Are market cap and present cash flows the best way to measure innovation?

All opinions are my own and do not necessarily reflect those of Novo Nordisk

Forbes, with the help of the folks from The Innovator’s DNA recently published their coverage and rankings of the 100 most innovative companies.  I’m particularly interested in their ranking method, as it contains elements that are near and dear to my heart–namely, metrics and crowdsourcing.  In a nutshell, they describe how they use a company’s current market capitalization, along with it’s current net present value based on cashflows, to extrapolate how much the market feels the company has in potential.  The method nicely incorporates crowdsourcing in that the market cap measures how much investors as a whole think a company is really worth, now and in the future, and if that’s higher than expected based on cashflow, that suggests investors are factoring in a bonus to value based on future expectations.  Higher future expectations are interpreted as investors seeing a particular company as innovative and having the potential for great leaps forward in offerings and/or income.

I really like using the crowd in this way, and would love to see an analysis that retrospectively looks at these kinds of values over, say, 1970-1990, and combines that with a mature assessment of which companies have been adjudged by business historians to truly have been innovative standouts, which is not the same as business successes.  We say now that Bell Labs was one of the most innovative places on the planet in the 1900s.  Would the same have been said at the time?

At the same time, I can’t help musing if this process couldn’t be made even better.  Recognizing innovation when it’s happening has obvious advantages for anyone looking to get into the next amazing thing, whether as a participant, an investor, or a policy maker.  So let’s start by examining where there might be shortfalls to the Innovator’s DNA method.

The authors themselves helpfully point out some of their assumptions and limitations.  They have a requirement of seven years of public financial data.  This could be a problem as truly innovative companies may exist that are either still privately held or have not produced seven years of data (they point to Facebook as an example). The authors also require a certain level of R&D spend, and have also chosen to leave out those companies that depend on commodities like energy and minerals, because in those industries market cap is in large part influenced by external forces like shifting international market demands.

To these limitations I would add that relying on investors alone is limiting.  Daniel Kahneman, among others, has pointed out that year to year correlations between the success of the vast majority of professional investors are extremely poor.   If the quality of the data used in creating a ranking is poor, the actual ranking may also be less than robust.  I also am not sure of the point about R&D spend, since to me one of the most innovative things a company can do is make advances with fewer resources.  And, while they shy away from commodities, it both ignores the innovation going on in fields like alternative energy and downplays the importance of market forces for other kinds of products.  For example realization that there’s an aging world population is probably a substantial driver behind the market cap of geriatric supply companies .

So what could we add to make this ranking potentially better?  Well, or at least different?

First, I wouldn’t leave companies out.  It would be…having a Bowl Championship Series in college football and decreeing that only members of the top six conferences have automatic qualifiers. That’s crazy!  Who would ever do that?  If necessary, add a modifier or penalty for having a business which is more subject to external factors.  In a similar vein, it seems like requiring seven years of data is too much. Especially now when mergers and acquisitions are a fact of life and are an explicit part of so many startups’ plans, existence for seven years is a strong filter.

Second, don’t limit the metric to market cap and cashflow.  The idea that this serves as a crowdsourcing measurement of the investment community makes sense, but studies of crowdsourcing suggest diversity of inputs and independence among evaluators are key elements of making the crowdsourcing exercise as powerful as possible.  Investors in many cases are working off the same set of data and also have many similar biases that might lead to less diversity in their opinions of a company’s value. And, you’re also just looking at one type of evaluator: investors.

What other kinds of metrics could we look at?  How about applications per position posted?  This is another form of crowdsourcing, and taps into the working population.  It seems reasonable to investigate whether the number of people applying for jobs at different companies reflects a perception of company innovation.  There should probably be corrections for things like location and salary, but I also believe job seekers at all levels are looking for fulfillment, challenge and purpose, which are elements addressed by innovation (and other aspects of a job, it must be admitted).

Another way to query the crowd is the tried method of creating a prediction market.  Intrade has unfortunately been going through some difficult times, but maybe the folks at the Iowa Electronic Markets, or some  other group, could be recruited to participate.  This market, especially if advertised widely and well managed, would allow people to buy and trade propositions regarding whether a given company is likely to appear on the top 100 list.  How’s that for recursiveness?

At the end of using these different methods, the final step would be compiling a score that rolls these inputs into the final metric used for ranking.  Details of said formula could be weighted based on the expected (Bayesian) predictive power of each metric.  And then the next year, the results would be evaluated and used to tweak the formula again.

Well.  It’s true that all of this might be a bit much to do.  But on the other hand, understanding and identifying innovation is important for so many industries today, and any ways that help us more accurately identify innovation are surely welcome.

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