Which of the following assets will power your business going forward?
- Cash and equivalents
- Accounts receivable
- Plant, property and equipment
- Other intangible assets
Arguably, among the six assets above, the most leverageable assets are the intangible assets, which, by definition, have not been quantified. When one company purchases another for a value greater than its assets minus its liabilities, that difference is reflected as goodwill on the balance sheet. Why does a company do that? Often, the excess purchase price is attributed to what’s referred to as “brand equity.”
The goodwill entry reflects a number of intangible assets but, arguably, the most significant component is the brand equity. But what is brand equity after all, other than the propensity of customers to buy from the brand in the future? To an extent, the allocation of an amount above and beyond book value that gets identified as brand equity reflects the fact that companies have historically not been able to assess the value of their most important asset, customer relationships. As such, it has been necessary to reflect extra value over measured assets as goodwill/brand equity. However, the inability to put a value on the customer asset is quickly becoming no longer the case for most businesses as new customer relationship valuation methodologies have evolved (discussed below).
Why should a company wait until it becomes an acquisition target to understand the value of its customer relationships asset? It should not. CEOs and CFOs, as well as investors, should demand it.
How to Value Customer Relationships
Should a customer be valued on the basis of the revenue they have provided in the past? The short answer is “no.” First of all, customer relationships should not be valued on the basis of revenue and second, they should be valued on future profits they can deliver. Past spending and profitability are just some of the factors that can predict future profitability. A new approach to corporate valuation is gaining credibility and support. Customer-based corporate valuation (CBCV), developed by professors Peter Fader of the Wharton School or Business and Dan McCarthy of Emory University, is based on analysis of the lifetime value of the customers a business currently has – its customer asset. This metric is one of the best indicators of future performance and the value of the business. It should also be one of the core metrics by which the company’s leadership is judged and by which investors determine the total value of the company.
Using such a metric would not only provide a more accurate picture of a company’s true value but can eliminate the short-term, reactive decision-making that investors and boards force upon organizations, as well as discourage investor groups that break up companies because the parts seem to be worth more than the whole when the whole is valued improperly.
Below, I focus on other core benefits that a company can realize by developing and maintaining a dynamic metric that represents the value of its customer asset.
Benefits to Regular Operation of the Business
- More effective strategic planning and budgeting – Strategic decisions, such as how much to invest in customer retention versus customer acquisition, are optimized based on new context gained when a customer is valued holistically, including the customer’s future value. So do decisions regarding growth strategies, service models, digital transformation and product/service development. Each of these strategic choices can be assessed more effectively when the impact on the customer relationship value is accounted for. Using customer relationship metrics better positions you to set expectations within your organization, to the board and to investors.
- A more complete and applicable approach to measuring ROI – If you believe the value of your customer asset is the ultimate measure of your business value and future success, the impact on this metric should be a measuring stick for every business initiative. By understanding the underlying factors that drive the value of the customer asset, you can begin to evaluate the ROI of initiatives across the business based on their impact to your customer asset value. These factors include impact on customer acquisition and the value of those customers, impact on projected tenure of existing customers, and impact on revenue growth and customer profitability. Whether you are contemplating a digital transformation, a new service model, a new product introduction or new policies, each one can be evaluated based on these metrics.
- Improved governance – A major challenge for leadership teams is governance as it relates to new initiatives, cross-functional projects and decision-making regarding specific strategies or tactics. There is always a competition for resources within the business. Different KPIs for different groups can further contribute to this organizational friction. Using a customer asset valuation as a core KPI that each team is judged upon can enable each team to better understand how the work it is doing is contributing to the overall success of the business and create a more natural alignment and collaboration across teams.
Benefits for Your Mergers and Acquisitions Activity
- A powerful tool in due diligence – In performing due diligence on an acquisition or merger target, an acquiring company wants to make sure there are no defects, risks or surprises that would impact the value of the deal or the ability of the acquisition to reach its objectives. By evaluating various customer cohorts in terms of when they were acquired, how long they stay/are expected to stay, share of wallet growth and profitability and other customer metrics, the acquirer can get a much better idea of the trend in the business and the true value and potential of the assets being purchased. Such analysis can reveal danger signs in customer growth that may be obscured when looking at the numbers at a more aggregate level over time. These activities are not just important for acquirers, but also for portfolio companies or others who may foresee selling all or part of their business, or who would like to be ready to be acquired.
- A forward-looking measure of the potential value created through the merger or acquisition – The goal of any merger or acquisition is not simply to get a 1 + 1 = 2 but, rather, to achieve a 1 + 1 = 4 or even greater outcome by realizing synergies between two organizations. By staying focused on the drivers of customer asset value, company leaders can more effectively pinpoint the opportunities with highest potential to achieve these synergies and get a clear vision for the strategies that will maximize success capitalizing on these opportunities.
- Provides a rudder for integration efforts and identification of efficiencies – Post-merger or acquisition, a top objective of the company is to find efficiencies, which could include removing redundant functions, combining some operations, reorganizing roles, responsibilities and reporting structures, or implementing new service models. These activities can be more effective and productive if each is considered through the lens of maximizing incremental customer asset value and limiting effects or impacts that would reduce customer asset value.