We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie [Munger] and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.

—Warren Buffett

Customers create long-term value because they have memories.¹ Each customer’s decision whether to buy from a business today will be based at least partly on his memory of any past experience he’s had with the firm, or perhaps on his impressions of it based on his friend’s past experience. The important thing is that every time a customer has an experience with any business, his intention or likelihood of buying from that business in the future is liable to change. Nice experience? Likely to buy more later. Might even talk about the brand with a friend or online. Bad experience? Likely not to buy much in the future. Also might criticize the brand to a friend or to a bunch of people online.

Although this is not a textbook on accounting or economics, nevertheless it’s important to remember that the actual economic value of any business enterprise can be measured in terms of the discounted net present value of the future stream of cash flow that the enterprise is expected to generate. So when a customer’s likelihood of buying in the future changes, or when her likelihood of sharing her experience with a friend changes, the company’s likely future cash flow also changes—which means that the company’s actual economic value goes up or down as a result of the customer’s changing frame of mind. This is the long-term component of the value that customers create.

For the overwhelming majority of companies, this kind of value creation (or, sometimes, value destruction) is not captured in the financial statements. Note, however, that the customer experience driving an increase or decrease in the enterprise’s value occurs in the present. Although the firm may not realize the cash effect for days or weeks or months, the value itself is created or destroyed today, with the customer’s current experience. Moreover, this is happening whether marketers at the enterprise think about it or not and whether they try to measure it or not. Even though the financial systems of most firms don’t recognize the long-term value constantly being created or destroyed by the individual current experiences of their customers, the financial metric that we introduced in Chapter 5, customer lifetime value (LTV), is specifically designed to capture it. To reprise the concept, a customer’s LTV is defined as the net present value of the future stream of cash flow attributable to that customer. It therefore directly represents the long-term financial benefit of a customer’s continuing patronage. When the customer becomes more predisposed to buy from the enterprise, her LTV will increase. When the customer becomes less enamored with the enterprise’s brand, her LTV will decrease. As a result, the increases and decreases in a customer’s LTV can be thought of as the direct, dollars-and-cents quantifications of the long-term value created or destroyed in particular customer interactions.²

However, there is a certain tension between encouraging customers to create value in the short term (through immediate sales) and encouraging them to create value in the long term (through changes in the customer’s predisposition). Focusing on either task can undermine the other. If a firm markets too aggressively in order to build up current sales, it will almost certainly damage a customer’s long-term value—maybe by cannibalizing sales it would have made in the future anyway, or perhaps by irritating the customer into not wanting to receive further communications or not even wanting to do more business. But by the same token, if a company smothers a customer in great service in order to maximize the future business he does with the firm—well, great service isn’t free either, and the funds required today to provide this service reduce whatever short-term value the customer might create. Therefore, companies have to strike a balance, because they need to create both short- and long-term value.

Unfortunately, for most businesses, the temptation to maximize the short term is nearly irresistible. Publicly held companies may have the excuse of investor pressures, but even nonpublic companies will succumb to the short-term temptation if they allow themselves to forget about the way customers really create value. An endemic problem among businesses is the fact that the traditional measures of financial success drive short-term thinking and actions, and these measures just do not account for all the ways customers actually can create shareholder value. Reconciling the conflict between current profit and long-term value is one of the most serious difficulties facing business today. Failing to take a properly balanced approach not only penalizes good management practices but also undermines corporate ethics by encouraging managers to “steal” from the future to fund the present. Often companies end up destroying value unintentionally—or worse, they know they are destroying value but feel they have no real choice about it. At the extreme, a firm might even resort to overpromising or tricking customers out of their money, in order to maximize short-term profit. Of course, doing this almost certainly hampers future sales and destroys long-term value by eroding the trust that customers have in the firm.

Balancing between such extremes in order to maximize overall value creation is not a new or revolutionary idea. As early as 1996, in an innovative and forward-thinking Harvard Business Review article, Bob Blattberg and John Deighton suggested that a firm should apply “the customer equity test” to balance marketing expenditures between customer acquisition and customer retention efforts. They even proposed a mathematical model for fitting exponential curves to find the optimum levels of acquisition and retention spending, based on executives’ answers to some level-setting questions.³ And the very concept of “brand equity,” which was a widely used metaphor during the heyday of mass advertising, was based on the idea that a brand’s value could be built up over time, with appropriate messaging, and that this store of value could become a genuine asset for driving competitive success.⁴

A 2003 white paper from Peter Mathias and Noel Capon of Columbia Business School considers the implications of managing customers for three “quite different outcomes: maximizing revenue in the near term, maximizing profitability in the short to intermediate term, and optimizing the asset value of customer relationships— customer relationship capital—over the long term.”⁵ The paper suggests that salespeople traditionally have been held accountable for short-term revenues, but as more organizations have come to emphasize key account management over the last decade, the metric of success has shifted perceptibly from customer revenue to customer profitability. To be successful in the future, say the authors, a firm will have to “take the long view” and “maximize the net present value (NPV) of future profit streams from these customers.”

Of course, even when executives understand the value of long-term planning, many say pressure from boards and shareholders forces them to act for short-term gains. According to a 2013 McKinsey survey of executives:

• “63% of respondents said the pressure to generate strong short-term results had increased over the previous five years.
• 79% felt especially pressured to demonstrate strong financial performance over a period of just two years or less.
• 44% said they use a time horizon of less than three years in setting strategy.
• 73% said they should use a time horizon of more than three years.
• 86% declared that using a longer time horizon to make business decisions would positively affect corporate performance in a number of ways, including strengthening financial returns and increasing innovation.”⁶

And let’s say executives get the go-ahead from their board—there’s still the question of how to measure intangible assets like customer equity over the long term.⁷ Charles Tilley notes, “Eighty percent of the market value of companies now lies in intangible assets. Yet many accounting practices and processes do not reflect this shift.”⁸ So, much of what passes for long-term strategic planning ends up focusing on metrics like cost assessment rather than revenue flow, because they’re a lot easier to predict and manipulate. Companies can’t control customers, but they can control costs! But as Roger L. Martin points out, although focusing on ways to influence customers can seem risky and unpredictable, it’s crucial, because “over the longer term, all revenue is controlled by the customer.”⁹

Determining the appropriate measurements to be used in quantifying the results of a company’s marketing efforts has always been a particularly elusive task, and to many it seems to have been made doubly difficult by the complexity of customer-specific marketing initiatives that new interactive technologies make possible. The very culture at many firms is intertwined with more traditional measures of success—or what we might call legacy metrics: quarterly product sales; cost of goods sold; number of new customers acquired; earnings before interest, taxes, depreciation, and amortization (EBITDA); return on investment (ROI); return on equity (ROE)—the tried and true. It shouldn’t be surprising that companies often find it challenging to supplement such legacy metrics with updated measurements designed around capturing the values that individual customers create, one customer at a time.

It is precisely because customers create both long- and short-term value that the customer-centric competitor will be well served to think of individual customers as being similar to financial assets—assets that are generating some cash flow now and are likely to continue generating cash flow for some time into the future. Each customer, in other words, represents a bundle of likely future cash flows—costs and revenues tied to that particular customer’s most likely future behavior.

The asset value of a customer is the customer’s LTV. Consumer marketing firms with databases of transactional and other customer records can use statistical modeling techniques to forecast their customers’ future behaviors and then calculate the LTVs represented by those behaviors. This is not an exact science, however, and no matter how sophisticated the computer modeling becomes, it will never be completely accurate, for the simple reason that predicting the future never can be completely accurate. (Of course, the accepted calculations of the “tried and true” have limitations in accuracy too. See Chapter 5.) However, many would argue that using predictive models to forecast future customer behavior is not substantively different from, and not inherently any less accurate than, using similar statistical models to forecast future economic variables, such as the supply and market demand for a particular product or service. In any case, the basic principle that a customer’s asset value should be thought of in terms of the future cash flows he represents is very useful, especially when we consider how this asset value goes up and down on a daily basis with the customer’s current experience.

