Setting the Stage
Economic value is defined as the measurement of the benefit derived from a good or service to an individual or a company. This is not the same as market value, which is an individual’s willingness to pay for a good or service. Neither of these values can be calculated using a precise formula, but it’s what investment bankers try to do anyways. Over time, markets are generally efficient and stock prices correlate with fundamentals and the expectations of future cash flows from a firm. Unless you’re GameStop!
When companies publicly adopt new cloud services, there is typically a short-term increase in market value due to the perceived notion of agility, innovation, or cost cutting that may come as a result. However, companies should be seeking increased long-term economic value when they adopt the cloud. Economic value is more sustainable and goes beyond a stock price dopamine rush.
So, how does a company do this?
First, the mechanics. Let’s start with a formula for a discounted cash flow, or DCF, valuation. If you’re a trader in this market, you may prefer to use multiples to perform relative valuations, but I think that’s just a pricing exercise.
At a high level, a DCF valuation helps an investor determine a fair present value for a company based on its future (n) cash flows. Cash flows (CF) are calculated after expenses, taxes, interest, and debt payments and divided by the company’s cost of equity or cost of capital (r). A series of cash flows typically has a growth component and terminal value after a firm’s high-growth period.
Cloud Adoption Must Add Economic Value
Putting the cost of capital (r) aside, there are a couple of ways to add economic value — some are obvious and some are less-so.
- Cash Flow Mechanics: Increase Revenue or Decrease Costs
- Increase after-tax earnings from existing assets
- Reduce reinvestment needs
- Growth: Scale the Business
- Increase the expected growth rate in cash flows by increasing the rate of reinvestment in the firm or improving the ROI on those investments
- Increase the length of a high-growth period by building competitive advantages around your brand, legal protections, creating high switching costs for your customers, or leveraging cost advantages that only you have access to
Increasing bottom line cash flows feels obvious, but you can’t cut your way to profitability. Don’t get me wrong, there are absolutely short-term benefits to be gained in finding efficiencies in your business, but they won’t add long-term value. Growth is what leaders must focus on.
The Best Ways to Grow
Ranked by the “Dean of Valuation“
- Launch a New Product (+)
- Expand an Existing Market (+)
- Maintain or Grow Share in a Growing Market (Neutral)
- Compete for Share in a Stable Market (-)
- Acquisition (-)
Common Cloud Scenarios
Lifting & Shifting Infrastructure
If done correctly, this is likely to decrease costs over time, but won’t add long-term economic value. Conversations at this phase of cloud adoption typically focus on transitioning from large data center capital expenditures (CapEx) to flexible operational expenditure (OpEx) models. You can learn more about this from my friends at 10th Mag if you’re interested.
Refactoring Applications for the Cloud
This helps cash flows by cutting costs and taking advantage of cloud elasticity, but again, you can’t cut your way to profitability! On the contrary, this actually creates higher switching costs for you, the cloud buyer, and doesn’t add long-term economic value. This is why portability (usually via containerization) and multi-cloud strategies are talk of the town. My personal opinion is to invest in a single vendor that meets the majority of your needs to minimize operational overhead and scale your cloud talent, but that’s not the point of this post.
Launching New Products Leveraging the Cloud
This is the golden goose and is how companies can leverage the cloud to add economic value to their firms. The key question that cloud buyers should be asking themselves when evaluating a new cloud service is: What can we create using this service that we couldn’t create before? The first four words of that question are the most important, so I’ll write them one more time:
What can we create?
Launch Products Using the Cloud
If you work for an organization that’s more than a few years old, I assume that most cloud conversations are probably happening in a central IT department. These conversations are likely focused on governance, security, networking, and maybe even a hint of DevOps. However, while these are essential conversations in the cloud adoption journey, they leave out a crucial wider audience.
Product & Innovation Teams
The most competitive companies of this century have moved towards a hypothesis-driven product model that puts users at the center of everything that they do. They know that the most successful tech companies do this well and that every business is currently undergoing a digital transformation. While I don’t subscribe to the notion that, “every company is a tech company,” I do believe that if tech is not the product, it is likely a key enabler of it. Successful product development focuses, in this order, on:
- User Needs
- User Experience
- Features
- Technology ← Cloud services enter here!
- Marketing
When you’re evaluating a cloud service, vendor, or even just an API endpoint, you should ask yourself if you’re evaluating it in the context of product development. It’s common to be drawn in by a shiny object, sales pitch, or a vendor’s whitepaper that you downloaded in exchange for your fake email address, however, these should be evaluated much later in your product development process. I’m not saying ignore these, they can be great creativity builders for ideation sessions or starting points for your next project, but unless you’re focusing on your users’ needs first, then they are just technology noise.
Once you identify what you want to build, then you can focus on how to build it. Ask your vendors how they can add value to your product development processes, ask them what they can do that no other vendor can, and ask them if one of their own product managers is willing to join an internal call. If your vendor isn’t partnering with you during every step of the journey, then you don’t want to establish a long-term relationship with them, especially if there are high switching costs to leave them.
A successful vendor partnership, cloud or otherwise, enables your product teams to capitalize on the vendor’s strength in the space and they should be willing to learn your business or at least take a walk in your shoes. If you do invest in a single vendor, improving the ROI of your investment is the next best step to add economic value.
Improve the ROI of Cloud Investments
This step sounds simple in theory but is difficult in practice — you need other teams in your organization to get more comfortable with technology.
- Hire Strong Talent
All technical product managers should have some familiarity with modern cloud services and best practices, and if not, they should be lifelong learners with a growth mindset and be willing to jump in and get their hands dirty. - Develop Your Team
Get your teams certified in the cloud services that you choose. The best vendors are happy to help you accomplish this and have many resources at your disposal. Require your team to learn the essentials and reward them for doing so. - Give Them Hard Problems
The people that build your products should like the challenges that you give them and get satisfaction out of solving them. Giving them new tools for their toolboxes should empower them, not scare them.
To learn more about becoming a great product manager, I highly recommend reading the books published by Lewis Lin. Most of his content focuses on mastering product management interviews, but the skills carry through into the roles.
Technical product development quickly becomes engineering work, and successfully managing technical teams pays off in dividends. One of my favorite books to start this journey is The Manager’s Path: A Guide for Tech Leaders Navigating Growth and Change by Camille Fournier, one of the founding members of Rent the Runway. I’ve also been lucky enough to work with the current leadership team at Rent the Runway and see them put these values into place.
TL;DR
Gaining economic value from cloud investments will not happen by finding cost efficiencies alone. Cost benefits often kick off an organization’s cloud journey, but priorities must change and flow through an organization to grow the business and gain long-term economic benefits from cloud adoption. These priorities should focus on getting product development and innovation teams comfortable with new technologies so that they can build with cloud-native services faster. The earlier a digitally transforming organization innovates using cloud services, even if the technology is only an enabler of a product, the more likely they will beat the competition to market.
If you’re interested in learning more about the mechanics of valuation or why acquisitions don’t add economic value, I highly recommend watching the YouTube videos of a former professor of mine, Aswath Damodaran.
