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 by visiting learn.theinnovatorsmethod.com.
Companies are ranked by their innovation premium: the difference between their market capitalization and a net present value of cash flows from existing businesses (based on a proprietary formula 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 FB +1.28%, for example, would be in the top ten if we used only 2012 data.) We include only industries that are known to invest in innovation., excluding industries that have no measurable investment in R&D, so banks don’t make the list. Nor do energy and mining firms, whose market value is tied more to commodity prices than it is to 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 returns to investors to be low, 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 a company’s income (cash flows, in this case) from its existing businesses and look at the net present value (NPV) of those cash flows. We compare this base value of the existing business with the current Enterprise Value (EV): Companies with an EV above the 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 Innovators DNA (Harvard Business Press, 2011), written with Harvard Business School professor Clayton Christensen. The following steps outline our approach in greater detail:
- In assessing a company’s current valuation, HOLT determines the next two years of cash generation from existing businesses for each firm based on the consensus estimate of earnings, revenues, and investment by analysts. These consensus estimate 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.
- 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).
- The difference between the company’s total enterprise value (market value of equity plus total debt) and this value of existing business constitutes the innovation premium, expressed as a percentage of the enterprise value.
While HOLT’s fade algorithm is based specifically on the historical and future projected performance of the given firm, it may appear to reflect sector identification or industry position. To the extent that firms in an industry or sector share the characteristics of ROI level, variability, and reinvestment, the pattern of fade will also be similar. There is also an apparent correlation between a company’s fade expectations and its position in the industry, since most industry leaders have higher and more stable rates of ROI and, having been through their growth phase in achieving their leadership position, no longer need to grow at above-average rates.
We require at least 7 years of financial data for a given firm to be considered on our list of most innovative companies. We also use a form “research and development” screen by excluding industry groups in which no member has reported R&D or similar spending. Also, to control for size differences, we include only those with a market value greater than $10 billion. This year we’ve seen an increase in our sample size and the number of companies with high innovation premium levels. As a result, the average innovation premium of our list has risen and companies that may have made the cut in the past ended up falling short this year (e.g. Google and Apple both have positive premiums, at 29.1% and 10.2% respectively, but that knocks them down to the 115th and 282nd spots this year). In very rare cases when a company derived more than 80 percent of their revenues from a single high economic growth market (e.g., India, China), we assumed a small portion of the company’s innovation premium was derived from higher domestic market growth rather than true innovation (i.e.,, entering new products, services, or markets). Accordingly, we made a slight downward adjusted to the firm’s innovation premium using a formula that compares the particular domestic region’s growth and compares it to rest of the world and assumes a portion of a company’s growth will come from those differences in market growth. However, this adjustment only made a minor change in a firm’s ranking and did not move any companies on, or off, the list. The innovation premium shown in the tables in this chapter reflect a weight average innovation premium over five years with the weighting as follows: most recent two years (30%), years 3–4 (15%), and year 5 (10%).
Additionally, our fade algorithm for a given company is based on the following:
- The forward two-year consensus estimate of ROI level. Firms with higher levels of profitability and ROI maintain higher returns into the future. However, the historical experience of most firms shows a “regression to the mean” effect, meaning that high ROIs will gradually fade toward the average ROI of firms in the economy. The higher the current level of profit, the faster the expected decline. (Firms will tend to maintain their rank order; however, the spread between the top and bottom performers tends to narrow.)
- Historical ROI volatility (over the previous five years). The greater the volatility of ROI historically, the faster the firm’s ROI tends to fade toward the average of all firms going forward. Firms with consistent and stable ROI are more likely to maintain a consistent ROI into the future.
- A company’s reinvestment rate. The faster a company’s recent growth and the greater the amount of cash it has reinvested, the faster the firm’s ROI will fade toward the mean profitability of firms in the economy. It’s hard enough for a management team to maintain high levels of financial performance; doing this while also growing rapidly is even more difficult.
This article was written by Jeff Dyer and Hal Gregersen from Forbes and was legally licensed through the NewsCred publisher network.