Market Sizing

Pitch Like a Startup to Win Budget at Your Big Company

Many people think that only entrepreneurs need to pitch investors and raise money, but the same process is happening every day in big companies. Boards, executives, and stakeholders are trying to determine how to allocate funds just like venture capital firms and angels. As a product manager or department head in an enterprise, you need budget to fund your projects and ideas. Just like an entrepreneur, you need to craft a compelling story that demonstrates your project will generate more money than is put into it.

But what makes a good pitch?

Our Product Pitch Cheat Sheet shows you.

We’ve combined top venture capital firm Sequoia Capital’s Writing a Business Plan–the outline of the story they need to hear to invest–and the Jobs-to-be-Done product development method to generate a clear and concise guide to pitching a product idea.

Sequoia’s outline tells you what to cover, and Jobs-to-be-Done helps you answer the key questions that will give you confidence in your material, such as:

  • How do you know your problem is worth solving?
  • How do you know your solution is good enough?
  • Is your market big enough?

Whether you’re trying to find budget to launch a new product or initiative, get more resources for your team, or confirm for yourself that your project is worth pursuing, Jobs-to-be-Done can quantify the justification you need to win investment.

After the cheat sheet, you’ll find Sequoia’s outline with the JTBD guidance under each point. If you’d like to learn how to do all of this yourself in detail, don’t hesitate to contact us.

 

1. State the Company Purpose
As Clay Christensen says, “your customers aren’t buying your product, they are hiring it to get a job done.” A “job” is an important goal that a person is trying to achieve in their personal or professional life, such as “reach a destination on time,” “acquire a customer,” or “overcome diabetes to achieve optimal health.”

The struggle people feel in attempting to get their job done is what causes them to look for a new solution–a product to hire. We call people who are trying to get a job done “job executors.” If your company gets the job done for the job executors, they will use your product.

A direct and simple way to state your company’s purpose is to say what job you are getting done for which job executor.

Here are a few examples:

Try to make your articulation compelling and, as Sequoia says, “declarative.” The job, the job executors and the key struggle should be very clear.

If you have chosen a job that has a lot of job executors trying to accomplish it frequently and the job is famously difficult to do well, it should be immediately clear that when your company achieves its purpose, it will create enormous value.

Finally, remember that your product is not part of your purpose. For example, if you’re trying to help small businesses acquire customers, your purpose should not be to “build the fastest, easiest-to-use CRM.” Small businesses don’t want lightweight CRMs any more than they wanted advertisements in print directories. What they want is to get a job done, so express your purpose in terms that reflect helping people overcome the stress and anxiety associated with getting a job done.

2. State the Problem
Your customer’s problem is that their job is complex and difficult to execute quickly and accurately. It could even require the use of multiple solutions.

How do you know if the pain is severe enough that people are looking for a new product to relieve it? Jobs-to-be-Done helps you quantify the pain and gives you a benchmark to know if the problem is worth solving.

The key is identifying the unmet needs. In Jobs-to-be-Done, we define customer needs as “the metrics customers use to judge how well the job is going.” The metrics we use are speed and accuracy. If the job is slow and inaccurate, the customer will want a new solution.

You can interview job executors to find out what’s frustrating and time-consuming about executing the job. Then, you can survey a statistically significant sample of job executors to determine which needs are the most important and least satisfied. These are your customers’ unmet needs.

The unmet needs are the precise articulation of the customer’s struggle to get the job done. Since a job is a key goal in a person’s personal or professional life (i.e. they need to execute the job frequently and they derive value from doing it well), the unmet needs are problems worth solving–they have great value.

It’s rare, but there are times when there are no unmet needs in a job. This means you don’t have a problem worth solving. Often this is because you came up with your idea for a solution first and it’s for a job that is over-served (the job is important but perfectly well satisfied in the market). This is a problem that’s not worth attempting to solve, as no one is looking for a new solution.

But once you’ve found a collection of unmet needs, you have the problem you need to start a business. In your pitch you can say, “[job executors] are struggling to [job-to-be-done].” Then, you can state the key unmet need(s) you uncovered in the market and intend to serve with your product.

For example, if you were pitching Waze, here’s how you could state the problem:

In this problem statement, the job executors are “drivers,” the job is “reach a destination on time,” and the unmet need is “reduce the time it takes to determine if you should take an alternate route due to traffic conditions.”

