The True Residence of Equity

One of the important management trends of the last decade is the increased emphasis on connecting nonfinancial decisions to their financial consequences. While several financial metrics can be linked to managerial actions, one that has recently gained popularity is equity. The notion of equity is borrowed from the financial principles of capitalizing future cash flows into their present value using an appropriate discounting mechanism. For example, many firms try to estimate the relationship between their investments in customer satisfaction management programs or in product development programs and their respective financial consequences. One of the metrics of interest when following these approaches is the lifetime value of each customer. And the aggregated lifetime value across the current and potential customer base is labeled customer equity. This metric represents the discounted value of the future cash flows associated with the customer base. The concepts of lifetime customer value and customer equity are then used for various strategic purposes, such as segmenting customers on the basis of high versus low value, or evaluating the relationship between customer-based rationalization programs and the value of the firm.

Now imagine a familiar situation where a firm makes a decision to let go of its unprofitable customers much like some credit card issuers and cell phone companies have recently done.¹ If the decision is correctly implemented, and if the customers that were let go were indeed unprofitable for the firm, the average lifetime value and the overall equity of the remaining customers will generally be higher than what it was before. It is also likely that the value of the firm might go up because the financial markets may reward the spinoff of unprofitable customers. Now the question is whether the increase in firm value should be attributed to the change in the customer equity of the firm. If we do a before-and-after comparison, we would indeed discover a positive correlation between the change in the firm value and the change in its customer equity. However, what really happened is that the increase in firm value and the increase in customer equity were both consequences of the decision to let go of unprofitable customers. Therefore, we argue that the true residence of the equity lay in the decision to rationalize the customer portfolio. The change in the value of the customer base, that is, the change in customer equity, was merely a downstream consequence of the decision. In other words, customer equity was not the cause or the source of the change in the value of the firm. Instead, it was a beneficiary of the customer portfolio rationalization decision. The true source of the change in firm value, that is, the true residence of equity was the strategic decision to rationalize the customer portfolio.

Similarly, the notion of brand equity is based on the premise that brands have a certain power to generate incremental cash flows for the firm over what an unbranded product in the same market might be able to. And the premise itself is true because all markets have strong and weak brands, and the financial returns associated with stronger ones tend to be higher than for weaker ones. So the natural question is whether a brand is a true residence of equity or merely a beneficiary of some strategic decisions where the equity really resides.

In order to address this issue, let us consider a few scenarios and assess the impact on a brand’s equity. First, take the case of category rationalization decisions that are currently being made by many retailers.² For example, Wal-Mart and Kroger are increasingly reducing their portfolio of national brands and substituting them aggressively with their own private labels. Imagine that a national brand in a common category, say powdered sugar, is dropped by a retail chain across all its stores. Overnight, the entire stream of future cash flows associated with the brand’s sale within the chain will now come to zero. Consequently, the equity of the brand, as we define it now, will suffer a substantial decline. However, not much fundamentally changed with the brand or what consumers thought of it. In other words, consumer preference for the brand presumably would remain the same before and after the chain’s decision to pull it off the shelves. The retailer’s demonstrable preference for the brand, of course, would be lower than what it was earlier. And the question we need to ask is whether the brand’s equity declined. What really happened was that, given whatever strength the brand had, the retailer found it more profitable to stock the shelf with its own product. Therefore, even though the brand’s strength remained the same, it’s so called equity apparently declined.

Consider an alternative scenario, where a firm decided to drop the price of its core brand in order to gain or regain market share from competition. Imagine that, as a result of the decision, the brand’s unit margin reduced and its overall profitability declined despite an increase in market share. Of course, depending on the size of the price cut and customers’ price sensitivity, the reverse could be true as well. In either case, there would be a change in the stream of cash flows resulting from a change in the brand’s price. From a computational perspective, this would reflect as a change in the equity or what is sometimes called the value of the brand. While numerically this might be true, the question again is where the residence of the equity shift really is. Is it in the brand or in the decision to alter price? To what should the change in cash flows be attributed?

More generally the question really is, what is equity and where does it really reside? Current marketing models assume or propose that it does reside in stakeholders such as employees, customers, or partners, or in entities such as brands or products. However, as the previous examples and many others later in the book illustrate, stakeholders and entities are often the beneficiaries of equity-enhancing or equity-damaging decisions, not the source of them. True equity resides in actions or strategic choices that lead to increases in cash flows or reductions in investments or both. For example, if an action is undertaken to increase the advertising spending for a specific brand, it is possible that the unit sales or price commanded by the brand might go up. However, the source of the resulting increase in equity is actually the action or decision to increase advertising. The brand is merely the beneficiary of the action and may have the increased equity attributed to it perhaps erroneously. Similarly, it is possible in this case that the increased sale came from the existing set of customers. In which case, the customer base may also be the beneficiary of the increased equity, and we may erroneously implicate it as the source.