The problem is that while LTV is a known and accepted concept in marketing circles, few marketers and even fewer finance people fully appreciate its real implications. Customers have memories and free will, so (unless we’re talking about the utilities monopoly) the treatment they receive from an enterprise today has a significant impact on the value they can be expected to yield for that enterprise not only today but also in the future. If a customer can be thought of as a financial asset, then changes in the value of this asset—changes in the customer’s LTV—are important. When a customer’s opinion of a firm improves or deteriorates, based on her experience with the firm today, her LTV goes up or down, and the amount of this increase or decrease in LTV is real economic value that has been created or destroyed as a result of the customer’s experience in the present. In this light, changes in the LTV of a customer are every bit as important, financially, as the current-period sales or costs attributable to that customer and captured on financial statements.

Consider this analogy: Suppose a business has some physical asset, perhaps a warehouse full of spare parts. Then suddenly the asset is rendered worthless by a disaster. Suppose a hurricane wipes out the warehouse, and the firm isn’t insured for the loss. If that were to happen, generally accepted accounting principles (GAAP) would require the firm to write down the value of that asset, and this quarter’s income would be reduced by the amount of the write-down. Now think again about the customer’s asset value. Suppose, instead of a hurricane wiping out a warehouse full of spare parts, there is instead some kind of customer service snafu, with the result that a very valuable customer becomes angry and upset with the firm. Because of this, his LTV plummets to zero (or even below zero, because he might communicate his bad feelings about the firm to his friends!). Didn’t the company’s value decrease when that happened? Surely, its future cash flow will decline if that customer’s opinion is not turned around again, right? Of course, the accounting treatment for this kind of “customer” event is quite different from that prescribed for the destruction of a physical asset carried on the balance sheet—but for now, we won’t focus on the accounting issues but on the simple reality of the economic loss to a company represented by an unresolved customer complaint.

The fact that a customer’s asset value (or LTV) will increase or decrease with his current experience, because he’ll remember that experience later, means that a customer-centric enterprise has to account for the value it is creating from customers in a different way from the way a product-centric enterprise accounts for the value created by its products. Products don’t have memories, while customers do. Note that how a company treats parts and supplies today will not affect the future cost of these supplies, or the profit to be earned from the products created with them. But how a company treats customers today will definitely affect the future profits likely to be generated by those customers.

Today’s accounting courses don’t often acknowledge customers as significant financial assets. But in the nonaccounting real world, customers are the only genuine value-creating assets any business has. As we said in Chapter 1, the only reason a business exists at all is to create and serve customers. Customers create, on the most basic level, virtually 100 percent of any enterprise’s value. Customers define a business as a business. And it ought to be clear to the most casual observer that a customer’s experience with a company, its products, or its brands has an economic impact that goes beyond the current financial period. Any company that spends advertising money to improve its brand image is explicitly acknowledging this fact. Such a firm is investing money based on the assumption that customer intentions have a financial value. If it can affect those future intentions today, then it hopes to see the cash effect tomorrow.

When it comes to understanding how Learning Relationships based on trust create financial value for a business, there are basically two approaches to the issue: a simple, philosophical approach and a quantitative, analytical approach. Both start with customers, for one simple reason: By definition, all the revenue you will ever generate will come from the customers you have now and the ones you will have in the future. (Take note: Brands, products, patents, logos, sales regions, and marketing campaigns do not pay money to a firm; only customers do.) The simple approach is to state your company’s value proposition as a straightforward quid pro quo:

1. You want each customer to create the most possible value for your business.
2. On the whole, a customer is likely to create the most value for you at about the point he gets the most value from you.
3. The customer gets the most value from you when he can trust you to act in his own interest.

Some companies—especially those that have grown up in the interactive age—have so internalized this view of the customer as a value-producing financial asset that it affects their whole philosophy of business. Amazon’s Jeff Bezos says his firm would rather spend on free shipping, lower prices, and service enhancements than on advertising. “If you do build a great experience, customers will tell each other about that,” he says.

In fact, Bezos clarifies that “if you’re long-term oriented, customer interests and shareholder interests are aligned. In the short term, that’s not always correct.” In fact, he says he cares about shareholders and that’s why he cares about Amazon’s long-term share price.

He has pointed out that a long list of initiatives such as Kindle, Amazon Web Services, and Amazon Prime—all of which have paid off in the long run but ran as a loss in the short term—would never have been started if the financial results at Amazon had always had only a two- or three-year horizon.¹⁰

Customer Equity

Products, brands, stores, bank branches, patents, information technology systems, marketing promotions and campaigns—even the best employees—do not pay money to any organization. Only customers—by definition—generate revenue. And if customers are the only genuine source of value creation for a business, then all the customers an enterprise has must be responsible for creating 100 percent of that enterprise’s shareholder value. This is the basic idea behind the concept of customer equity. If we sum all the LTVs of an enterprise’s current and future customers, then we have calculated the actual economic value of that enterprise as a going concern.¹¹ Thus, if all of a company’s cash flows come from its customers, then the sum of all current and future customers’ LTVs is the same thing as the economic value of the firm (i.e., the NPV of the firm’s future cash flows). Take away a profit-generating customer, and the value of a firm declines. Improve the cash flow expected from a customer, and the firm’s value increases.

The term customer equity can describe the effectiveness of customer strategies and implementation because it is primarily determined by the total value of the enterprise’s customer relationships. For a customer-centric competitor, a company’s customer equity can be thought of as the principal corporate asset being tended. One of the hazards of short-term thinking (i.e., of marketing efforts designed to produce current-period sales without much attention being paid to customer LTV) is that even a firm with current high profitability may find that it is not “banking” enough customer equity to sustain its future financial success.

Not long ago Dell got into financial trouble, as its earnings failed to keep up with expectations. For years, thanks to its groundbreaking direct-to-consumer business model, the company had been the only major personal computer manufacturer making any money, with profit margins a full 10 points higher than most of its rivals. But according to BusinessWeek, “Rather than use that cushion to develop fresh capabilities, Dell gave its admirers on Wall Street and the media what they want: the highest possible [short-term] earnings.”¹² The result was that Dell failed to maintain its profitability and in 2007, the original chief executive officer (CEO), Michael Dell, had to be brought back to take over again and try to restore the company to its former luster. Then, within just a few months, the company announced it would have to restate four years of earnings results because “unidentified senior executives and other employees manipulated company accounts to hit quarterly performance goals.”¹³ The company bought back its own stock and went private again in order to have the luxury to focus on customers and innovation for the long term.¹⁴

Some companies—such as JC Penney—have tried to improve their stock value by trying on new, short-term strategies but didn’t first test what customers wanted—with disastrous results.¹⁵

Comcast, whose notorious customer service resulted in a recent ACSI rating as second-lowest-ranking company for customer service, began to make noises in 2014 of a merger with Time Warner, which had ACSI’s lowest ranking. The merger was later abandoned. Customers gave their lowest marks for major customer service touch points: call centers and Web sites. Customers often feel they have no options even though they are terribly unhappy.

In one example of poor customer service that went viral, customer Ryan Block started recording a call with Comcast after his wife handed him the phone following her request that the service be disconnected, very upset by the call center rep repeating questions she had already answered. It’s clear from the recording that the rep would only stop badgering Mr. and Mrs. Block when he got the answer “Okay, we won’t disconnect the service.” Comcast apologized, but the recording had “struck a chord with hundreds of thousands of listeners; many commented saying they’re hoping Google Fiber enters the market in more cities so consumers have better Internet options.”¹⁶

One analyst wrote, “Comcast has done well for shareholders. Over the past five years, shares rose from roughly $16 to $53. However, knowing that a significant portion of their earnings may depend on providing poor customer service in order to prevent customers from buying their own equipment bothers me.” He said he would not recommend the stock [italics ours], since customers are unhappy enough to be looking for alternatives, leaving Comcast vulnerable to any competition that emerges.¹⁷

Short-term gain, long-term loss.

