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Marketing and Shareholder Value

In my previous post I wrote about the dangers of applying crude supply-side financial metrics to try and simplify marketing measurement.  Not only does this create the illusion of control it also gives the non marketing executive community the permission to ignore the complexity of how marketing works.  Marketing measurement should do the exact opposite.  It should create transparency and should never be shy to expose the fuzziness of how marketing helps create demand. 

 

Does this mean there is no place for supply-side financial metrics that try and simplify how marketing works by adopting the more linear concepts non marketing executives feel comfortable with?  No, on the contrary, these metrics can be extremely useful.  They can help break down the barriers that often exist between the marketing and other parts of the organization.

 

Non marketing executives often think marketing as a discipline lacks business understanding and accountability and that it has goals that are not aligned to the corporate agenda.  As a result marketing is often marginalized.  Adopting the boardroom vernacular can be an important first step to breaking down the barriers.  This is exactly what supply-side financial metrics can achieve. 

 

Peter Doyle thinks a focus on shareholder value creation for example can help marketing gain more credibility among non marketing executives.  He thinks marketing should adopt shareholder value as the single metric to demonstrate the performance of its efforts.

 

Here is how shareholder value analysis (SVA) works.  It is based on the 4 key principles that are at the foundation of Finance as a discipline :

• The importance of cash flow : an investment’s return should be evaluated by looking at the future cash flow it will generate.
• The time value of money : cash today is worth more than cash tomorrow
• The opportunity cost of capital : the return an investor could get if they would have invested their money somewhere else should be taken into account
• The concept of net present value : future cash flows should be discounted by the opportunity cost of capital to calculate their value today.

 

If you are not interested in the detailed calculations of SVA skip the next paragraph.  I just wanted to include some of them to demonstrate that they really aren’t very complicated and that the principle can be illustrated with a very simple spreadsheet model.  Here is how SVA works in one of Doyle’s hypothetical examples :

 

		Year	Year	Year	Year	Year
	Base	1	2	3	4	5
Sales	100.0	110.0	121.0	133.1	146.4	161.1
Operating Margin	10.0	11.0	12.1	13.3	14.6	16.1
Tax	3.0	3.3	3.6	4.0	4.4	4.8
NOPAT	7.0	7.7	8.5	9.3	10.2	11.3
Net Investment		4.0	4.4	4.8	5.3	5.9
Cash Flow		3.7	4.1	4.5	4.9	5.4
Discount Factor		0.909	0.826	0.751	0.683	0.621
Present Value of Cash Flow		3.4	3.4	3.4	3.4	3.4
Cumulative Present Value	16.8
Present Value of Residual	70
Other Investments	7
Value of Debt	25
Shareholder Value	68.8
Initial Shareholder Value	52.0
Shareholder Value Added	16.8
Implied Share Price	3.44
Initial Share Price	2.60

 

In this example the company’s sales and net operating profit after tax (NOPAT) can be found in the “Base” column.  The board has to evaluate a marketing strategy that is expected to generate an annual sales growth of 10%.  The investment would be 40% of the incremental sales and the opportunity cost of capital is 10%.  The discount factor would therefore be 1/(1+10%)ⁱ where I =  1,2, … is the year.  The cumulative present value of the 5 year cash flow is 16.8 million.  Doyle uses the standard perpetuity method to calculate the value of the investment after the 5 years.  This assumes that the return of the investment will be equal to the opportunity cost of capital after the 5 years.  The value associated with this is called the residual value and it equals NOPAT divided by the opportunity cost of capital. 

 

The investment according to this SVA will generate an incremental 16.8 million of shareholder value.  Assuming there were 20 million shares outstanding this would mean that the investment increased the share price by 88c.

 

Doyle builds on this example by running a couple of scenarios that illustrate how shareholder value can be grown through a couple of strategies :

• Increasing the level of future cash flow generated by the investment
• Accelerating the cash flow generated by the investment
• Reducing the perceived risk associated with the investment
• Increasing the sustainability of the competitive advantage as a result of the investment
• Increasing the options for longer term growth as a result of the investment (Doyle combines the latter 2 in one “effect on continuing value”

 

SVA is not the silver bullet that will answer all our accountability questions – again, there is no single metric that explains marketing’s performance in its entirety. Neither does it help us quantify the anticipated effect of our marketing investment on future revenue streams.  That remains the hard part that has to be answered through measurement, historical analysis, econometric modeling and in market testing. 

 

However, SVA does help in a number of ways. 

• It forces marketers to consider longer term effects.
• It makes the case for alternative strategies for proving the value of marketing, most notably the impact on price elasticity.
• It uses very straightforward math that can be done in a simple spreadsheet.
• It translates marketing results in a metric that is understood outside of the marketing community and thereby breaks down the language barriers that often exists especially between the marketing and finance communities.

 

I think that once SVA has helped prove the value of marketing and the lines of communication between marketing and other parts of the organization are open, SVA should be replaced as possible by metrics that are rooted in the reality of how demand is created.  This will be a combination of financial and brand equity indicators.  These are the metrics that really help companies improve their marketing decisions. 

 

 

 

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