Leveraging Intrinsic and Extrinsic Value: Understanding Why Successful Digital Businesses Are Cash Rich

This feature article was written by Ralph Windsor, Digital Asset News editor and Project Director of DAM Consultants, Daydream.

 

In this article I am going to examine why digital businesses tend to have larger cash reserves than their conventional counterparts.  While lower operating costs by virtue of operating in a digital environment are certainly an important factor, in this piece I suggest that the ability to leverage the intrinsic and extrinsic value of their digital assets to yield greater ROI is a more significant reason.  I also assess the opportunities and threats for businesses that might result from these effects and how both digital and conventional businesses can take advantage of them.

 

Reviewing the Meaning of Intrinsic and Extrinsic Value

In 2017, I wrote an article for Digital Asset News with a definition of digital assets which describes them in terms of intrinsic and extrinsic value.  To summarise what I mean by those terms: intrinsic value is the fundamental attributes of an asset, i.e. the reason someone might want to acquire it.  In the case of a business, it might be the cash in the bank or stock inventory.  For a digital asset it is the binary essence or a unique identifier.  Extrinsic value refers to non-core or additional value, e.g., the brand of a business or its intellectual property it owns.  In the case of digital assets, extrinsic value is metadata (which can also be referred to as contextual data).

Frequently, when an asset is referred as having ‘no intrinsic value’, the implication is that it has no value at all, but this is a misconception.  As explained in the definitions article, intrinsic and extrinsic value is a concept I took from financial derivatives like options contracts where the differences between the two types of value are more widely understood.  As such, it is a fallacy to assume that non-digital assets have only intrinsic value.  I contend that not only does the same hold true of digital assets, extrinsic value is of far greater importance.  It is possible to have a digital asset with very little intrinsic value other than a unique identifier, but depending on the context, the extrinsic value could be quite substantial.

 

How Digital Businesses Leverage Intrinsic Value

As should be clear, there are some characteristics of intrinsic and extrinsic value that have an impact on the value of an asset (and therefore, the price that someone is prepared to pay for it).  For financial assets, this concept has been understood for centuries, but it is particularly relevant for digital assets where the implications of the distinction are only recently beginning to be realised.

In no small part is this situation due to the fact that digital assets tend to have very little intrinsic value.  For the type of content digital assets like images, videos and documents, there tends to be a far greater focus on the intrinsic value by most users, even though most Digital Asset Management experts acknowledge the extrinsic value (metadata) is where the ROI on investments into digital assets can be maximised.

More illustrative case studies that offer a hint of how extrinsic value can be leveraged to generate a significant yield from the intrinsic value in digital assets comes from analysing the modus operandi of some kinds of digital businesses that use models that are easily recognisable in the physical world.  There are a diverse range of commercial operations that are currently pursuing this strategy.  For example, digital car sharing services make digital models of cars, the extrinsic value is the digital asset (the record of the driver, his/her rating, journey history, how close he/she is to you etc).  The intrinsic value is the driver and the car.  The digital asset is worthless without the intrinsic value, but the intrinsic value cannot be leveraged without the extrinsic value: it is just someone who owns a car and is willing to offer a lift.  The extrinsic value contained in the digital asset is required so that prospective customers know they exist, the intrinsic value is why they are interested in it to begin with.

A lot of what pure digital businesses offer are digital assets which are representations of real world assets.  The intrinsic element is either rented from (or sub-contracted to) micro businesses in the most capitally efficient manner possible.  I would argue they would be more accurately termed ‘digital asset businesses’.  The vast majority of Digital Transformation initiatives in conventional businesses are predicated on this method, although most fail to acknowledge the role the digital asset has in all this, they assume it is just ‘data’ or ‘content’.  Some commentators have suggested referring to these entities as ‘objects’, which is technically accurate, but is too generic and lacking a business context.  I hold the view that Digital Asset Transformation is both more accurate in terms of what activity is taking place and more desirable.  What most businesses want to achieve is to increase their own asset value and by proxy, all the component assets which they utilise to provide their products or services.

 

Leveraging Digital Assets – The Ultimate form of Value Engineering

Digital asset businesses have the ultimate form of value engineering, their intrinsic value offer is rationalised as far as is possible. A proportion of the cost saved from this more efficient operating model can be re-invested in the customer’s interactions with the business, aka ‘the experience’.  The digital asset business owns the extrinsic value, the intrinsic value is someone else’s responsibility.  Their branding, marketing and positioning enables them to act as an intermediary, while still owning the customer relationship.  They actively encourage competition with the suppliers who provide them with the intrinsic value not only for cost reasons, but because it enables them to offer a wider and more diverse range of potential value which further makes it more likely that prospective customers will favour them.  They effectively own their value chain, but without having to pay for the most cost-inefficient component of it: the intrinsic value.

The differential between the cost saved from more efficient leveraging of the intrinsic value and the increasingly perceived equivalent value of a digital asset by consumers offers a very profitable margin, if the digital assets are managed skilfully.  Most of this management activity focuses on the extrinsic value, i.e. the metadata of the digital asset.  This is the reason digital businesses are cash rich.  All of the examples of successful digital asset businesses invest heavily into capturing and managing the metadata their customers generate for them because it offers an opportunity to generate compound ROI growth by leveraging up on their existing digital assets.