Anyone who drove a car before Waze has felt this problem, which means if you state it well, it should resonate. More importantly, if you have executed Jobs-to-be-Done, you will have data to back up your statement. You will be able to show that this unmet need is worth attempting to solve.

3. Show the Solution
When presenting the solution, Sequoia says to “demonstrate your company’s value proposition to make the customer’s life better.” In other words, how is your solution going to serve the job executors’ unmet needs in the job and how do you know it will do it well enough for customers to switch to your solution from whatever they’re doing today?

Using Jobs-to-be-Done, you can measure the value of your solution. Customer needs are all metrics of speed and accuracy. Consider how long it takes to meet your targeted needs and compare that time to the existing solutions. The closer your product gets to making the job automatic and extremely accurate, the more customer value you are adding.

Instead of talking about the features of your product, frame the discussion of your solution by how quickly and accurately it meets the needs in the job. For example, if the job is overcome diabetes to achieve optimal health and you’re targeting unmet needs around reducing the time it takes to determine costs, benefits and risks of available options for the patient, then demonstrate how quickly your product enables patients to meet these needs.

4. Why now
Sequoia recommends setting up the “historical evolution of your category” and then defining “recent trends that make your solution possible.”

Combining this with Jobs Theory, this becomes “What has changed that enables you to get your customers’ job done better?”

Consider the following examples:

In the examples above, new technologies and changing regulatory environments enabled new and better ways to get the jobs done. If you look further back in history, we see that this has always been true. Think about those people that have solved a job for a large, underserved market at the right time. Some legendary examples include:

  • Karl Benz: The potential of gasoline had just started being explored; people (and things) needed a way to get from point A to point B faster.
  • Frank McNamara (the credit card): Consumer confidence in post-WWII America was rising; people needed to reduce the likelihood that not having cash on hand prevented them from buying what they needed.
  • Jeff Bezos: In 1994, internet usage was growing by 2,300% per month and was an excellent foundation for serving the needs in the job “purchase a product” better than the existing solution of stores and mail order catalogues, which gave birth to Amazon.

During your pitch, be sure to identify recent trends that show why now is the time for your product or service. The people above tackled age-old jobs by capitalizing on technological advancements that made solving those jobs easier and faster.

5. Market size
Don Valentine, Sequoia’s founder, has always stressed the importance of the market: “We have always focused on the market–the size of the market, the dynamics of the market, the nature of the competition–because our objective always was to build big companies.”

When companies flounder, it’s because they try to define the market based on product ideas rather than market needs. Then, they invest too much in the manifestation of their assumptions: their unwanted products. This is a gamble (and almost always a mistake), as it assumes there will be a line of customers waiting to use that product simply because it exists.

Before you take your product to investors, Sequoia says to calculate market size. But how do you do it? You have to carry out research to see how many people need to complete the main or related jobs your product completes. Remember: the job-to-be-done is the market—not the product.

This is why the traditional ways of examining a market are flawed. These include the following:

  • Total Addressable Market (TAM): All units sold in a product category multiplied by the price per unit.
    Served Available Market (SAM): Units sold of a specific product type multiplied by the price per unit.
    Share of Market (SOM): Percentage of customers buying a certain company’s products.

These are product-based ways to calculate market size. Jobs Theory teaches you that the target market is the job executors and a job-to-be-done.

As an example, consider the Microsoft Zune, which was an answer to the iPod. Using traditional ways of analyzing market size, Microsoft measured the iPod market, which, at the time, was in the billions of dollars (e.g. 200 million iPods sold x $150 per unit = $30 billion market). But in 2007, the iPhone and Pandora launched, getting the job of curating music done more effectively, and the the iPod market quickly dipped to $0.

Microsoft made the mistake of defining the market based on the product. The market vanished because it was defined by a product. This left Microsoft trying to grab a market share of what was essentially nothing.

Instead, with Jobs-to-be-Done, the market size should be defined based on the customer’s willingness to pay to get the job done (regardless of the products currently in the market). To size the market into an accurate dollar amount, survey customers in the market to find out how much they are willing to pay to get the job done more accurately, efficiently, and/or conveniently. The resulting number is termed the securable market—the revenue you can generate by enabling customers to get a job done better.

