Toward Value-Based Innovation

CEOs are constantly under the gun to create value for shareholders. If they succeed this year, shareholders expect the same or better next year. The pressure never ends. Executives have responded to this pressure in a number of ways: through quality initiatives that reduce waste and set their products and services apart; through productivity improvements; by moving manufacturing to low-cost countries; through the divestiture of unproductive units. Each of these solutions has the potential to create value for shareholders—at least in the short term. The long-term is another story. Quality can be matched by competitors. Every round of productivity improvement is harder to win. And cutting costs by moving overseas is generally a one-time fix—and one that competitors can copy. So, if you’re the boss and you’ve done all these things, where else can you turn?

Innovation is the answer. As Peter Drucker once put it, “Business has only two functions – marketing and innovation.” Innovative products and services that create value for customers do the same for companies and their owners. Best of all, innovation is theoretically inexhaustible as a well-spring of value creation. Innovation assures corporate vitality, motivates employees, and makes shareholders happy.

The course of innovation follows a rational process of gathering many ideas, winnowing them down to the most promising prospects, and developing the best and most feasible of these into products and services that can be successfully commercialized. Focusing on individual ideas and projects is an excellent way to create value. For large corporations that must innovate on several fronts simultaneously, an occasional blockbuster can solve a lot of financial problems and squelch shareholder grumbling, but sustained value creation is seldom the result of one or two great new products. Instead, it is the outcome of a balanced portfolio of R&D projects. Executives who attempt to pick one or two winning ideas and ride them to success are no more likely to build corporate wealth than are investors who put all their efforts into picking a few home run stocks. Real and sustained corporate wealth is built over time through the strategic management of portfolios of innovative projects with different risk/return characteristics. This is what’s missing from most of the advice offered on innovation and in most corporate practice.

A Practical Method

Outstanding portfolio performance requires a practical decision making method for:

• identifying promising ideas;
• choosing the best ideas to invest in;
• portfolio review and rebalancing over the development cycle; and
• Commercialization.

We call our method Value-Based Innovation. It begins with analysis of promising projects. That analysis—which SmartOrg calls “Rapid Deep Dives” —begins with the end in mind: What is the economic value, expressed as net present value (NPV), of a particular innovative idea or project based on what we currently know about the market, the costs of development and manufacturing, and so forth. That NPV should not be expressed as a single number (point forecasts are always wrong), but as a range of possible values based on the probability of various outcomes. This same analysis should be repeated at every stage of development, from idea screening to development to commercialization. It provides insights into which innovations have the best odds of producing value and how R&D, product development, and commercialization plans should be directed and redirected to create maximum portfolio value.

Appraising innovation projects in terms of bottom-line business value is the only logical way for a portfolio managers to determine how much to spend and on which projects to spend it. Other methods devolve into the internal political games that so often lead organizations astray.

Not many years ago, project analysis of this intensity took weeks or months, eating up the time of managers, scientists, and staff personnel. Consequently, it was seldom done. Today, software tools make it possible to complete this work in one or two days.

At the Portfolio Level
While Rapid Deep Dives can tell us about the risks and potential value of individual ideas and projects, the big payoff is often found at the portfolio level of analysis. SmartOrg’s Web-based tool, Portfolio Navigator™, rapidly assesses projects for input into portfolio aggregation. It gives executives the information they need to select, prioritize and manage projects based on each project’s forecasted contribution to portfolio value. The tool provides a clear view of potential winners and losers, of aggregated financials, and of overall risk and return. By using Portfolio Navigator™, decision makers can better gauge whether an R&D portfolio will achieve its business goals.

Example: A Pharmaceutical Portfolio — the Innovation Screen

The Innovation Screen (figure 2) gives insight into whole portfolios by displaying the positioning of projects in terms of two characteristics: the probability of technical success (this includes regulatory matters), and expected commercial value (assuming technical hurdles are overcome). This 2X2 matrix contains Pearls, Bread and Butter projects, Oysters, and White Elephants. The Pearls have the greatest probability of both technical and commercial success. These represent the projects of highest value . To create more of them, the company must nurture its Oysters—early stage projects with substantial strategic and commercial potential, and the source of future Pearls. The yellow lines show haw the projects have moved since the last major evaluation. Here we see that a couple of Oysters have moved into the Pearl quadrant. Unfortunately, one of the Pearls, has fallen from grace. A portfolio must contain many Oysters if it wants to produce blockbuster Pearls on a regular basis.

Routine Bread and Butter projects dominate the upper left quadrant; these are usually incremental innovation projects with high probabilities of technical success and fair to good commercial prospects. White Elephants in the lower left quadrant, however, have limited potential, yet absorb time and resources. Identified White Elephants should either be terminated or repositioned to create greater expected value.

