. The fact 
that these businesses are often growing fast and don’t earn profits early on 
does not affect the valuation approach. Eventually, they will need to generate 
profits and cash flow and earn an attractive ROIC. In Chapter 36, we describe 
how to value high-growth companies. The key point is that with high-growth 
companies, you must start in the future to estimate revenues when the market 
begins to stabilize, based on the market’s potential size. You should estimate 
ROIC based on an assessment of the fundamental economics of the business.
An important consideration in estimating the potential size and ROIC of 
a new digital business is whether or not it will have network effects, also called 
increasing returns to scale. The basic idea is this: in certain situations, as com-
panies grow, they can earn higher margins and return on capital because their 
product becomes more valuable with each new customer. In most industries, 
competition forces returns back to reasonable levels. But in industries with 
network effects, competition is kept at bay by the low and decreasing unit 
costs of the market leader (hence the tag “winner take all” for this kind of 
industry).
Take Microsoft’s Office software, a product that provides word process-
ing, spreadsheets, and graphics. Office has long been the standard used by 
most companies and other users. Early on, as the installed base of Office users 
expanded, it became ever more attractive for new customers to use Office for 
these tasks, because they could share documents, calculations, and images 
with so many others. As the customer base grew, margins were very high, be-
cause the incremental cost of providing software through DVD or download 
was so low. Office is one of the most profitable products of all time. That said, 
even such a successful product may be threatened by competition as more 
computing moves to the cloud.
Such network effects are not the usual case. The history of innovation 
shows how difficult it is to earn monopoly-size returns on capital for any 
length of time except in very special circumstances. Many companies and 
investors didn’t realize how rare this was during the dot-com bubble of 
1999–2000. More recently, investors again may have gone overboard with the 
number of “unicorns,” typically defined as start-up companies with values 
above $1 billion (usually still private) and negative profits. In 2019, as some 
unicorns went public or tried to, there was a renewed realization that not 
all these companies could earn extraordinary returns from network effects, 
and values fell considerably. It’s unlikely that companies offering analytics 
services, selling e-cigarettes, or renting out short-term office space will achieve 
long-term network effects.
Cost Reduction  Many digital initiatives can help companies reduce their 
operating costs. Predictive maintenance on factory equipment reduces both 
maintenance costs and lost production from downtime. Another example is