6. Competition
As Sequoia says, it’s “better to identify all the competitors than have the investors discover them afterwards.” How do you capture a comprehensive list that is meaningful? Which products are worth including and how do you analyze them to show that your solution can beat them?

The competition is not just similar products. It is any existing solution–a product, service, or manual process–that the job executors use to get the job done today. This view generates a much broader list and a more comprehensive understanding of what your product needs to beat.

You can show how you will beat them by eschewing the traditional feature-to-feature comparison and instead looking at how well the competition serves the needs in the job. Your customers don’t want more features, they want to get the job done, so showing that your product has more features does not demonstrate that people will adopt it.

Let’s look at the Nest learning thermostat as an example.

A typical list of competition would include other thermostat companies such as Honeywell and Emerson. The first version of the Nest didn’t include all of the features of the Honeywell programmable thermostat and it was far more expensive, so how could you have shown that it would succeed?

First, identify the customer’s job by asking, “What job is the customer hiring this product to get done?” In this case, it’s to “achieve comfort in the home.”

Next look at the needs in the job. One need is “reduce the likelihood of the home being cold when you return to it.” How quickly and accurately does a programmable thermostat serve this need? Programming the thermostat takes minutes. The schedule is rigid, so if you get home early one day and forget to turn the thermostat up, you will be cold. The time it takes is minutes and the accuracy is low. The Nest improved upon this need by controlling the thermostat based on your location. It doesn’t require programming so it meets the need faster. It’s more accurate because it will turn on the heat automatically when you are home.

By showing how much faster and more accurately your product meets the needs in the job, you can show that you will beat the competition.

7. Product
Sequoia recommends you provide a product development roadmap covering functionality, features, architecture, intellectual property, form factor, etc.

Whether your product is far enough along to show a demo or all you have is a road map of your future, be sure to focus this section of your pitch on the unmet needs. It’ll frame your story, giving your feature set meaning and showing why customers would switch to your product.

It’s critical to demonstrate how early versions of your product will serve unmet needs better than the competition. Otherwise, your audience will question why and how you will get early adoption.

In your roadmap, you can show how even though your product only gets a few needs in the job done today, over time it’ll expand to get the whole job done (and potentially expand to adjacent jobs), creating more value for the customer and a competitive moat.

8. Business model
Sequoia’s outline recommends discussing your revenue model, product pricing, average value of a customer, sales and distribution model, and customer pipeline list. Here, you must make clear who is willing to pay (and how much).

The examples of Airbnb and Facebook show how viewing your business through the lens of Jobs Theory can help you construct a sound revenue model.

Airbnb generates revenue from the job executors of the two primary jobs the product set out to serve from day one:

1. Travelers finding lodging

2. Residents providing short-term rentals

Airbnb charges a fee on the transaction because the job executors have a willingness to pay to get these jobs done.

Facebook doesn’t make money off the primary jobs it originally helped its users complete: students getting to know their classmates and staying in touch with friends and family. Instead, the mountains of user data Facebook collects created an asset to get another job done: businesses acquiring customers. The willingness to pay for this second job done is very high.

When conceiving your revenue model, first research the willingness to pay for the primary job your product gets done. If the job executors are not willing to pay for it, consider whether or getting the primary job done creates an asset that can be deployed to getting an adjacent job done where the job executors have a high willingness to pay.

Final Advice
Jobs-to-be-Done not only provides a rigorous foundation for your pitch, but it also provides a framework for you to determine if your idea is worth pursuing or to find a new idea worth pursuing. However, just because you’ve learned the language of Jobs, Job Executors, and Unmet Needs does not mean the audience for your pitch (company stakeholders, your company’s board, potential investors) knows this language. Abstract your story from the theory to drive your points home. No one needs to know what a job or a job executor is to understand that drivers struggle to reach a destination on time. Use the theory to do your homework and then tell your story in plain English.

If you have any questions, get in touch.

A Step-By-Step Guide to Using Clay Christensen’s Competing Against Luck and Jobs Theory to Launch Great Products, Part 2: Answering The Right Question

unmet-needs-whiteboard

This is Part 2 of two-part series explaining thrv’s process for executing Jobs Theory. Part 1 is about customer research you can do to define the right question that will drive your product development. This part is about answering that question.

