The Customer Confidential Podcast
If investors focused on the value of customers instead of the income statement, what would change? For starters, says Dan McCarthy, executives wouldn’t make decisions that boost short-term profits but hurt customers in the long run.
Dan is an assistant professor of marketing at Emory University’s Goizueta Business School and a cofounder of Theta Equity Partners. He and his colleague Pete Fader wrote an article called “How to Value a Company by Analyzing Its Customers” for the January/February 2020 issue of the Harvard Business Review; their article appeared alongside one of my own as part of a spotlight section called The Loyalty Economy.
Dan joined me for the second part of our discussion on what Theta calls customer-based corporate valuation (CBCV), which is Theta’s way of valuing a company by looking at the strength of its customer base
In this episode, Dan and I discuss how investor and executive behavior would change if companies had to disclose metrics that revealed the true strength of their customer base rather than the many accounting disclosures that actually can mask the damage done to customers and customer relationships. If you missed the first part of our conversation, I recommend you go back and listen to that part first to gain an understanding of how CBCV works.
You can listen to my conversation with Dan on Apple Podcasts, Spotify, Stitcher or your podcast provider of choice, or through the audio player below.
In the following excerpt, Dan explains one way his firm takes traditional analysis methods and adapts them into a model to generate data that more truly reveals what’s going on inside a corporation.
Rob Markey: Dan, a skeptic might say, “Look, if this was real, if this was a big deal, then a number of investors would have picked this up already and incorporated it into their valuation.” And the ability to profit from customer-based corporate valuation in public markets would basically go away because really smart investors would put a lot of money behind the companies that are most likely to have higher value than the other investors think. They'd basically compete away or invest away all the profit to be had. Is there evidence that there's anybody really picking this up and investing behind it in a big way?
Daniel McCarthy: There is a growing number of firms that focus on this, but more on the private equity side than on the public market side. As we both noted in our letters to FASB, it would sure be wonderful if we had more public companies regularly disclose auditable measures. I think we're getting there on the public market side, but the private equity side is where we've seen more traction.
This can get priced into equities, whether it's private or public. The value creation element would remain the same. So, certainly, from that aspect, if it did get priced in, that would be a sign of success that this is actually having the intended effect on creating value for the economy. It means that the executives of these firms would say, "Now I know for darn sure if I did this value-diminishing thing that would goose short-term profits, it's not going to do me any good. So, I'm definitely not going to do it now."
Rob Markey: Well, and, of course, you and I share this goal that this will get priced in appropriately over time and that it will then lead managers—leaders of companies—to make more informed decisions about whether and how they should grow their business. It basically will eliminate a lot of the bad profits and foster investment in customer experience and innovation on behalf of customers because it gets rewarded by the market. That's the goal.
Daniel McCarthy: But also to your point, it's not that easy to do it very, very well. And there's a lot of nuance that goes into the analysis to get it just right, to make sure that you're applying the principles properly and doing the modeling correctly.
One of the best examples that I personally experienced was through my previous start-up Zodiac, which was also cofounded with a Wharton professor, Peter Fader. We basically built best-in-class marketing science models to predict what customers will do. So in a sense, very similar in spirit to customer-based corporate valuation. But we were working with the marketing analytics head at very large companies. So, we were within the firm, and we were working with the transactional data. And I can say firsthand, most of those companies, their internal capabilities were quite poor. By and large, our models were significantly incremental to what they had been doing.
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Rob Markey: I think one of the reasons that this hasn't caught on as much in the public company world is that it's hard. Another reason is that the data required to do it, to manage to it, is often buried in a bunch of different systems, and so it’s hard for companies to work with. I think you found some great ways to do that at scale.
But I keep coming back to this: Because there's no requirement that companies be transparent about the drivers of value in their customer base, there's no accountability to shareholders. And because there's no accountability to shareholders, but there is accountability to shareholders on a traditional P&L, management teams just don't invest in the things required to measure and manage customer value.
So it's going to take time. It's going to basically require some of the loyalty-leading companies that are adopting these kinds of approaches to demonstrate that they can outperform their competition and for investors to figure that out. And then ultimately, because it becomes more common practice, for organizations like the Financial Accounting Standards Board, the International Accounting Standards Board and others to basically require transparency on these issues.
Daniel McCarthy: I fully agree. The other negative consequence of making it discretionary—well, there's a few, but—as we wrote about in our respective articles, it creates the incentive to game the measures. The measures can then be impossible to trust.
And then there's also the issue of strategic disclosure: that the people who show you the good numbers are the ones who look good along those measures, because they're not going to show you something that's going to make them look bad. And so all the other companies that don't disclose it, you then wonder, "Are you not disclosing it because you were lazy? Or are you not disclosing it because those numbers look really bad for you?"
We're now just starting to see more and more of that latter view coming up with more regularity. I've seen people say, "Why aren't you putting that in your filing?" I think that's also just a sign that we are seeing this mindset shift.
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