Dell certainly wasn’t the first business to suffer because it tried to maximize quarterly earnings and profit, and Comcast won’t be the last. U.S. automakers succumbed to a similar problem when they failed to plan for how newly available Japanese imports might alter consumers’ tastes in cars. Consumer electronics manufacturers in the United States made the same mistake with respect to their Pacific Rim competitors. Retailers that ignored the significance of Wal-Mart’s new business model have yet to catch up. Most semiconductor manufacturers failed to embrace very large-scale integration (VLSI) chip technology when it replaced transistors, and their business was taken over by new entrants like Intel and Hitachi. In industry after industry, companies focused exclusively on current sales and profit falter primarily because they are focused exclusively on current sales and profit.

Many executives recognize that their company’s obsession with short-term results is fundamentally destructive but feel powerless to do anything about it. Others feel equally strongly that if they just focus relentlessly on immediate sales and profit, then the long term will be okay. But this is a false assumption, because the investment community’s obsession with short-term performance is irrational and destructive. Just before the recession of 2008, William Donaldson, former chairman of the Securities and Exchange Commission (SEC), commented, “With all the attention paid to quarterly performance, managers are taking their eyes off of long-term strategic goals.”¹⁸ And we don’t have to look any further than the financial meltdown and Great Recession of 2008–2009 to see the consequences of rampant, unchecked short-termism.

And yet, since then, SEC Commissioner Daniel M. Gallagher has bemoaned the same issue, blaming the demands of individual and institutional investors.¹⁹ But not all investors think short-termism is a good investment; Larry Fink, chairman and CEO of BlackRock, the world’s largest money manager, believes corporate leaders have a greater duty to “the company and its long-term owners” than to “every investor or trader who owns their companies’ shares at any moment in time,” and promises support to companies whose corporate leaders follow this model.²⁰

Customer-centric firms, because they deal more carefully with the issue of customer value creation, are naturally more oriented to balancing long- and short-term goals. Indeed, the very idea of using a customer-centric program to improve, say, customer satisfaction and loyalty is based entirely on generating future profits as a result of providing good service currently.

The difficulty comes in convincing the board that long-term investment in customers and customer engagement is a good idea for shareholders. The average tenure of a chief customer officer (CCO) is only about 30 months, and most CCOs who outlast that tenure report it took them three-to-five years before they could “clearly demonstrate the significant value that they had offered to the company.” In the first year they typically spend a lot of time putting out customer fires, then they begin to focus on key customers and what they want out of the relationship with the company and how to address customer needs and balance them with requirements of the business. According to Blake Morgan, the director of the Chief Customer Officer Council, the time frame when thinking of how to measure and build customer equity is years, not quarters.²¹

An article in Fortune magazine²² pointed out that many customer-centric firms concentrate on raising their “returns on specific customer segment” and that this results in a “rerating” of a company’s profits/earnings ratio, as Wall Street “decides that the company can sustain [its] profit growth for years into the future.”

In 2014, CVS Pharmacy announced that it would no longer sell cigarettes or tobacco products in any of its 7,600 nationwide stores. The second largest U.S. pharmacy estimated it stood to lose $2 billion annually from the loss of tobacco sales, but CEO Larry Merlo, a 58-year-old former pharmacist, said, “Cigarettes have no place in an environment where health care is being delivered. This is the right decision at the right time as we evolve from a drugstore into a health-care company.” The move clearly required CVS to rethink the balance of short-term profits and long-term value of the company.²³

Knowing that removing cigarettes does not necessarily mean people will quit smoking, CVS also launched a “uniquely personalized” smoking cessation program that involves all its stores, its 900 MinuteClinics, and its “leading administrator of drug prescription benefit coverage.” CVS has also made online resources available and is partnering with the American Cancer Society and service providers in local communities.

From its launch on Sept. 3, 2014, through December 2014, CVS pharmacists counseled more than 67,000 patients filling a first prescription for a smoking cessation drug or prescription nicotine replacement therapy (NRT), and consulted with thousands more smokers seeking advice about over-the-counter NRT products. . . . Purchases of over-the-counter NRT products that assist smokers trying to quit increased by 21 percent in that timeframe compared to the previous four months. And, customers picked up 2.3 million tobacco cessation brochures at CVS/pharmacy and thousands of “Last Pack” encouragement toolkits, reaching millions of additional smokers with education, information and support.²⁴

A year later, CVS Health conducted a study into the effects of its decision to stop selling tobacco after one year. In states where CVS/pharmacy has greater than 15 percent market share, there was a 1 percent decrease statewide in cigarette pack sales over the 8 months since CVS removed tobacco from its stores, amounting to 95 million fewer packs. There was a 4 percent increase in the sale of nicotine patches in the month following the removal.²⁵ Key to this discussion was the reaction by analysts and investors. ISI Group analyst Ross Muken wrote in a note to investors:

The ultimate economic impact on CVS/Caremark will not be known for some time but financial analysts have been supportive of the change. We believe the move will be viewed as a positive long-term decision by CVS/Caremark, despite the near-term profit drag, as it paves the way for increased credibility with both healthcare consumers and payers.

A classic customer equity success story is that of Verizon Wireless, the mobile phone company. During the four-year period from the end of 2001 through the end of 2005, this firm, which was at the time a joint venture between Verizon and Vodafone, dramatically increased its customer equity. According to publicly reported figures, the company earned $21 billion in operating income in those four years while growing its customer base from 29.4 million handsets in use to 51.3 million. This kind of acquisition story is the kind that makes headlines and was touted as a great reason to invest in Verizon. But during the same period, Verizon Wireless quietly reduced its monthly customer churn rate on postpaid retail (contract) customers from 2.6 percent to 1.1 percent.

A back-of-the-envelope calculation²⁶ would show that partly because of the reduced customer turnover rate, Verizon Wireless’s customer equity grew by around $20 billion during this period. In other words, Verizon Wireless actually created nearly twice as much shareholder value as was reflected in its income statements during these four years. About half of this increase in customer equity was attributable to the new customers acquired; the other half came from the increased average LTV of all its customers due to the dramatic reduction in customer churn during the period. Consider that the reduction in turnover would have required Verizon to take steps that made it easier to stay a customer—better service, proactive reminders, hassle-free solutions to problems such as a lost phone—all capabilities that could be seen as distracting from the acquisition mission.

Significantly, Verizon Wireless relied on some highly sophisticated predictive analytics to anticipate and reduce customer churn. The truth is, Verizon Wireless’s four-year surge in value creation was probably a one-time event for the company because the more customer churn has been reduced, the harder and costlier it becomes to reduce it further. But other wireless firms throughout the world face opportunities every bit as rich as this, and for the most part they have failed to take advantage of them. In fact, if anything, there is strong evidence that many mobile telecom companies are running in the opposite direction, chipping away at their customer equity as they compete fiercely to acquire new customers at any cost—even when it means acquiring customers with lower and lower LTVs at higher and higher acquisition costs.

In Chapter 3, we described what a trustable telecom company would look like, and asked the key question: If customers understood what a “trustable” company was like, would they be willing to pay more, and how much?

Additional research indicates health care insurance customers would be willing to pay an average of $25 more a month to do business with a company they trust.²⁷ A survey involving more than 2,400 respondents, all U.S. residents and customers at one of the five major U.S. mobile operators—AT&T, Sprint, T-Mobile, U.S. Cellular, or Verizon²⁸—began by asking respondents how much they thought their mobile services provider could be trusted. The results found very significant differences on a variety of issues that add up to a great deal of money for a business. Most significantly, participants said they would be willing to pay about $11 more per month, on average, for a mobile carrier consistently demonstrating a higher level of trustability.