If you’ve read Part 1 of this series, you know about the first 5 steps to executing Jobs Theory:

  1. Define your customer’s jobs: functional, emotional, and consumption
  2. Identify all of the unmet needs in your customer’s jobs
  3. Find the unmet needs
  4. Segment your customers
  5. Identify competitor weaknesses

This work leads to defining your question:

What can you do to serve your customer’s unmet needs in the job better than the existing solutions?

The next step is to generate great product ideas that answer this question.

Step 6: Generate Ideas
You might have noticed something: in all the steps so far we haven’t had any ideas. The traditional innovation process usually starts with product or solution ideas. An ideas-first process is fundamentally flawed because the goal of innovation is not to generate more ideas, it is to satisfy customer needs better than the existing solutions. Jobs Theory enables you to build a needs-first innovation process.

When I was a product manager at Microsoft in the 1990s, we had a “brainstorming” room where our team would go to spitball new ideas. Anything went. As you probably know, the only rule in brainstorming is “there are no bad ideas.” This was (and is) absurd. There is a nearly infinite supply of bad ideas.

When executing Jobs Theory, you don’t need to “brainstorm” because you have clear criteria to judge product ideas: the unmet customer needs in the job.

When you get your team together to generate ideas, start by writing an unmet need on the whiteboard. Then, ask the room: “What can we do to serve this need?”

It’s still helpful for your team to think out of the box–perhaps your product is a website but a chatbot would serve the need much faster–but now, because you are answering a specific, measurable question, you know whether to keep the idea or move on.

If surgeons were your customers and you wanted to help them “restore artery blood flow,” you’d ask about the unmet need, “Does the idea help surgeons reduce the likelihood of restenosis?”

If drivers were your customer and you wanted to help them “get to a destination on time,” you’d ask “Does the idea help drivers reduce the time it takes to determine if an alternative route should be taken?”

If the ideas don’t satisfy the needs, quickly move onto the next idea. If they do meet the needs, keep them on the list.

Push the team to build on the ideas and achieve step function improvements over the existing solutions. Don’t let them be boxed in by the limitations of your existing product. The sky is the limit. Later, you can plan your roadmap to get there, step-by-step.

Now that you have a list of ideas that serve the unmet customer need, measure how well they do it–how much they improve the probability of achieving the goal as stated in the need.

Stack rank the ideas based on how much more reliably or faster they meet the needs than the existing solutions. If you see an idea that produces a step function improvement–reduces the time from days to hours, minutes to seconds, etc.–you may be sitting on a gold mine.

Jobs theory enables more efficient, precise, and relevant idea generation. Not only can you ensure all the ideas are relevant, but you can see if they are good enough.

Step 7: Price your product.
Pricing typically uses a combination of inputs, including the cost to make the product (or deliver the service), perceived value, and the price of substitute products in the market. Using this last input can be a fatal mistake for both pricing and market sizing.

To know why, you need to understand a pitfall of traditional market sizing: products and technologies come and go.

Traditional market sizing is based on variations of the following equation: the market = product price * the number of units sold. For example, in 2007 the iPod market was huge ($150 * 200 million iPods sold = $30 billion). Microsoft thought this was a big market and launched the Zune, an iPod competitor.

This is what the iPod market looked like at the end of 2011.

screenshot-2016-10-11-14-24-23

The “market” (defined by a product) went away, which means that Microsoft was looking to take a share of virtually nothing. But, of course, the true market, the customer’s job-to-be-done, didn’t go away. The iPod may have gone away, but people didn’t stop executing the job.

Jobs Theory’s definition of a market explains what happened.

There is no such thing as the “iPod” market. Customers don’t want iPods anymore than they want records, cassettes, or CDs. What they want is to get a job done, i.e. create a mood with music.

“Price * units sold” is a flawed definition of a market because it can disappear from right under your feet. Defining the market based on the customer’s job-to-be-done is much more helpful because the job will exist forever and therefore, the market will too.

To execute market sizing with Jobs Theory, you can look at the willingness to pay to get the job done. Willingness to pay can be measured by asking job executors (and if necessary purchase decision makers) how much it is worth to them to get the job done perfectly. The resulting data can be plotted (from high to low) on a line against the number of job executors. We call this a “need curve.”

The area under the curve is the total market size. It will also identify the prices that will place your product at the high end of the market, the low end, or somewhere in between.

