Does innovation really deliver tangible financial results a company? Do investments in innovation yield a positive return? Does innovation pay? And if yes, how much positive impact does it have on financial performance?
Tracking the innovation premium
In 2006, BusinessWeek magazine and Boston Consulting Group (BCG) jointly devised a ranking of the world’s 25 most innovative companies. The list was led by Apple, Google, and 3M, and also included Toyota, Microsoft, General Electric, Procter & Gamble, Nokia, Starbucks, IBM, Virgin and Samsung, among others. Then, they compared the profit margins and stock prices of these Top 25 innovators with the median for all companies in the Standard & Poor’s Global 1200 index over a 10-year time period.
The Top 25 innovators delivered median profit margin growth of 3.4% a year from 1995-2005, compared with 0.4% for the S&P’s Global 1200. This striking difference, which BW attributed “in large parts to innovation”, also showed when comparing the median annual stock returns of both groups: The Top 25 innovators yielded 14.3% over the 10 years, a full three percentage points better than the S&P 1200 median. No wonder that BusinessWeek titled the article “Creativity Pays. Here’s How Much”.
In a follow-up study in 2009, BCG found a similar result: Innovative companies achieved significantly higher total shareholder return premiums — 4.3% higher over three years and 2.6% higher over 10 years — than their less innovative industry peers. Interestingly, the figures for Asia-Pacific were much higher, at 17.7% over three years and 5.5% over 10 years, suggesting that it pays even more to lead innovation in traditionally less innovative environments.
One of the most dramatic examples of superior stock performance by an innovator is Apple. When Steve Jobs returned to Apple on July 9 1997, the firm was on the verge of bankruptcy and its stock closed at $0.49 (in today’s prices after various share splits in between). Ten years later, the share price had soared to $18.62, a multiple of 38 times. Twenty years later, the price had skyrocketed to $145.06, a multiple of nearly 300. Had you purchased two Apple shares for one dollar on the day of Steve Jobs’ return, they were now worth nearly $300.
So, 20 years of fanatical focus on innovation at Apple led to tremendous value, not only for consumers who benefited from groundbreaking innovations such as the iPod, the iPhone and the iPad, but also for Apple shareholders who reaped massive wealth gains.
Investing in design pays too, as several studies have confirmed:
- A 2007 study by the British Design Council found that design-focused firms didn’t need to compete on price as much as their peers. Every £100 they invested in design increased turnover by £225, and their shares outperformed key stock market indices by 200%.
- In a 2014 Harvard Business Review article, Jeneanne Rae introduced the Design Value Index, a new tool to track the financial performance of design-centric companies against those that are not. When comparing the stock performance of 15 design-focused companies it showed that over 10 years, shares of design-centric firms (such as Target, Walt Disney or Nike) beat the S&P index by 228%.
To summarize, all the aforementioned study findings suggest that investing in innovation and design pays huge dividends for companies and their shareholders alike.
Why do innovative firms perform better financially?
BCG found that innovative companies tend to grow faster, have richer product mixes than their peers, expand into adjacent or new categories (especially if these promise higher margins), and produce more patents than less innovative companies.
Innovative companies also enjoy higher profit margins because customers are willing to pay higher prices for more innovative products perceived to offer more value than ‘plain vanilla’ products.
Innovative companies can charge even higher prices for their more innovative value offering (products, services, solutions and experiences) if they also invest in standout design, which further magnifies the perceived value in the eyes of their customers.
Ergo, they enjoy considerably higher operating profit margins — and the best innovators even amplify those further through operational innovations (such as optimized processes and innovative structures) that allow them to produce superior value at a lower cost base than their peers.
Moreover, innovative products sell faster and more frequently than normal ones, thus boosting revenues further, especially if the top innovators also multiply revenues through the leverage innovation types.
Mapping out the financial dynamics and implications of innovation investments
We can sum-up the financial performance implication of investing in innovations as follows:
- Innovative value offerings sell at higher prices and in higher volumes, both of which increase revenues. The higher the value differential, the higher the revenue growth driven by both price and volumes.
- Firms that magnify the perception of value of their products (and other value offerings) through design can achieve higher prices, which again boosts revenues and increases (operating) profit margins.
- Likewise, companies who make operational innovations typically can produce their value offerings at lower costs, which also increases profit margins (albeit to a much lower degree).
- Companies that market a value proposition through innovative channels, networks, platforms, partnerships and business models can multiply their revenues even further.
- Strong revenue and profit margin growth increase the demand for a company’s stock and its share price, and may trigger a positively reinforcing loop. If the innovative company shares part of its superior profits with its investors in the form of dividends, the share price and demand for the stock rise even further. A rising share price increases market capitalization, and over time the company shifts from being a potential acquisition target to being a dominant player with amble opportunities for strategic acquisitions.
Conclusion: Embrace innovation and invest in innovative firms, as innovative firms deliver a noticeably better financial performance compared to the market average. It’s seems to be a safe bet to increase your wealth in the long run. As Warren Buffet put it: “Value is what you get.”
© Dr. Detlef Reis 2017.