Let’s do the math: If you run a telecom company and your customers would be willing to pay you an additional $11 per month, 12 months a year, then for every 10 million customers your company has, you are face-to-face with a potential revenue increment of more than $1.3 billion. Three of the major players have about 70 million customers, so for each of them, increased customer equity due to higher levels of trustability could be worth nearly nine billion dollars. Only a fraction of this would be needed to accomplish most of the trustable actions listed in Chapter 3. The rest would drop to the company’s bottom line, improving customer experiences and loyalty in the long term.²⁹

So how do we decide how much you can really afford to spend today in order to create a better experience for the customer, to build the current and future value of your relationship with her, based on her expected future change in behavior? Trustability is a question we have to answer with two ways. The first approach to the question of how trustability creates financial value is a philosophical approach, an inevitable response to technology-driven interconnectivity and the transparency it creates. But the second is a quantitative, analytical approach, and that helps more in our strategic planning and our rewards and reporting. Here’s how to think about it:

Every business executive knows that customers are financial assets.

And, as is the case with any other financial asset, every customer has a certain value, based on the cash flow he can be expected to produce for the business over his lifetime.

The usual term for this customer asset value is lifetime value (LTV). And while no one can ever know with certainty how much cash flow any particular customer will generate in the future, increasingly sophisticated analytical tools do allow businesses today to model their current customers’ likely future behaviors statistically, based on what previous customers have done—that is, similar customers in similar situations. It will never be completely accurate, of course, because no matter how good the analysis is, predicting the future is impossible. But as data become richer and analytical tools become more capable, this kind of modeling has become more and more practical for a variety of businesses.

In a nutshell, two different kinds of current-period business success are on every company’s menu, and it’s critical to know the recipe for both:

• Good current profitability, while generating more customer trust and customer equity (have your cake and eat it too); or
• Good current profitability, while eroding customer trust and customer equity (use your cake up so there’s nothing left).³⁰

But when we examine it closely, building the value of customers through trustability and improved customer experiences is in fact financially attractive for a business even though in many situations it may cost money up front in the form of forgone profits or newly incurred expenses, as many business improvements do. If current-period earnings were the only criterion by which Amazon ever evaluated its financial performance, it would never do anything so “stupid” or “irrational” as refusing to make a profit from a willing (if forgetful) customer, by reminding you that you previously bought something most people only buy once. But the fact is that when Amazon warns you before you forgetfully buy something you probably don’t want, the company gains something far more financially valuable than the profit they could have made off of your forgetfulness. In addition to the increased likelihood that you’ll recommend Amazon to friends and colleagues, they’ll be solidifying your loyalty and continued patronage (after all, you’ll now want to buy all your books from Amazon so they can prevent you from accidental repeat purchases, right?).

The clue to understanding why trusted customer relationships can be financially attractive to a firm is recognizing that many of its economic benefits don’t come immediately but over time, as returning customers buy more and as a company’s solid reputation continues to generate more new business. Quantifying these benefits—including the value of increased customer loyalty, referrals, and additional sales—requires a robust customer analytics capability, as well as a financial perspective that fairly balances short- and long-term results.

Today’s most successful firms focus on the long-term value of their customers, and the importance of maintaining their trust and confidence, despite the fact that sometimes the actual economic value can be difficult to quantify. In his portrait of one such forward-thinking firm, Googled: The End of the World as We Know It, Ken Auletta tells the story of how its founders approached their IPO (initial public offering):

Google’s two 31-year-old founders were driving the company with a clarity of purpose that would be stunning if they were twice their age. Their core mantra, which was echoed again and again in their IPO letter, was that “we believe that our user focus is the foundation of our success to date. We also believe that this focus is critical for the creation of long-term value. We do not intend to compromise our user focus for short-term economic gain.”³¹

In The Facebook Effect: The Inside Story of the Company That Is Connecting the World, author David Kirkpatrick repeatedly makes reference to the fact that the company’s founder is not consumed with making money in the present but with creating lasting value:

They all knew Zuckerberg only approved projects that fit into his long-range plan for Facebook. “Mark is very focused on the long run,” says one participant in the meetings. “He doesn’t want to waste resources on anything unless it contributes to the long run. . . .” While Zuckerberg had been forced by circumstances to accept advertising, he did so only so he could pay the bills. Whenever anyone asked about his priorities, he was unequivocal—growth and continued improvement in the customer experience were more important than monetization.³²

To forward-thinking online companies like Google and Facebook (not to mention Amazon, Apple, Zappos, and other successes), it is the customer relationship that links long-term consequences with short-term actions. These companies are following a course of action that is intuitively obvious to them even if it might be difficult to quantify mathematically. Don’t forget: Jeff Bezos was monomaniacally focused on Amazon.com’s ultimate success even though the company lost money for 28 consecutive quarters after it was formed.³³

Customer Loyalty and Customer Equity

The CVS and Verizon Wireless discussions clearly illustrate the fact that customer loyalty is likely to play a large part in any enterprise’s effort to maximize the value its customers create. Executives frequently cite the problem of improving customer loyalty as one of the key reasons for embarking on a customer-centric initiative to begin with. This is because for many businesses, even small increases in average customer loyalty can have quite significant effects on their financial results in the long term. But because customer loyalty doesn’t create nearly so much short-term value as it does long-term value, the most useful way to analyze the impact of an improvement in customer loyalty is usually to examine its impact on a firm’s underlying customer equity.

This was exactly the approach taken by Sunil Gupta and Donald Lehmann.³⁴ In an important classic study, Gupta and his colleagues examined the financial reports of five different publicly held companies—Ameritrade, Amazon, Capital One, eBay, and E*TRADE—in order to try to estimate each company’s customer equity. Then they calculated the impact on each firm’s customer equity of changes in different marketing variables, including the average cost of new customer acquisition, the average profit margin, and the average customer retention rate, or loyalty.

What they found was quite remarkable, as shown in Exhibit 11.1, which compares four of the five companies:

• If the cost of new customer acquisition is reduced by 10 percent, customer equity values of these firms will increase by between about 0.5 and 1.5 percent.
• If product margins are raised by 10 percent, the customer equity levels of the firms will go up by roughly the same 10 percent.
• But if customer loyalty is increased 10 percent, then the customer equity levels of the firms improve by roughly 30 percent.

A 10 percent boost in customer loyalty for these companies, in other words, increases their overall value, as companies, by about 30 percent! Traditionally, everyone talked about the importance of acquisition, but retention is how you build the value of the company. Because it costs more to get a new customer than to keep one, and because retention improves customer equity by three times as much as acquisition, then it’s important to measure retention in order to drive a greater focus on customer experience and relationships. In other words, measure what matters.

Gupta and his colleagues had to use publicly reported financial data, and they limited themselves to analyzing five companies with fairly straightforward and easily modeled business structures. Each of the firms sells directly to end-user customers, for instance, so there were no complicated channel or distributor relationships to consider, and each has a high concentration of repeat customers who do business frequently. But the implications of this study still should be applicable to more complex businesses with more complicated business models.

In any business, customer retention may or may not be the most appropriate variable to try to evaluate. Customer values can change in many ways. Customer attrition or retention is like an on-off switch, but in most categories, customers should be thought of more in terms of volume dials. Increasing the amount of business your customer does, or at least avoiding a reduction in the business she does, could be a much more useful objective in many cases. A survey of the behaviors of more than 1,000 U.S. households across a variety of industries concludes that while reducing defection definitely represents an opportunity for most businesses, there is far more financial leverage in simply increasing the amount of business done by customers, or avoiding reductions in the volume of business done.³⁵

Jill Avery at Harvard details four mistakes companies commonly make about acquisition, retention, and churn. Companies:

1. Don’t measure the real cost of churn because of the natural time lapse between failing the customer and the churn, which is often six to eight months later.
2. Don’t look at churn as a behavior on the part of the customer that is a response to behavior on the part of the company, but unfortunately look at churn as a number.
3. Think there is a magic number for churn: Buy different numbers acceptable for different business models.
4. Don’t realize that churn is really an acquisition problem. If a company determines which customers will be the most valuable and the most likely to engage, churn will go down because the company has brought in and kept customers to whom your company has the most value and who have the most value to your company.³⁶

Customer loyalty itself is not always easy to define. If a consumer who considers himself loyal to a particular retail brand of gasoline is to stop at a different brand’s filling station because it is more convenient at a given time, has he become less loyal than he was? When a business that buys all its office furniture from a particular contractor decides to put the next set of furniture purchases out to bid, is that “defection”?