In Competing Against Luck, Clay Christensen says, “The reason why we are willing to pay premium prices for a product that nails the job is because the full cost of a product that fails to do the job — wasted time, frustration, spending money on poor situations, and so on — is significant to us.”

By looking at the willingness to pay to get the job done, you can price your product to target the part of the market that will be the most profitable, and you can measure how lucrative that market will be over time, without the risk of it going away.

Step 8: Create messaging and positioning.
Positioning a product in a market and creating messaging that will resonate with customers is quicker and easier using the job-to-be-done and its customer needs.

When messaging misses the mark, it is usually because the message is focused on the product and its features. For example, Magellan messaged to potential customers that its RoadMate product has a “Wide-Angle Lens” and a “G-shock Sensor,” both sophisticated technologies.

But how does a Wide-Angle Lens or a G-shock Sensor help a driver get to a destination on time? What need is it satisfying? If messaging describes the product features or technology, the customer has to figure out on their own how (and if) the features help them get the job done better.

Messaging based on satisfying the job-to-be-done is easier for customers to understand. And because the needs in the job-to-be-done are prioritized based on importance and satisfaction, you can create messages based on the most underserved customer needs in your market.

Step 9: Plan your roadmap.

“Jobs Theory enables innovators to make the myriad, detailed tradeoffs in terms of which benefits are essential and which are extraneous to a new offering.”

–Clay Christensen, Competing Against Luck

The unmet needs in the job-to-be-done are your basis for making smart tradeoffs. Each job typically has about 100 customer needs. You can prioritize the needs by calculating the difference between the importance and satisfaction scores. The needs with higher importance and lower satisfaction are top priority. When you’re choosing which product features to build now and which to postpone–making tradeoffs–you choose the features that meet the top priority needs.

The same mindset can be used to plan your road map. A great road map will balance cost, today’s impact, and tomorrow’s promise. During your idea generation, you may have come up with some brilliant ideas that will take a long time to build or be very expensive to execute. This doesn’t mean you should ditch them. You just need to figure out how to increment your way to the brilliant idea while meeting customer needs better and better along the way.

This is step 1 of your road map planning: Determine the incremental improvements that will take you from where you are today to where you want to be tomorrow, getting the whole job done faster and more reliably than the existing solutions. Step 2 is to determine which of those incremental improvements to tackle first. The criteria for this prioritization is the extent to which the improvements serve unmet needs. You prioritize the work that tackles the most important and least satisfied needs.

Without good customer metrics, such as needs in the job-to-be-done, companies often prioritize their roadmap based on a flimsy projection of business impact, the charisma of people lobbying for the features they like, and the “HiPPO” (the Highest Paid Person’s Opinion). All of these methods are subjective and/or based on unreliable premises.

Your product roadmap (and your tradeoffs) should not be prioritized by your team. They should be prioritized by your customer’s unmet needs in the job.

Step 10: Mitigate your risk.
Understanding what causes a customer to purchase (“hire”) a product can help you mitigate product development risk.

Competing Against Luck points out, “In 2015… one thousand publicly held companies spent $680 billion on research and development alone.” And yet, “Most people would agree that the vast majority of innovations fall far short of ambitions, a fact that has remained unchanged for decades.”

Once a product enters development, companies spend an enormous amount of capital, time, and resources on building, marketing, and selling the product. Jobs theory can help you avoid product failure and ensure the roadmap will generate the revenue and profit growth needed to justify the investment.

Failure occurs when a product does not create customer value in a market. What is “customer value?”

Customer value is a measure of the difference of customer satisfaction with getting the job done between your solution and the existing solutions. Since the goal is to satisfy customer needs and needs are metrics related to speed and accuracy, you can compare the speed and accuracy of getting the job done with your solution vs. a competitive solution. That difference is the customer value you’ve created.

satisfaction-chart-001

Market opportunities exist because a person is struggling to get the functional job done. Improving the speed and accuracy of getting the job done reduces struggle and anxiety, which increases customer satisfaction and the likelihood they will hire your product.

This means you can measure the value of an idea even before you build it. Consider how much faster and more accurately your idea will meet the needs in the job if your idea is executed perfectly. Compare that to the baseline–the current satisfaction levels with each need in the job. You now know if the idea adds value to the market, so you’ve mitigated the risk of your idea. You still have execution risk, but your situation is a lot better than the risk of executing perfectly on an idea that does not add value in your market.