Contrast this with businesses whose assets are non-digital and who do own the intrinsic value.  The capital cost required to build something like a hotel, staff it, supply all the required goods and services necessary to keep it operational is usually substantial.  Further, there will be extended periods of time where the intrinsic value is under-utilised (costing the business money, rather than earning it).  Diversifying product ranges by expanding destinations, room sizes etc involves yet more expenditure and exposure to the risk that demand will be insufficient.

 

Opportunities For Conventional Businesses

Leveraging the power of digital assets to transform businesses presents both an opportunity and a threat for both conventional and digital businesses, respectively.

For conventional businesses who operate in a non-digital environment, the rapid rise of digital counterparts can give the impression that they are doomed to obsolescence and inevitable commercial failure.  Having an existing asset with intrinsic value, however, presents an untapped opportunity to collect data which can be contextualised to derive metadata (i.e. extrinsic value) and creates a digital asset associated with a physical one.  This model is widely understood by preservation-related organisations such as museums and libraries.  The latter frequently refer to their collections as ‘a wealth of knowledge’ for exactly this reason.

By definition, digital asset businesses cannot possess all intrinsic value attributes offered by their conventional counterparts and this can present a further opportunity to retain a competitive advantage.  A case in point is the market for electronic books as compared with printed equivalents.  For a brief period of time, electronic book sales outstripped print editions and the demise of the latter was widely predicted.  In recent years, however, print has been resurgent with the limitations of the digital medium being unable to compete with the intrinsic value offered by the book as a physical object.  Just because the book is non-digital, it does not mean that the data associated with it (as a physical object) cannot be encapsulated with an electronic record, or a digital asset, to use an alternative term.  How long physical books will retain their popularity is harder to predict, however, they demonstrate that there are windows of opportunity for some sectors to leverage their existing intrinsic value and synthesise it with some of the characteristics of digital assets to maintain their advantage.

 

Threats To Digital Asset Businesses

The threat to conventional businesses from digital competitors is now widely understood and the subject of numerous articles and books about digital transformation, ‘disruption’ etc.  What is less frequently acknowledged is the potential ease with which one digital business can usurp another.  The disruption is unlikely to be a one-time event and the frequency with which it might occur is likely to be greater for businesses that depend more heavily on extrinsic value.

The most obvious example of how this might occur is cost.  Technology markets are deflationary and rely on innovation to sustain growth.  If the opportunity to innovate declines (or management of the business fails to invest into it) then cost becomes an increasingly significant competitive factor.  As described, many established digital businesses are cash rich and their margins are derived from the differential between perceived intrinsic value and the expenditure they incur to generate that.  If a challenger wants to gain market share, the temptation to reduce margin is more likely to become greater and a formerly cash-rich digital business might see its margins cut with cash reserves depleting more quickly.  Some commentators argue that the existence of large cash surpluses is indicative of declining innovation, i.e. they have run out of ideas and decided to warehouse cash rather than invest it.

The other key threat to digital businesses is that extrinsic value tends to be more volatile than its intrinsic counterpart, so leveraging it increases both the upside and downside risk.  These are two sides of the same coin: what propels a digital business to generate rapid growth can work against it if the extrinsic value suddenly falls away.  Some well-known examples of this effect are social media web properties which have declined in popularity, such as MySpace.  Branding is another example of extrinsic value which translates equally between non-digital and digital value.  If the brand  of a business is positive, the leverage effect works to the advantage of the business, however, negative press or publicity can have the reverse effect.

As can be seen, the two major threats to digital asset businesses are a lack of willingness on the part of businesses to invest in innovation and volatility in the value of their existing digital assets.

Below are some factors which offer an opportunity to reduce the volatility of digital assets:

  • Duration: the longer period of time a digital asset has existed, the larger its footprint will be and therefore the more likely it will be to have contextual relevance.
  • Connections (links) to other digital assets: the more one digital asset is connected to others, the greater the likelihood that it will be discovered and used. This point is closely related to both the previous point about duration and the next one.
  • Contextual relevance: the more easily it is to quickly assess the relevance of a digital asset to the user’s needs, the more likely it is to be used and therefore the greater the potential to acquire more metadata (extrinsic value).
  • Stronger connections to intrinsic value and real world experiences. This is particularly relevant for digital businesses, as the earlier discussion about electronic vs physical books demonstrates.

 

Stabilising and Growing The Value of a Digital Asset Business

As with other kinds of assets, a desirable valuation trajectory is a steady inclination in growth that occurs as at a predictable pace, rather than one that fluctuates wildly (and consequently makes management of them more demanding).  There are two digital asset strategies which can be derived from this analysis, depending on how a business is defined by its history and current market positioning:

  • Conventional businesses need to model their existing intrinsic value into digital asset equivalents and use this as a framework to develop hybrid assets that can compete with digital businesses. They have to do this before the opportunity to maintain their intrinsic advantages are eroded.
  • Digital businesses have to reduce the volatility of their digital assets and connect them to the intrinsic value which conventional businesses already possess. In addition, they need to continue to innovate and avoid competing on low value factors like cost.

The distinction alluded to above is likely to be a transitory state of affairs.  In 20 years (and some would argue less than that) there might not be any appreciable difference between the two, they will be fully converged.

One thing is clear, there will be an exponential growth in both the volume and functional scope of digital assets as there is massive demand for them that will only increase as digital activity increases.  Those businesses that have begun to strategize models and solutions to manage them across all the operational facets of their organisation will be vastly better placed – to both maintain their competitive position and grow – than their competitors who have no strategy in place to enhance the value of their digital assets.