In the digital world, new business models are driving value in new ways, even when financial markets are troubled. This new pattern suggests both strategic risks and opportunities for organizations to explore. For generations, investors have consistently valued organizations based on their capacity to create products or services that the market demands and then sell them for a profit.
Over the past few decades, however, the economy has shifted. Investors are measuring and rewarding value much differently. Today, it’s not uncommon to see organizations with no profitability commanding market capitalizations into the billions.
What has changed? Innovation and information. Now-ubiquitous technology has redrawn traditional market boundaries, enabling industries to converge. New business models are emerging, and they are disrupting long-standing conventions about how value is created.
Through this evolution of the business model, virtual is replacing physical. Digital technology is not just in the business. It is the business, both when markets are growing and during downturns.
Revenue Multiplier Explained
Consider some recent transformations in the marketplace. Some car makers have become technology companies that build vehicles. Some well-known e-commerce companies have become platforms integrating sellers rather than stand-alone retailers. Is an app-based ride-hailing service a transportation provider? Or is it a network of providers and consumers linked by technology? Entire banks can be constructed without laying a single brick.
As companies become more digitally enabled, they often trade more on revenue performance than on earnings performance. Profit is not necessarily the gold standard for business performance that it once was. The rapidly evolving fintech sector offers a salient example. Many organizations make their money via subscriptions, advertising, or other third-party arrangements. Few of these organizations are profitable in the traditional sense, and they are attracting investor capital.
To ascertain how investor behavior and business valuations are changing over time, Deloitte studied 40 years of financial results for companies in the S&P 500. The research explores price-to-revenue ratios—the revenue multiplier—as a key metric for understanding this evolving trend. Revenue is a more stable, predictable measure than earnings, and it’s less susceptible to high variations such as those exhibited with price-to-earnings ratios.
The research suggests the majority of companies in today’s economy can be categorized across four primary business models, each of which is characterized by a somewhat consistent revenue multiplier result. Two models fall below the digital divide—meaning the models for revenue are not digital intensive—and their valuations are generally $1 or $2 for each $1 in revenue. The other two models embrace digital technology as integral to the revenue side of business, and they are rewarded in the marketplace with far greater valuations. The four business models are:
Asset builders. These are traditional producers that use capital to make, market, distribute, and sell physical products. The model includes organizations in manufacturing, agriculture, mining, utilities, construction, wholesale, and retail.
In the revenue multiplier framework, these organizations receive approximate $1 in valuation for each $1 in revenue. Their growth rates, typically 2% to 6%, are limited by the scalability of the model; the business can generate new growth only to the extent it can deploy more capital to produce new product.
Service providers. These organizations hire people to provide a service, measured as billable hours, rather than make products. This category includes financial or professional services, health care, hospitality, and similar businesses.
Valuations for service providers are often twice their revenue, so they tend to generate closer to $2 in valuation for every $1 in revenue. Growth rates are typically 6% to 12%, and the model is also somewhat limited by scale, as services can only be delivered to the extent adequately skilled personnel are available to provide them.
Technology creators. In this model, organizations use capital to develop and sell intellectual property. The presence and importance of technology within business models is a critical differentiator in an organization’s ability to grow and scale more rapidly, which drives higher margins and revenue multipliers. Examples include software developers, biotechnology firms, and other franchise- or subscription-based businesses.
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The value in this model is captured in the shift from hard to soft assets, from physical to intellectual property, and from tangible to intangible benefits. The market pays approximately $4 in value for each $1 in revenue in this model, and growth rates are typically in the teens.
Network orchestrators. Organizations in this model develop and use digital networks consisting of businesses or consumers to create, market, and sell goods, services, or information. This includes social networks, credit card companies, and stock exchanges, for example. On average, the market pays approximately $8 of valuation for every $1 of revenue, and growth rates can reach 20%.
Strategic Risks, Opportunities to Consider
The research reflects the critical effect digital technology is having on the economy. Technology creators and network orchestrators, the models above the digital divide, yield significantly higher revenue multiplier results. Investors in these types of organizations recognize the value of technology within business models and reward those with the ability to grow faster.
Across the 40 years studied by Deloitte, including periods of financial strife such as the dot-com bust, the subprime mortgage crisis, and the COVID-19 pandemic, the resilience of digital-based business models is consistent. Models above the digital divide experience less volatility and faster recovery through crisis.
Further analysis of seven years of data across nine countries encompassing 68% of global GDP provides additional support for this conclusion. Country leaders that support all four business models had positive GDP growth, while countries with leaders focused on the two more traditional business models had negative GDP results.
These findings have important implications for organizations that are assessing their strategic risks in the COVID-19 era. Business model diversification incorporating digital technology offers strategic benefits not only when markets are growing but during downturns as well. With 86% of S&P 500 companies currently below the digital divide, the potential is significant for those organizations to pursue growth via business models infused with digital technology.
Whether achieved organically or by partnering with others, traditional asset builders and service providers have an opportunity to reduce their strategic risk by leveraging technologies, information, and customer data to propel themselves beyond the digital divide, driving higher revenue multipliers and shareholder value. Shifting to a new business model is not easy, but organizations that remain one-dimensional are more likely to struggle over time.
Insights from Deloitte’s most recent study on business models can help business leaders reflect on how to leverage existing intangible assets, such as technology, intellectual property, and networks, to enhance revenue-generating capabilities or create new revenue streams. Business leaders are challenged to rethink and evolve the way they manage and exploit risk, using a dynamic approach to risk management that drives strategy, builds resilience, and delivers financial results.
Businesses that dominate the future economy are likely to be those that seize opportunities to reallocate capital, build intangible assets, and move toward information- or network-based models—blending the physical and virtual worlds.
—by William J. Ribaudo, partner, and Seema Bajaj, manager, Deloitte Risk & Financial Advisory, Deloitte & Touche LLP; contributors include Parikshit Sinha, solution manager, and Aditya P. Singh, lead solution advisor, Deloitte Risk & Financial Advisory, Deloitte & Touche LLP[wsj-responsive-related-content id=”0″]