Step 11: Accelerate your growth.
Steps 1 through 10 are all the preparation steps to launching your product and accelerating your revenue growth. Jobs theory gives you a different lens through which to view your market, your customer, and your competition. It gives you powerful, metric-driven, customer-centric techniques to identify unmet needs and competitor weaknesses. And it gives you the tools to generate great product ideas that customers will pay for and to create messages that will resonate with customers.

Jobs theory is not easy to practice, but it is extremely effective if you make the organizational changes required to execute it well. As Clay writes, “Organizations typically structure themselves around function or business unit or geography — but successful growth companies optimized around the job. Competitive advantage is conferred through an organization’s unique processes: the ways it integrates across functions to perform the customer’s job.”

If you are interested in learning more about jobs-to-be-done techniques that you can use at your company, feel free to contact me directly.

JTBD Product Management: An Education Market Example, Part 2. Generating Ideas, Pricing, & Revenue Projection

Today, we continue our exploration of how Jobs-to-be-Done helps product managers think different, drive innovation, and develop new products and features based on the needs of the customer. In our first two posts, we gave you a Jobs-to-be-Done Cheat Sheet and used the example of an educational publisher to look at defining your market with the customer’s job-to-be-done. Let’s dig deeper into this example, looking at generating ideas, pricing, and market sizing.

Generate Ideas

We’ve all been in those meetings where “no idea is a bad idea” and the goal is to come up with as many ideas as possible. Brainstorming is the best way to generate ideas, right? Well, often these sessions lead to long lists of features without clear criteria for prioritizing them. Not to mention some people are now excited enough about their creative efforts, they are willing to fall on a sword to see their ideas realized.

You don’t need a long list of ideas. You need to generate ideas that will lead to results for your customer and your bottom line. High impact features are more likely to come from asking a specific question: How do we serve our customers’ most important and least satisfied needs?

In the last post we discussed the need of a student to reduce the likelihood that they have a question which can’t be answered in the moment. Imagine you’re a Product Manager at an educational publishing incumbent like Macmillan or Pearson. It’s the late-90s and the internet is just beginning to reach a mass market. To serve this need, you could add more information to printed books or to a new CD-ROM product. Or you could notice that the internet enables students to connect with other people who could answer their questions. The customer need “reduce the likelihood of having a question which can’t be answered in the moment,” gives us clear criteria for knowing which solution is best. It’s the one that makes it most likely the student’s question can be answered immediately.

Pricing

The difference between paying for a product or getting the job done can seem subtle. Think of it this way: A person may only be willing to pay a one time purchase fee for a book (a product), but might pay a recurring monthly subscription to learn a language (see how DuoLingo gets the job done). Pricing by the customer’s willingness to pay to get the job done helps you avoid leaving money on the table and gives you a more accurate picture of your market size.

Market Sizing

There are two conventional methods of estimating the size of your market and your projected revenue: top down and bottom up. Top down is an estimate of the total revenue for some geography and industry (eg. dollars spent on education in the US) multiplied by an estimated percentage of that revenue you can obtain. The bottom up approach looks at how many people you can get to buy your product based on marketing and sales projections and multiplying that estimate times the price of your product. For instance, we project our marketing will reach 1 million people and we’ll convert 10%, so we’ll sell 100,000 books. Multiply 100,000 by $50 per book to get a $5 million market.

With Jobs-to-be-Done, the focus isn’t on the product because products change over time. The focus is on the customer’s job. The market size is based on the customer’s willingness-to-pay to get the job done and the number of job executors.

This approach helps you avoid market mistakes, which can be lethal. For example, Encyclopedia Britannica was a leader in education, the gold standard of information. Its business model was to sell books to consumers to help them and their children learn subjects. But just as there is no “iPod” market, there is no “encyclopedia” market. To size the market opportunity, instead of calculating the market size based on encyclopedias sold times price, education markets should be sized using the job executor (e.g. parents, students or teachers) times their willingness to pay to get a job (e.g. learn a language, learn a skill) done better.


 

That does it for this second installment of JTBD Product Management. Is your company still operating the old way? Could you benefit from implementing the thrv approach? If so, get in touch with us, we’d love to talk with you about how our products and services can help you launch high growth products. Next week will wrap it up by exploring how to approach the product roadmap, aligning your team and delivering an MVP.