Most companies end up creating a practical definition of retention for their customers that includes two features.³⁷ Unless the customer has a single, subscriber-like relationship with a company and clearly “leaves,” retention is rarely considered an all-or-nothing variable. Thus, at an initial level, retention tends to be defined progressively—from “downgrading” behavior, to “inactive” status, to “no longer a customer.” For some firms, a downgrading pattern itself is an indicator of increased risk of loss. A cable customer with premium channels and many pay-per-views each month may downgrade to just basic cable, or even to local broadcast only, until he completely defects to streaming.

At a second level, any definition of retention must also recognize the multiple relationships that a customer may have with a firm in terms of products that span business units. Customers who terminate a relationship in one area—paying off a home mortgage with a bank, for instance—may or may not retain a strong and active relationship in other areas, such as retail banking, investments, and credit. And marketers can’t come to grips with this phenomenon at all unless they take an enterprise-wide view of each customer, across all business units and channels.

Although any lost customer is a real loss, understanding the nature of the loss will help to manage the costs of trying to reactivate customers or even to win them back. At the base level, it’s important to distinguish between customer attrition and customer defection. Attrition almost always results from a circumstance outside the direct control of a business—an elite business traveler retires, an office supplies buyer declares bankruptcy, a retail customer moves to another territory. Defection, by contrast, is a customer loss that might have been mitigated, because the customer is clearly choosing to move part or all of her business to the competition (e.g., a landline customer choosing to drop her service in order to go “only mobile” or to go to voice over Internet protocol [VoIP]). By distinguishing defection from attrition, we can isolate the drivers of each behavior and invest where we are likely to earn the highest Return on Customer.³⁸

There is also the question of tenure. In any population of customers, those most likely to defect will be the first to do so. Thus, the longer any particular group of customers has remained “in the franchise,” the less likely any of them are to defect in any given time period. Stated another way, the average annual retention rate among any population of customers will tend to increase with time.³⁹ When we talk in general about “improving retention,” we have to be quite careful, because the least loyal customers are always the newest ones. The easiest way for almost any enterprise to improve its average retention rate would simply be to stop acquiring new customers altogether! Again, resolving this problem requires a metric that can balance immediate profits and costs against the long-term value being created or destroyed.

In the final analysis, regardless of whatever behavior change a company can effect in its customer base—whether it is an increase in purchasing or a reduced likelihood of attrition—all of the financial results are captured in the LTV and customer equity numbers. The only question is how accurately the LTV equations have been constructed and modeled.

Forecasting customers’ future behaviors and estimating the financial impact will never be simple, but with the customer analytics and statistical tools now available, it’s not exactly rocket science anymore either. Some straightforward factors contribute to increases or decreases in an enterprise’s customer equity:

• Acquire more customers.
• Acquire customers who are more valuable to begin with (i.e., acquire customers likely to have higher LTVs).
• Increase profit per customer.
• Reduce servicing costs per customer.
• Sell customers additional products or services.
• Reduce the rate of customer attrition.
• Increase the propensity of customers to refer other customers.
• Add social and influence value—willingness to rate products and services, participation in social media, etc.⁴⁰
• Improve willingness to recommend (Net Promoter Score [NPS]).⁴¹

Many of these factors can be measured currently, even though their primary effect is to alter how customers buy in the future. These are some of the leading indicators of LTV change, and we will return to this topic later in this chapter.

But first, we need to answer a bigger question. If customer-centric companies concentrate on maximizing the value that their customers create, and these customers create value both in the long and the short term, is there a single, overall metric that would help an enterprise gauge the efficiency with which its customers are creating value?

Return on Customer

When companies engage in untrustable behavior, we find a nearly manic obsession with short-term financial results and almost total disregard for longer-term financial implications. Short-termism generates many dysfunctional and even self-destructive business practices, as profit-oriented companies dismiss the long-term consequences of their actions in order to generate current-period profits—profits that feed the bonus pool, pump up the stock price, and meet analysts’ expectations. Short-termism is characterized by unadulterated self-interest and directly conflicts with trustability, but it is still easily the most pervasive and destructive business problem on the planet today.⁴²

In one survey of 401 chief financial officers (CFOs) of large, publicly traded companies in the United States, for example, 78 percent of them confessed that they would be willing to give up actual “economic value” for their firms if that was necessary in order to hit the quarterly numbers.⁴³

Short-termism like this emphasizes the “selfish” aspect of free-market competition, without allowing room for the empathetic, nonselfish side of every person’s nature. Elinor Ostrom, the first woman to win the Nobel Prize in Economics, has suggested that “when we assume people are basically selfish, we design economic systems that reward selfish people.”⁴⁴ Obviously, there’s no longer any question that a free-market system is much more efficient and fair than any state-controlled system could ever be, but the “greed is good” philosophy that animates so many is testimony to the fact that it offers its biggest rewards to the most selfish people.

The truth is, however, that short-termism only reigns supreme at most businesses because the financial metrics we apply to business are not economically true measures of success.⁴⁵ They never have been, and they haven’t substantially changed since being introduced at the beginning of the Industrial Age. The way most businesses “do the numbers” to document their financial performance focuses entirely on the past—that is, on the most recent financial period. Most companies’ financial reports to shareholders include absolutely no consideration of the way the most recent performance has either helped or harmed a firm’s prospects for generating future profits, leaving this detail to the stock market analysts and others to figure out. Yes, a good business will track customer satisfaction or maybe even NPS or customer lifetime values.⁴⁶ Ultimately, though, these figures should have more effect on how earnings are calculated. Unfortunately, today earnings from the most recent financial period are the Supreme Performance Metric, the key performance indicator (KPI) to beat all other KPIs.⁴⁷

Managers sometimes take comfort in the sophistication and precision of their short-term financial metrics, ignoring the long-term effects simply because they can’t be as precisely defined. But this is like the classic joke about the man who lost his car keys late one night and is now looking for them near a street corner, even though he lost them half a block away, closer to where his car was parked. When a police officer asked the obvious question—Why?—the man glanced up at the street lamp illuminating the corner and said, “Because the light’s better here.”

The simple fact about business metrics: If you aren’t measuring the right things to begin with, you’re not going to get better results by measuring them more accurately.

Nowhere was this no-headlights philosophy more in evidence than during the run-up to the 2008 Great Financial Crisis, a global disaster brought about by rampant, overconfident short-termism. Short-term metrics and incentives, when they are applied to businesses based on current-period financials, almost inevitably end up promoting the interests of commission seekers, bonus-earning senior managers, and short-term investors. Usually, this is directly counter to the legitimate interests of a company’s shareholders, not to mention its customers, employees, partners, and other stakeholders.

So how do we measure better in order to make the most of the customers we have, and will have—the customers who are, by definition, a company’s only source of revenue? If it is in a company’s own economic self-interest to be trustable, then how should that company measure and report its value if it is building customer equity through trusted Learning Relationships and the better customer experiences that result? And what if a company’s short-term actions increase current numbers but decrease future value at the same time? Companies cannot simply ignore the reputational damage they would do to themselves if they were to resort to spamming or rampant telemarketing, and as interactivity accelerates, and trustworthiness becomes even more important, it won’t just be spamming that damages a reputation.⁴⁸ Untrustworthy activities will cause genuine economic harm to a business, and its cost is likely to dwarf whatever short-term profits a business might have been able to generate. Because while economics may not be everything, when it comes to operating a profit-making company with a payroll to meet and shareholders to satisfy, it’s almost everything. It’s extremely important to realize, therefore, that while acting in a customer’s interest will sometimes require a company to incur a short-term cost, it will nearly always be economically beneficial for the firm in the long run. So how can we calculate how much a firm can invest in building customer value to support short-term profits and increased long-term value?

