Most innovation rankings are popularity contests based on past performance or editorial whims. We set out to create something very different with the World’s Most Innovative Companies list, using the wisdom of the crowd. Our method relies on investors’ ability to identify firms they expect to be innovative now and in the future. You can learn more about our research on innovation at The Innovator’s DNA website.
Companies are ranked by their innovation premium: the difference between their market capitalization and the net present value of cash flows from existing businesses (based on a proprietary algorithm from Credit Suisse HOLT). The difference between them is the bonus given by equity investors on the educated hunch that the company will continue to come up with profitable new growth.
To be included, firms need seven years of public financial data and $10 billion in market cap. (Facebook, for example, would rank high on the list if we used only the data since they went public.) We include only industries that are known to invest in innovation, excluding industries that have no measurable investment in R&D, so banks and other financial services don’t make the list. Nor do energy and mining firms, whose market value is tied more to commodity prices than innovation. Big caveat: Our picks do not correlate with subsequent investor returns. To the extent that today’s share price embeds high-growth expectations, one might even anticipate low returns to investors, as these expectations may be difficult to meet.
We use something called the Innovation Premium to compile our list. It is calculated first by projecting the cash flows a company produces from its existing businesses without any growth and look at the net present value (NPV) of those cash flows. We compare this base value of the existing business with the company’s current total Enterprise Value (EV): Companies with an EV above their base value have an innovation premium built into their stock price. You can read a more detailed explanation of our work around innovative companies and leaders in our book The Innovator’s DNA (Harvard Business Press, 2011), written with Harvard Business School professor Clayton Christensen. The following steps outline this approach in greater detail:
1. In assessing a company’s current valuation, HOLT determines the next two years of cash generation for each firm based on the consensus estimate of earnings, revenues, and investment by analysts. These consensus estimates are based on the median of the combined estimates of carefully screened analysts covering a public company as selected by Institutional Brokers Estimate System [I/B/E/S]). Benchmarks for historical periods (as are used in the Innovation Premium) use actual reported profitability and reinvestment rates as the starting point for the cash flow forecasts.
2. HOLT then projects future free cash flows well into the future, assuming no real growth in the investment base and a “reversion to the mean” of the profit rate based on fade algorithms developed from an analysis of historical cash flows from over 45,000 firms and more than 500,000 data points.* The concept of fade embodies the common-sense notion that competition is the one enduring constant in free markets (à la Schumpeter’s “creative destruction”) and that technological change and changing market dynamics all militate against the persistence of excessively high returns (this is consistent with prior research that consistently shows a “regression to the mean” effect with regard to firm profitability).
Read the full post at Forbes.
Jeff Dyer is the Horace Beesley Professor of Strategy at the Marriott School of Management at Brigham Young University.
Hal Gregersen is Executive Director of the MIT Leadership Center and a Senior Lecturer in Leadership and Innovation at the MIT Sloan School of Management.