Two studies, separated by a decade, examined the topic of company valuation based on customer valuation. While intuitively and logically related, the two approaches to valuation were rarely regarded in conjunction. The first study – an award winning paper – was published in 2004 by Prof. Sunil Gupta of Harvard and Prof. Donald Lehmann of Columbia. The second, published more recently in 2016, was based on work by Prof. Peter Fader and his colleagues at Wharton. Key findings from the two papers suggest:
- Your business is only as valuable as your customers
- Customers are important intangible assets whose value should be measured and managed
A summary of the two studies and their key findings follows.
The 2016 Wharton Study:
This research team successfully built a model that allowed them to value businesses using publicly available customer data. Complete with formulas that link the value of a business’s customers to the overall value of the firm, they tested and validated the model with exceptional results.
The Value of the Customer
At its simplest, the model looks at current and future value of individual customers, or groups of customers, and rolls them up to arrive at the value of the firm. Their approach brings together what are traditionally two silos at work – one in the marketing domain and the other in the financial domain. Applying the same rigor of data and analysis that is typical in the financial realm to the marketing domain, imparts a degree of robustness to the model, dispelling perceptions of loose approximations commonly associated with marketing.
The Model & its Validation
The company chosen as the key example for this exercise was Dish Network – a publicly traded firm with a decently long time series of desired customer data. Publicly available customer data such as number of customers, their tenure, retention, and churn rates was used. Where possible, raw data was extracted from available derived measures to maintain integrity of the model.
Among methods used to validate the model, two stand out as remarkable:
- Forecasts for revenue and profits emerging from the model were even more accurate than those of Wall Street analysts
- The worth of the firm based on customer valuation model came within 5% of what the company had been trading for at the time of data disclosure
– For companies – Understanding the financial impact of customer centricity can empower firms to implement strategies based on customer data. It helps make better decisions in every aspect of running the enterprise, to generate even greater value.
– For investors – More accurate forecasts for company performance and the potential to find under or overvalued companies is powerful.
If using published customer information can yield such results, more granular and nuanced customer feedback can only make it better.
The 2004 Harvard Study
Authors of this study focus on two ideas –
- The contribution of intangible assets (brand, customers, employees, knowledge) in the financial value of a firm and
- Customer Lifetime Value. How valuing customers makes it feasible to value firms, including high growth firms with negative earnings.
They connect the key focus of marketing effort – the customer – with the key measure of financial success of a firm – its market value. The value of a customer to a firm is defined as the expected sum of discounted future earnings based on key assumptions concerning retention rate and profit margin. The value of all customers is determined by the acquisition rate and the cost of acquiring new customers.
Choice of firms
Five firms were selected to demonstrate the author’s valuation methods – one an old economy, traditional financial institution, and four “new economy” internet firms where traditional financial models have difficulty. Using customer data from these firms in an empirical application, they generated interesting results.
- Estimates of customer value arrived at in this way were very close to current market valuation for three of the five firms, confirming customer based metrics are value relevant. Traditional methods have trouble valuing many of these firms with negative earnings.
- Retention has a very large impact on customer value. Retention elasticity was found to be in the region on 3-7% (i.e. a 1% improvement in retention increases customer value by 3-7%). In contrast, margin elasticity is 1 and acquisition cost elasticity in 0.02-0.3.
- Retention rate has a significantly larger impact on customer and firm value than the discount rate or cost of capital. Suggesting the financial analysts focus on managing discount rates needs to shift to a focus on a firms customer retention rate.
- Cutting acquisition cost may not be the best way to improve value.
While the two studies address the topic of Customer Valuation from slightly different perspectives, both are unequivocal on two counts:
- A significant part of the value of a firm resides in and is tied to its customer base.
- Customer data is powerful – not only in determining value but also in finding paths to enhancing that value.
Customer Value and Loyalty
The LRC is a strong advocate of measuring customer value. We have found that the three loyalty segments – Loyal, Neutral, and Vulnerable – provide strong discrimination in the customer value and consequently, firm value. The table below illustrates some of our findings:
Valuation of Customer Base by Loyalty Segment