For managers, the toughest resource allocation choices are between the incremental value afforded by Bread and Butter projects and the blockbuster potential of Oyster projects. Portfolio Navigator™ helps focus on this balance

Example: A Pharmaceutical Portfolio — The CFO Chart

The CFO chart below (figure 3), is a curve that build up value beginning with the most productive project, in terms of that ratio of expected value to expected cost, and adding each new project in order of its productivity. This R&D productivity curve measures cumulative contributions to company value (in terms of NPV) relative to expected costs. By adding projects incrementally in the order of their value to cost ratios, the CFO chart displays a curve of diminishing economic value. Like a stock market “efficient frontier,” any portfolio not on this curve must lie below it, and is therefore inferior. This curve is typical in that about half of the R&D budget brings the company well over half of its expected NPV.

This economic comparison, based on the all of the factors considered in each project, leads one to ask why the returns on the right-side projects are lower and whether anything can be done to improve them. Also, what can be learned from the greater value represented by projects on the left?

Project-Portfolio Optimization
For sizable portfolios, joint optimization of all projects presents a huge value creation opportunity. To capture that opportunity, project teams should envision ways they can spend more resources; spend fewer resources; or abandon projects entirely
SmartOrg has found four questions to be especially helpful in getting people to rethink the resourcing of their projects. Those questions force teams to think creatively about alternative approaches:

1. What are your current development plans, and what resources are needed to carry them out?
2. If management increased your budget by 25 percent to 50 percent, how would you use those new funds to get the most value from your project?
3. If management reduced your budget, how would you cut back your project while preserving the greatest possible value?
4. What budget would be required to terminate your project and still reap the greatest “salvage value?”

This exercise challenges the status quo, stimulates creativity, and, as a side benefit, often results in improvements to the current strategy. All teams are commissioned to develop at least these four alternative ways for moving forward. Team members and senior management then participate in a peer review, where everyone can critique each other’s assessments, to assure that all projects are evaluated on a “level playing field.”

By combining alternatives at the portfolio level, decision makers go beyond the question of which projects to fund to the deeper question of what is the optimum level of funding for each project – which combination of alternatives should be chosen? SmartOrg methods and software tools produce an enhanced “efficient frontier” curve showing the optimum strategies for each project as a function of the total level of resources available. In practice, most portfolios gain 30 percent to 50 percent in value when they are subjected to this procedure. In addition, the efficient frontier tells where to cut back if you must, and how much the bottom line value will improve from any increase in total portfolio funding.

Project-Portfolio Optimization avoids the “sheep” approach to R&D funding—that is, matching the R&D spending: revenue ratio exhibited by the industry; instead, it bases R&D budgets on the estimated value of innovation.

Example: How SmithKline Beecham Improved Resourcing Decisions1

This company wanted to examine four alternatives for each of its R&D projects: the current plan and funding; a buy-up case in which resources were added; a buy-down case in which some resources were taken away; and a minimal case, wherein the project would be harvested for its salvage value. While the ultimate purpose of the exercise was to optimize resource allocation within the overall portfolio, most of the value-based analyses that followed revealed better, higher value ways of pursuing the individual projects.

Once each project team had created its four alternatives, a new CFO chart was created, beginning with minimal allocation to each project and then awarding the project with the best value/cost ratio funding its next budget increment. This builds an “efficient frontier” for the portfolio beginning at the steepest end. All possible allocations not on the curve have either lower value or more cost.

Consider the two curves in figure 4, where the lower one is the calculated value of the current portfolio and the higher one represents the “improved” portfolio of the very same projects. For any level of financial investment along the current projects curve, the improved frontier represents a substantially higher NPV—as much as $3 billion better, or about a 30 percent improvement. However, adding $500 million to the R&D budget would generate another $2 billion in shareholder value, or 20 percent, giving a total 50 percent increase in portfolio value (exact numbers are disguised to protect confidentiality).

SmithKline Beecham’s management was initially reluctant to allocate more funds to R&D because it anticipated reduced revenues from products going off patent. However, the case for doing so was so compelling that it eventually added major resources and publicly announced its decision. Contrary to the expectations of some, the market responded positively to this news. After all, shareholders—especially well-diversified shareholders—want their companies to make the investment bets with the highest potential for value creation.

Value Today—and Tomorrow

Is innovation the best approach to creating value for your shareholders? Chances are that it is, especially if your company has already achieved a high level of quality and operational effectiveness. Innovation can differentiate your company from its competitors and bring new life to product and service lines. Best of all, it’s a source of new value that is theoretically inexhaustible.

Just remember that innovation takes more than bright ideas and an organizational ability to push them through the development pipeline. Because resources are limited, you must decide which bright ideas hold the greatest potential value, and then manage them strategically in a portfolio of value creating ideas and active R&D projects. Individual innovations are important, but a portfolio of them represents your company’s future.