It has never been possible to succeed for long with a business that offered substandard product quality or uncompetitive pricing. A business might generate extra profits for a brief period by cutting back on quality or raising prices above the norm, but as customers acquire the information needed to compare one company’s offerings with others, it is inevitable that lower-quality, higher-price companies will lose out to higher-quality, lower-price competitors.⁴⁹

To begin with, a company has to consider that customers, even if numerous, are finite in number. A company can make more products, but cannot manufacture more customers. And if customers are a scarce productive resource—imposing a constraint on a company’s growth—then it would make sense for executives to track how efficiently they use this scarce productive resource to create value. When an enterprise wants to track the efficiency with which it deploys capital to create more value, it uses some metric such as return on investment. Return on Customer^SM (ROC^SM)⁵⁰ is a metric directly analogous to ROI (and thus usually is pronounced are-oh-see) and specifically designed to track how well an enterprise is using customers to create value.⁵¹ (For an example of how a company can use up customer value, see the section “Using Up Customers” in Chapter 14.) ROC can provide a company with financial bifocals—a single lens through which it can see its earnings from customers clearly, whether these earnings are up close and immediate or in the more distant long term.

To understand the ROC metric, start with a simple analogy. Imagine that last year you bought a stock for $100, and during the year you received a dividend payment of $5, while the stock price climbed to $110 by the end of the year. Your total ROI for the year would have been 15 percent. You put up $100 initially, and the total new value created amounted to 15 percent of that initial investment. If, however, the stock price had fallen $10 during the year, from $100 down to $90, then your total ROI would have been a negative 5 percent, and even though you received a $5 dividend, you would have suffered a net loss overall.

Now apply that thinking to customers. Suppose you begin the year with a customer who has an estimated LTV of $100, and during the year you make a profit from the customer of $5. By the end of the year, let’s suppose your predictive modeling calculation shows that the customer’s LTV has increased to $110. In that case, your ROC for the year would be 15 percent. But this measurement of the economic performance of a particular customer will capture not just the sales you generate from the customer during the year but also the change, if any, in the customer’s value to your business—LTV, that is, or the value of his likely future purchases, recommendations to friends, and so forth, as modeled in your customer database.

To understand why ROC is important, go back to the stock purchase for a minute, and imagine that the only information you have is how much the dividend is. You can’t see whether the value of the underlying stock is increasing or not. In that case, even though the actual value of the stock will be going up and down all the time, you really can’t say how well your investment is doing. So far as you’re concerned, as long as the dividend continues or increases, you seem to be doing just fine, but the truth is that without also knowing how the underlying stock price is changing, it’s impossible to say whether you’re really creating value or not. If you had a stockbroker who wouldn’t tell you, you’d fire that stockbroker.

The fact is that many companies are content to measure, carefully and sometimes with maniacal precision, their current sales from customers, without ever noticing, or measuring, or demanding to know how much the customer equity lying underneath the current numbers has gone up or down. But because customers are a scarce resource for businesses, when a company doesn’t try to measure how much of that resource is being used up to create its current numbers, it is getting an incomplete picture of its financial performance.

A firm can calculate ROC for a particular customer, if it has reliable information about that customer’s LTV, change in LTV, and profit for the period, or it can calculate ROC for a particular group or segment of customers, as well. If the firm calculates its ROC with respect to its total customer equity, the result will be mathematically the same as its TSR during the period (see “Return on Customer = Total Shareholder Return,” above). Remember that a firm’s customer equity is virtually the same thing as the value the firm has as an operating business.

Therefore, ROC equals TSR.

Suppose we try to estimate ROC and use it to begin tunneling a path through the mountain of a company’s financial performance while at the same time the company’s accountants try to estimate the firm’s TSR (based on its discounted cash flow value as a going concern), and begin tunneling toward us from the opposite side of the mountain. The mathematics suggest that we should meet at roughly the same place in the middle. And because of the ROC = TSR connection, a company can be truly happy with its ROC only if it exceeds its cost of capital, because only then is the firm actually creating value, overall, for its shareholders. (Obviously, if an investment doesn’t earn a return greater than a firm’s cost of capital, the firm is better off not making the investment at all. Whenever a firm creates net new shareholder value, this is because its total shareholder return has exceeded its cost of capital by at least a tiny margin for some period of time.)

Therefore, when a firm’s ROC for some marketing initiative is less than its cost of capital, whether it is calculating ROC for the whole company or for some smaller subset of customers and prospects, it would be better off not undertaking the initiative. No value is created for a business when TSR is lower than the cost of capital, and because ROC = TSR, no value is created for a firm when ROC is less than the cost of capital either. Even though a firm may be showing a current-period profit from some set of customers, if its ROC for those customers is less than its cost of capital, then it isn’t benefiting its shareholders, because not enough customer equity is being generated.

Many companies that show little growth or hard-fought, tepid earnings are actually not creating net new shareholder value at all but simply harvesting the customer LTVs they already have “in the bank.” If an enterprise wants to grow and continue to grow, it has to ensure that every sales, service, and marketing initiative will yield an ROC greater than its cost of capital. That way, even as it is realizing earnings in the current period, it will also be building enough new customer equity to support future earnings.

Analyzing a company’s ROC at the enterprise level can help clarify its financial prospects in ways that traditional financial statements aren’t likely to reveal. To help you visualize this, Exhibit 11.2 shows an array of five different hypothetical companies divided into three categories, depending on whether each company is creating value, destroying it, or merely harvesting it.

Companies 1 and 2 in this exhibit are value creators. For these two companies, the combination of short- and long-term value created by their customers is occurring at a rate that is almost certainly higher than their cost of capital. In each case they are ending their year with higher customer equity than they started with, so they can expect to grow their earnings in future years as well. Although it’s clear each company is creating net new value for its shareholders, in Company 2’s case, this net new value is being created despite the fact that the firm’s current profits are actually negative.

Companies 3 and 4, however, are what we would call value harvesters. They are simply treading the financial water by harvesting customer profits that already have been “put in the bank” in the form of customer equity. Their ROC is not negative, but it is clearly below their cost of capital. Although each is earning a current profit, neither one is replenishing its customer equity enough, so it’s unlikely that either of these companies will be able to achieve much growth in future years. They may continue to report lukewarm, increasingly difficult profits for the time being, but sooner or later, their customer equity will no longer be sufficient to sustain a profit at all. Technically, they may not be destroying shareholder value yet, but if these firms were people, they would be living off their savings.

As a value destroyer, Company 5 is in the worst situation of all, with ROC below zero. True, the company has scraped out a profit this year, but this profit was achieved only by stealing even more from the future. One can imagine a car manufacturer offering the deepest-ever discounts in order to prop up the fourth quarter’s numbers, in the process saddling itself with a saturated market and customers trained to wait for more discounts, creating a much more difficult problem when it comes to making next year’s numbers. Company 5 is on the skids, whether this is revealed in its current financial statements or not. It may be reporting a profit to shareholders. But shareholders who dig deeper will see that this firm doesn’t have the operating and financial strength necessary to sustain this level of earnings for long. What this firm is really doing is “eating itself” and reporting the meal as a profit.

From the figures in Exhibit 11.2, it should be clear what kind of company represents the best value for an investor, although to a large extent savvy investors will have already discounted each firm’s stock price to reflect its growth prospects. Nevertheless, if a firm succeeds in converting itself from one class to another—say, from value harvester to value creator—this will likely have a major impact on its economic value as an operating business. As investors uncover this information, the firm’s stock will almost certainly be revalued in a significant way.