The Math Behind Warren Buffett’s $1 Billion Stake in Apple

The news of Berkshire Hathway’s billion dollar stake in Apple reminded me of a post I wrote in January, 2014 explaining the math behind valuing Apple at over one trillion dollars.

From Matt Phillips at Quartz “Apple is the New IBM” and Timothy Green at Motley Fool “Apple is Not a Warren Buffett Stock” to Daniel Sparks at the same publication “Warren Buffett is Right: Apple, Inc. Stock is Undervalued” and John Gruber “Apple has long struck me as the sort of company Berkshire likes to invest in” opinions and interpretations of Buffett’s investment have been all over the map.

To add to the conversation, I’ve reposted my January 2014 thoughts here. This is likely how Warren Buffett valued Apple before he invested.

Apple just released impressive quarterly results: $57.8 billion in revenue, 51 million iPhones, 26 million iPads, 4.8 million Macs, and 6 million iPods sold. So how should we value Apple? How much is a share of Apple really worth?

Let’s combine a few things to value Apple: (i)Warren Buffett’s intrinsic value model, (ii) market disruption theory, and (iii) jobs-to-be-done innovation theory.

To read the headlines, you might think Apple is, again, doomed: “Apple’s Shares Slump on Weak Forecast” and “Apple iPhone Shares, Outlook Come Up Short” are just two examples. These headlines always encourage people to tell Apple what they must do, and John Gruber wrote about the problem with this approach.

If you look at any valuation number for Apple (for example, a P/E of 12.6, an EBITDA multiple of 8.4) it is remarkably low relative to its competitors (for example, Google has a P/E of 32.2 and an EBITDA multiple of 18.6).

To put this into perspective, if Apple had Google’s P/E, it would be worth $1.2 trillion (yes, trillion with a “t”) instead of the $452 billion it is worth today. So why is Apple valued with a multiple so much lower than Google?

The Buffett model is important because it will tell us what assumptions we should analyze to determine Apple’s value and ultimately its multiple. The model is straightforward: a company’s value is based on its ability to generate future cash for its owners (what Buffett calls “owner earnings”). We can analyze Apple’s owner earnings by taking its net income plus depreciation and amortization less capital expenditures. This number was $34.7 billion for the 2013 fiscal year.

The key to the Buffett model (and any valuation model, really) is projecting the growth rate of this owner’s earnings number. If we assume a future growth rate we can determine the company’s value. All of the future owner earnings are discounted back to today’s dollars to determine the value of the company. The trick, of course, is being accurate about these growth assumptions, which is where disruption theory and jobs-to-be-done theory can help us.

If we assume that Apple will grow its owner earnings at 5% for the next 10 years, and then 2% for all years after that (with adjustments for cash and debt), Apple’s market cap wouldn’t be $453 billion. It wouldn’t even be $1.2 trillion. It would be $3 trillion. This is a share price of $3,275 in contrast to today’s share price of $506. At just 5% annual growth for Apple.

Here is the math behind this valuation:

Intrinsic Value AAPL

Let’s put this in perspective: from 2004 to 2013, Apple grew at a compound annual growth rate of 74% (meaning it grew owner’s earnings basically 74% every year, see the chart above). That is impressive, but not likely to continue forever. So how do we determine if this historical growth rate will slow to 5% then 2%? As Horace Dediu and Jesse Felder have noted, the market is undervaluing Apple’s ability to produce future cash flow, so understanding this growth rate assumption is critical to our assumptions.

Disruption helps us analyze Apple’s future growth rate because (i) Apple’s recent growth has been based on the premium iPhone and (ii) disruption ends up displacing the premium players in a market.

A quick review: Clay Christensen first described disruption as the “process by which a product or service takes root initially in simple applications at the bottom of a market and then relentlessly moves up market, eventually displacing established competitors.” (Christensen somewhat famously analyzed the iPhone’s disruptive power incorrectly, but the theory of disruption is still correct).

So will Apple be disrupted? If they were, their growth rate would clearly slow, and thus their valuation would fall as well. The market seems to be saying that Apple will almost certainly be disrupted.

But let’s look at an interesting chart tweeted by Jason Snell. It shows Apple’s percentage revenue by product.

