Marketing

Whole sum of parts

Why not value companies based on the value of their customers? Gupta and Lehmann argue that traditional measures of company value are not sufficiently connected to the value of their customers.

To access the first part of the series, please click here.
To access the second part of the series, please click here.

Proceeding with their examination of customer value, Professors Sunil Gupta and Donald Lehmann (of Harvard and Columbia business schools respectively; for bios click here) ask themselves how this concept can be transferred to a broader requirement: company valuation.

The logic seems simple enough: if customers have a defined value, and companies are ‘constituted’ of customers, why not assess the value of a company based upon the value of its constituent clients? For example, if one cable subscriber is worth say $100, can one deduct what the value of a cable company with 16 million clients is?

The principle here is that most of a company’s value depends on the value of its customers. So if one can properly calculate the value of all of one’s customers, then one can also extrapolate the value of the firm.

Naturally, there are several caveats. As the authors point out, one of the first limitations of this approach is that a firm may have some financial transactions that generate revenues that are independent of customers.

Another limitation – not evoked by the authors – is that an exact calculation of customer acquisition cost (and therefore customer value) may be as creative as the accounting for a Hollywood movie (remember how the Eddie Murphy top-grossing blockbuster movie Coming to America was then shown by creative accountants to have lost money?). Indeed, proper accounting for customer acquisition costs would have to bear full costs (e.g. indirect overheads), and not just the direct costs that are easily attributable to specific marketing efforts.

So the author’s purpose is not to offer a replacement for the tried-and-tested valuation methods (e.g. discounted cash flows), but rather to suggest another calculation benchmark that can help establish a valuation range. They also point out that the overly sophisticated valuation methods serve one sad purpose: to muddy the waters and make a company’s true value less clear… and levy high transaction fees!

What happens when you do not link the two?
To illustrate what happens when analysts do not consider customer valuation in assessing firm value, the co-authors use the example of AT&T’s acquisition of TCI and MediaOne, which we briefly touched upon in part 1 of this series. AT&T paid about $4,200 per subscriber to acquire the 16.4 million cable subscribers that the two target companies had amassed.

Yet, what do the co-authors reckon the value should have been? Well, over a span of six pages, they raise some damning questions regarding the assumptions used for the valuation:
-   projected annual revenue (from cable and high-speed Internet access) of $2,400, although high-speed Internet access could not be rolled out so quickly
-   assumed (and projected) retention rate of 90% instead of the industry standard of 75% to 80%
-   profit margin expectation of 44%, when AT&T’s margin had been closer to 20%

So, in a nutshell, a more reasonable valuation of the TCI and MediaOne acquisitions would have probably valued the two deals at something closer to $3,000 per cable subscriber, or about 30% lower than what AT&T paid. (The authors then expose the further folly of those heady M&A times when various European companies paid up to $21,000 per subscriber!)

Whither from here?
What conclusion are the co-authors leading us to? That customer valuation is an excellent additional tool when assessing company valuation – namely when looking at revenue projections. In particular, the customer lifetime valuation methodology allows analysts to avoid the stereotypical: “Oh, we expect revenues to increase by 12.5% per year over the 20-year time horizon of our DCF analysis…”

Although the co-authors emphasize the usefulness of customer valuation for firm valuation, they also point out that the focus on customer valuation can provide guidelines to improve a company’s value. In particular two questions stoke the authors’ interest:
-    how do marketing actions/campaigns affect customer (and thus firm) value?
-    which levers carry the most weight – marketing tools or financial tools?

In analyzing the drivers of customer and firm value, the authors show that work on the retention rate brings the biggest bang for the buck, with each 1% improvement in retention having a 4.9% improvement in firm value. Paradoxically, efforts on reducing the customer acquisition costs do not deliver much value: only 0.1% better firm value for every 1% reduction in acquisition costs.

 

One last finding for the CFO: a 1% improvement in the cost of capital (or discount rate) adds only 0.9% improvement to the company value. The implication? Although it will make sense for a startup with high cost of capital to seek ways to reduce that burden, a mature company with lower cost of capital is better off working on the retention rate and the margin-per-customer.

The next installment will appear on July 21 and will cover customer-based planning, namely planning for customer acquisition, retention and margin management.

 

Published in July 2010