The Verizon Wireless situation we discussed earlier in this chapter resembles Company 1’s situation in the exhibit. The firm produced good earnings while simultaneously accumulating even more customer equity. We calculated Verizon Wireless’s ROC in each of those four years, and it averaged a whopping 68 percent annually. Stated differently, each year during the period we analyzed, Verizon Wireless created enough total new value to equal about two-thirds of its value as an operating company at the beginning of that year.

Yes, such a high ROC for four years running represents a remarkable spurt of value creation, but the way to think about it is that each year Verizon Wireless was revaluing its entire customer base, steadily improving the overall value of its business. Its success in customer retention was building up the company’s customer equity account to a level that could support even higher earnings.

Estimates for Verizon’s competitors during the same period revealed ROC measures ranging from only 19 percent to below zero. Even if all of the companies, including Verizon, offered investors about the same current returns, which company would you rather invest in? Or work for? Or acquire? Or be the customer of?

Tracking customer LTV allows a firm to calculate ROC in a variety of situations, sometimes in order to decide what the best course of action is and sometimes simply to avoid self-defeating business decisions that generate unanticipated (or unmeasured) costs. At many firms, for example, customer acquisition programs are evaluated simply on the basis of the quantity of new customers acquired rather than on their quality (i.e., their expected LTVs and growth potential). Profit optimization programs often look at cost savings without considering customer retention issues. And retention programs designed to reduce churn might do so by maintaining marginally profitable customers or even unprofitable ones.

These are, in fact, the self-defeating criteria by which many telecom companies evaluate their own actions. Because they don’t track changes in customer LTVs, they have no real understanding of the overall value they are creating or not creating with their everyday tactical decisions. For the most part, many telecommunications firms seem to have an indiscriminate hunger simply to win any new customers they can and to avoid losing their current ones, no matter what the LTV economics are in either situation. These firms are making decisions designed to maximize their current-period earnings, and it’s possible that they actually are doing so. The problem, however, is that this undermines their companies’ long-term viability. They actually may be destroying more value than they are creating.

According to one group of industry experts,⁵² many if not most telecom firms have seen the average LTV within their customer bases decline quite significantly in recent years:

Some [telecom companies], for example, have tried to reduce churn by offering discount plans and other incentives—but ended up retaining customers they would have been better off losing and making formerly marginal customers unprofitable. Others have tried to contain the surge in unpaid bills by tightening credit limits on new applicants but are now turning away many customers who would have been profitable.

In essence, according to this authority, here’s one example of a whole industry full of companies that are strip-mining their base of customers and prospects in order to feed their current-period results. As they continue with these policies, it becomes harder and harder to pump up the current period, while at the same time the customer environment is becoming increasingly polluted with uneconomic offers and unprofitable programs. It is anyone’s guess as to whether telecom firms are actually willing to sacrifice the future in their increasingly desperate effort to prop up the present, or they simply are unaware of what they are really doing, because they don’t have the right customer-centric metrics in place.

Leading Indicators of LTV Change

Once a firm is practiced enough in analyzing LTVs to begin monitoring how changes in LTV are caused, it can begin to apply the ROC metric to manage its marketing initiatives and its overall business more productively, focusing on the most important factors in improving its customers’ LTVs. If customer loyalty is the dominant factor in an enterprise’s customer equity calculation, then improving customer loyalty will be key to success. If profit on value-added service is the dominant variable, then services should be emphasized. Making the right business decision will depend on the current performance of a firm’s LTV parameters and on the effort required to influence the improvement of these parameters. Improving on a metric where performance is already high is generally more difficult (and costly) than focusing on an area with more room for improvement. Once Verizon Wireless had reduced its monthly churn from 2.6 percent to 1.1 percent, for instance, it will not be possible to duplicate that reduction, and the firm likely will have to find other ways to increase its customer equity if it wants to sustain such a high ROC.

ROC requires an enterprise to predict future customer behavior changes using currently available information. In essence, a company’s analytics program must identify and track the leading indicators of LTV changes. The question is, what data are available today to forecast up or down movements in a customer’s LTV?

The predictive modeling process involves two basic steps.

The first step involves devising an equation for LTV that includes whatever transactional records or other data are available on customers’ actual past spending (and other measurable behaviors, such as visits to the Web site or social media platforms, trackable referrals, complaints, etc.). It’s best if there are several years’ worth of transactions, but often a company will have to make some assumptions based on business judgment or sampling. Such records might include, for instance, each customer’s purchases every year, the margin on those purchases, and the number of years the customer has done business with the firm. Essentially, the company is using the computer to go back through historical customer records and make the actual calculations of LTV for as many individual customers as possible.

The second step is to identify the most predictive currently available variables with respect to the LTVs calculated in the first step. If we start by calculating LTVs for individual customers using historical records, we then comb back through all the information we have about those individual customers in order to pick out correlations and relationships with their individual LTVs. The data to be used should include purchase transactions to the extent possible but might also include complaint and service records, demographic (B2C) or firmographic (B2B) information, needs-based research, or even information on customer attitudes—essentially, any information at all that can be obtained in a customer-specific form, with respect to the customers whose LTVs already are calculated.

In the end, the objective is to generate a second equation for LTV, but this will be an equation that uses currently available data to predict an individual customer’s LTV rather than using transaction data to calculate it retrospectively, as is the case for RFM (recency, frequency, and monetary value), which often is used by database marketers. One large consumer service business devised a predictive model for LTV based on 10 years of customer transaction records. The company first ran a statistical analysis to see what independent variables most affected a customer’s likelihood of returning, because likelihood of returning seemed to be the most important single factor in determining LTV. Using the findings from this analysis, the company created an equation for predicting the future revenue from each customer. This formula was not limited to transactional records but included “outside” variables as well, such as the general level of consumer confidence in the economy at large. Each customer’s future contribution was estimated by applying historical margin to his or her predicted future revenue.⁵⁴ As one of their executives explained:

For a very high level summary of the LTV calculation, we ran a regression to see what independent variables affect a [customer’s] likelihood of returning. We then used the coefficients of the successful variables to create a formula for predicting future revenue for each [customer]. At least one of these was external—something like consumer confidence. Finally we applied the historical contribution of each [customer] to get to future contribution. Our LTV calculation contains only future expected contribution. We applied the formula to historical customer data to get LTV from previous years.

In the end, in addition to demographic data, the company’s LTV model used such variables as the first type of service purchased, the average rate paid, and how recently the last service was purchased.

The variables driving any firm’s LTV model can be thought of as the leading indicators of LTV change. The model won’t ever be perfect, because predictions never are. There always will be problems having to do with the availability of data, analytical issues, and other obstacles. But reliability will improve with experience, as a firm learns to collect, monitor, and weight the information more and more accurately. The leading indicators of LTV change fall into four general categories:⁵⁵

1. Lifetime value drivers. These are the elements of the LTV equation itself—the actual components that determine how much value the customer creates for the company, over time.⁵⁶
2. Lifestyle changes. When a customer takes a new job, or gets pregnant, or retires, or gets married or divorced—when his or her lifestyle or personal situation undergoes a substantial change, the LTV may also be affected.
3. Behavioral cues. The number of contacts initiated, the services or products contracted, the number of complaints or comments submitted, and payments made or not made are all examples of behavioral cues.
4. Customer attitudes. These include such things as satisfaction level, willingness to recommend your company or products, and likelihood of buying from you again. A customer’s attitudes have a strong influence on his or her future behavior.

Stats and the Single Customer

To maximize ROC, an enterprise has to gain some practice in using LTV as a tool and in tracking changes in LTV over time. It can never be known exactly how much an investment in acquisition will yield, or how to measure retention precisely over an extended period, or how much additional business actually will be stimulated by a particular offer. Yet from empirical observations an analyst eventually will be able to deduce how LTV is likely to be influenced by various drivers and by the attitudes of customers. The big challenge will be to fashion the company’s strategies not just to maximize this quarter’s sales or “new customers added” but rather to maximize the rate at which the enterprise is creating overall economic value, in the long term as well as the short term.