BfBPyA_CAAARuWg.png-large

If we simplify this a bit, it looks like almost exactly like the classic disruption theory chart explaining how incumbents over-serve the market at the high end, while a low-end entrant starts at the bottom of the market, but takes over to become the dominant player.

Here is the simplified Apple chart:

Apple Disruption
And here is the disruption theory chart:

disruption

But there is a fundamental difference between the two. In disruption theory, it is a new entrant who disrupts the incumbent. But in Apple’s case, the iPhone and the iPad are an example of self-disruption. Apple disrupted the Mac (and the PC) with the iPhone and iPad. While the Mac continues to be a healthy high-end product, Apple absolutely destroyed its own iPod. Six years ago, the iPod was almost half of Apple’s revenue. In the latest quarter, iPod sales fell by 50%.

MG Siegler noted that Apple “wants to be the ones to disrupt themselves… But never with stakes this high…” But I would argue the stakes were incredibly high when Apple decided to disrupt the Mac and the iPod (both about 100% of their revenue) at the same time. And history is a good indication that Apple is probably thinking about disrupting the iPhone, even now. A truly disruptive product to the iPhone might not emerge for years, but I can’t think of another company that would prepare for and execute a self-disruption strategy like Apple. It is in their culture to do it, as long as the new product is insanely great. As a result, Apple deserves a higher future growth rate than the market is currently giving it.

Disruption theory is a good tool to analyze what happens to companies, but it is not a good tool to help companies figure out what to do. How do you respond to disruption? When is the right time to disrupt? How do you disrupt yourself before a competitor does? These are the really hard questions.

The answer is jobs-to-be-done (JTBD) theory, popularized in Christensen’s Innovator’s Solution. In short, JTBD theory shows that markets should be defined not by products, which change (and are disrupted) over time. Markets should be defined independently of any product. They should be defined based on the job the customer needs to get done. Products change, jobs are stable.

The iPod is a great example. Microsoft made the mistake of targeting the “iPod market” with the Zune. But JTBD theory shows us that there is no such thing as an iPod market, just as there isn’t a cassette market, an LP market, or a CD market. Companies get disrupted because they define the market based on their product, not on the customers job-to-be-done, e.g. the markets for listening to music and discovering new music.

And even simple jobs are extremely complex. Every job has 50 to 150 different customer needs that are independent of any product or solution.

This is the real reason Apple succeeds: they focus on jobs and the customer needs. In the recently discovered Lost Interview with Steve Jobs, we get a look at how Jobs thought and how I think Apple as a company innovates. Jobs says designing a product is a process of “keeping 5,000 things together in your brain” and getting them to fit together. In addition, while people frequently think Jobs said “customers don’t know what they want,” he actually never said that. What he did say was: “you can’t just ask customers what they want and then try to give that to them. By the time you get it built, they’ll want something new.” And second he said, “you’ve got to start with the customer experience and work back toward the technology–not the other way around.”

So this is how Apple innovates: they don’t ask customers what product they want, they focus on the job they are trying to get done (the customer experience), the hundred of needs required to get the job done (the details of the customer experience) and the different technologies and solutions to get the job done best (the “5,000 things” are the 50 to 150 needs combined with an almost infinite number of possible product solutions).

I have worked with a lot of companies over 25 years, and almost none think like Apple and are organized to focus on the customer experience like Apple. And I have been an Apple customer continuously since 1979. If Apple is acquiring new customers today that have even a tiny percentage of my loyalty to Apple products (and I buy them because they help me get important jobs done better in my personal and professional lives), then they will almost certainly be able to sustain at least a 5% growth rate.

Finally, let’s look at Apple’s product success rate vs. Google. This is another important number, like a batting average for a baseball player. Who would you rather bet on? A player with a .175 average or one with .400?

I am sure my list isn’t complete, but if you look at the Google Graveyard of products and the history of Apple launches (from the new Jobs era), Google has about a 7% success rate and Apple has about a 90% success rate. My quick analysis is here (Download Apple vs. Google), and while I am sure it isn’t entirely accurate, it is generally correct.

So in summary, this is Apple:

1. A company with a track record of growing at 74% per year.

2. A company that knows how to disrupt its own products better than any other company.

3. A company that knows how to focus on the customer’s job-to-be-done.

4. A company with a 90% product launch success rate.

It is a good bet that Apple will beat a 5% growth forecast over the next ten years…