A Blueprint for Digital Companies’ Financial Reporting  

3 December 2018:

On July 25, 2018, Facebook lost market capitalization of more than $100 billion in just two hours of trading after it announced its quarterly performance, despite exceeding analysts’ earnings forecasts. What caused this slump? It failed to meet its revenue and subscriber growth targets. This example illustrates that investors consider information beyond just earnings as value-relevant. In a recent HBR article, we claimed that modern digital companies such as Uber, Facebook, and Alphabet play an increasingly important role in the economy, but their financial statements fail to capture company’s main value drivers. In a follow up HBR article, we interviewed several chief financial officers (CFOs) of leading technology companies and senior analysts of investment banks and distilled seven key insights from those discussions. Based on these insights, we now propose a new blueprint for financial reporting of digital companies.

Information on revenue and its drivers are, without doubt, the digital companies’ most value-relevant disclosures from the investors’ perspective. The level and trend of a company’s top-line metric is an advance indicator of the success of its business model. The company’s first revenues indicate the acceptance of its product or services by customers. When multiple players compete for the same space, revenues indicate the progress towards achieving market leadership that creates the dominant protocol for industry partners, suppliers, and customers. (In a market like social media, a firm’s success can depend on the winner-take-all profits that come from market leadership.)

Investors, therefore, look not just for reported revenues but for drivers behind the revenues, especially because digital companies’ operating activities often differ from their revenue-generating activities. For example, ostensibly, Facebook’s customers are its daily users (call them “asset units” for argument’s sake). However, the real revenue-providing customers are companies that pay for advertisements (they may be called “revenue units”). The distinction between the two sets of customers, and how the growth in the first set drives the growth in the second set, is a key to investors’ understanding of shareholder value creation.

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Source: Harvard Business Review

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