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Customer Equity

Posted on Thursday, Feb 15th 2007

by Lance Glasser, Guest Author

[In the Philippe Cortout interview, we heard a lot about focusing on the Customers. Here is Lance Glasser’s view on the same issue.]

How much is a company worth? After adjusting for debt, receivables, etc., one formal way to think about the company’s value (its equity) is that it is the net present value of the profits from all future products. That is, the company will generate profits now and into the indeterminate future. If you knew with certainty what those profits were going to be then you could ask, what am I willing to spend today for that future annuity stream? Since you cannot know this exactly and since a $1 tomorrow is worth less than a $1 today, one sums this future profit stream multiplied by an appropriate discount to achieve a net present value (NPV).

There is another way to look at the value of a company. It is mathematically equivalent to what we just described, but it requires twisting your head sideways. Our first view was, “we are our products.” A second equally valid view is, “we are our customers.”

After all, who buys the products? So instead of adding up the future profits from the product portfolio, including products not yet invented, we could say that the company’s net present value is the sum of the appropriately discounted profits from each of the customers, from now to eternity, including from customers to whom the company does not yet sell and subtracting off customers that the company looses.

With this point of view, the company’s market capitalization should be the sum of the customer equity from each of the customers. I like this view because it drives a customer-oriented viewpoint. Thinking about it this way says that there are certain ways you must treat customers because you are trying to maximize the net present value of the profits one achieves from them, forever.

Of course, profits today are worth more that profits tomorrow, as approximately given by the discount rate. If we call this “customer equity,” as is done by the service industry [see, for instance, Driving Customer Equity : How Customer Lifetime Value is Reshaping Corporate Strategy], then classically that equity is made up of several parts.

The first is product equity, meaning how much would we make if each customer behaved 100% rationally based on the relative value of our product to the competition for their job at each decision point with no memory of previous experiences. This kind of thinking drives a lot of product development, as it should. Of course customers do not behave 100% rationally and people also make rational decisions based on experience, so there are other parts of the customer equity.

This next part is called brand or reputation equity. This equity covers the part of the customer decision that is based on emotion and general experience. Clearly how we treated our customer the last time has a big impact on how much profit we will get from them in the future. This is brand equity.

The third type of equity is retention equity. That is, if my customer bought my widget last time he is more likely to buy from me next time than if he bought his last widget from someone else, all else being equal. It is several times harder to get a new customer than to keep an old one. Sometimes we talk about this in terms of repurchase intent.

Many companies invest a lot in product development. They do this because they believe they will have a great return on those products that will more than make up for the discount rate that one must apply to those future returns. Companies also invest in their customers. It is often tracked less precisely, but companies also invest in winning a customer today so that they can get those future profits from them tomorrow, for instance by invoking special support or discounts. The classic example of this is giving away shavers to sell razor blades. The trick is making sure the return on that investment materializes. It is a lot easier to give away profits today than reap them tomorrow.

So we now have two ways of thinking about a company’s equity: “we are our products” and “we are our customers.” Both are right, but turning your head from one to the other helps you think more clearly about what actions you should be taking to make that equity grow.

Link to full essay.

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