Of course, statistical analysis has its limits. In a group of a million consumers, a statistical model can predict aggregate behavior, such as a likely response rate or attrition rate, with reasonable accuracy. Such models can detect behavior patterns that tend to indicate some future actions, such as defection, providing the manager with an ability to intervene. They can also be used as benchmarks. But reduce the size of the overall group being analyzed, and the stability of these statistical calculations begins to break down. At the level of the individual customer, even the most sophisticated statistical models are subject to a great deal of randomness and noise.

However, once a company does drill all the way down to the level of an individual customer, it can make direct, one-to-one contact, and this kind of interaction will always trump statistical models. If a firm has really good, up-to-date, reliable data about an individual customer, and if those data are based on direct interaction with the customer, then it should be able to predict the customer’s behavior much more precisely than it could if the customer were simply one customer within some statistical cluster. For this reason, direct interaction with customers will provide an enterprise with the most useful and reliable leading indicators of those customers’ future behavior.

For a company serving just a few hundred B2B customers, statistical models are rarely as useful as the objective judgments of the sales and account managers closest to the customers. These judgments, too, are just educated forecasts, but they can be made more reliable and accurate by adhering to a standardized set of criteria. Has a contract been proposed? Is there a standing purchase order? Do we provide the back-end maintenance as well as product installation? Is the relationship characterized by partnership and collaboration? Can this customer refer other customers to us? Have they done so in the past? Judgments made on the basis of such objective but nonquantitative criteria are critical to making educated decisions about customer LTVs. They help get a firm as close as possible, as objectively as possible, to understanding the actual values of individual customers.

Summary

The metrics associated with managing customer relationships can provide invaluable insight into the profitability potential of the enterprise’s customer base and the viability of the enterprise’s new customer-strategy business processes. The customer-centric enterprise does, however, have to concern itself with other measurements and analyzing other pieces of information that are more specific to growing the overall value of each customer. Treating different customers differently can entail a detailed analysis of each customer to determine how the enterprise can alter his trajectory with the enterprise. Often this analysis can help turn customer information into knowledge the enterprise can use to help customers meet their needs.

The triggers, or predictors, of individual customer action and opportunity usually cannot be seen without detailed analysis. This is the increasingly complex and far-from-intuitive science of customer-based analytics and customer experience analytics, and having this discipline well represented on an enterprise-wide cross-functional team is critical. Sophisticated statistical models powered by technology can uncover some remarkable and highly predictive patterns. The ability to “mine data” is so valuable that its precise manifestations can be proprietary within certain companies. In the next chapter, we uncover some of these scientific applications of analytics within the customer-strategy enterprise.

Food for Thought

1. Let’s imagine you are the customer portfolio manager of a wireless phone company. How should you be evaluated at the end of the quarter? Straight sales from your customers? Net sales (sales minus cost to serve)? Customer satisfaction? Would it make sense for you to be evaluated on a combination of how much your company made from your customers this quarter and also—as of this quarter—what the two-year projected value of your customer base is? Five-year projected value? Why?
2. If a company rewards employees based on a combination of current and future values of customers, how might that change decision making?
3. Should the value of customers a company doesn’t yet have be calculated and taken into account in the present quarter? Why or why not?
4. How is retention different from share of customer (SOC) as a measure and how would it be used differently? Why are both important?

Glossary

Business model

How a company builds economic value.

Churn rate

The rate at which customers leave and enter the franchise. High churn indicates a simultaneously high number of defecting customers and high number of new customers. Usually a symptom of low customer loyalty. Also called customer churn or turnover.

Customer equity

The sum of all the lifetime values (LTVs) of an enterprise’s current and future customers, or the total value of the enterprise’s customer relationships. A customer-centric company would view customer equity as its principal corporate asset.

Customer portfolio

A group of similar customers. The customer-focused enterprise will design different treatments for different portfolios of customers.

Customer service

“Customer service” involves helping a customer gain the full use and advantage of whatever product or service was bought. When something goes wrong with a product, or when a customer has some kind of problem with it, the process of helping the customer overcome this problem is often referred to as “customer care.”

Demographic data

Directly supplied data that include age, income, education level, marital status, household composition, gender, home ownership, and so on.

Differentiate

Prioritize by value; understand different needs. Identify, recognize, link, remember.

Leading indicators

The variables driving any firm’s LTV model, which tend to fall into four general categories: LTV drivers, lifestyle changes, behavioral cues, and customer attitudes.

Legacy metrics

Metrics based on running a business before technology made it possible to treat different customers differently. Such metrics would include things such as quarterly product sales, cost of goods sold, number of new customers acquired, and financial metrics such as EBITDA (earnings before interest, taxes, depreciation, and amortization), ROI (return on investment), and TSR (total shareholder return). Also refers to any measurements a company has traditionally used.

Lifetime value (LTV)

The net present value of the future stream of cash flow attributable to that customer. LTV directly represents the long-term financial benefit of a customer’s continuing patronage.

Lifetime value drivers

The elements of the LTV equation—the actual components that determine how much value the customer creates for the company over time.

Most valuable customers (MVCs)

Customers with high actual values but not a lot of unrealized growth potential. These are the customers who do the most business, yield the highest margins, are most willing to collaborate, and tend to be the most loyal.

Needs

What a customer needs from an enterprise is, by our definition, synonymous with what she wants, prefers, or would like. In this sense, we do not distinguish a customer’s needs from her wants. For that matter, we do not distinguish needs from preferences, wishes, desires, or whims. Each of these terms might imply some nuance of need—perhaps the intensity of the need or the permanence of it—but in each case we are still talking, generically, about the customer’s needs.

Net Promoter Score (NPS)

A compact metric owned by Satmetrix and designed initially by Bain’s Fred Reichheld to quantify the strength of a company’s word-of-mouth reputation among existing customers, and widely used as a proxy for customer satisfaction. See www.satmetrix.com.

NPV

Net present value.

Predictive analytics

A wide class of statistical analysis tools designed to help businesses sift through customer records and other data in order to model the likely future behaviors of other, similar customers.

Return on Customer (ROC)

A metric directly analogous to return on investment (ROI), specifically designed to track how well an enterprise is using customers to create value. ROC equals a company’s current-period cash flow (from customers) plus the change in customer equity during the period, divided by the customer equity at the beginning of the period. ROC is pronounced are-oh-see.

Share of customer (SOC)

For a customer-focused enterprise, share-of-customer is a conceptual metric designed to show what proportion of a customer’s overall need is being met by the enterprise. It is not the same as “share of wallet,” which refers to the specific share of a customer’s spending in a particular product or service category. If, for instance, a family owns two cars, and one of them is your car company’s brand, then you have a 50 percent share of wallet with this customer, in the car category. But by offering maintenance and repairs, insurance, financing, and perhaps even driver training or trip planning, you can substantially increase your “share of customer.”

Total Shareholder Return (TSR)

Represents the change in capital value of a listed/quoted company over a period (typically one year or longer), plus dividends, expressed as a plus-or-minus percentage of the opening value.

Trajectory

The path of the customer’s financial relationship through time with the enterprise.

Turnover

Also known as churn rate or customer churn. The rate at which a company loses some customers and acquires others in their place.

Unrealized potential value

The difference between a customer’s potential value and a customer’s actual value (i.e., the customer’s lifetime value).

Value creators

Companies with increasing customer equity over time. The combination of short- and long-term value created by their customers occurs at a rate that is higher than their cost of capital.

Value destroyers

Companies with ROC below zero, regardless of current profitability.

Value harvesters

Companies whose ROC is below their cost of capital (but not yet negative), so that they are using up customer profits that have already been “put in the bank” in the form of customer equity. These companies may earn a current profit, but because they are not replenishing their customer equity enough, their future growth potential is limited.

Word of mouth (WOM)

A customer’s willingness to refer a product or service to others. This referral value may be as small as an oral mention to one friend, or a robust announcement on social media, or may be as powerful as going “viral.”