Last week we talked a lot about how the value of a company is measured, and ended up with an incredibly incisive discussion about how marketers contribute to that value. This week, we’re going to look at Southwest Airlines, and some new ways to understand how marketing has helped them consistently beat the competition. If you’re just joining the discussion, you can get up to speed by visiting the index to this Book Discussion on Victor Cook’s Competing for Customers and Capital. If you missed the last thread, I highly recommend reading Vic’s comments on how marketers can demonstrate the contribution of value to the bottom line in a way that’s relevant in the boardroom.
Once again, Vic has put together a narrated PowerPoint to discuss the important concepts in his analysis of Southwest Airlines. This section looks at Southwest the same way a savvy investor would. But instead of looking at typical ways to measure stock performance like, say, a price/earnings ratio, Vic introduces a number of measures that look at a company’s performance within a competitive group, and at how marketing impacts performance.
One example is the Value/Sales differential, which clearly differentiates the winners and losers of a competitive group according to their ability to generate shareholder value, relative to their share of revenue. Southwest consistently soars above the competition in its ability to generate a higher premium for its stock among investors, compared to its share of revenue among competitors. There are a number of marketing factors to consider in explaining the relative market value of a company among its competitors, which Victor will help elucidate this week.
As a lead in to this week’s discussion, I’d like to ask Victor to discuss what has been missing from the investor’s tool kit in measuring the value of a company on the stock market, and how that relates to marketing.
LINDA TAN’S BLINDERS
Chris, you asked me what’s been missing from the investor’s tool kit in measuring the value of a company on the stock market, and how that relates to marketing.
The answer to this question is pretty simple: product markets, competitors and people are missing. This goes right back to the story of Linda Tan in my post on THE CMO CHALLENGE. The lion’s share of the value creators in the investor’s tool kit come from the balance sheet. Nowhere on this financial statement will you find numbers on product market performance, the impact of competitors, or the contributions of people to the value of a company on the stock market. Strip away all the statistics and micro economics in my book and you come down to these three fundamentals. These are Linda Tan’s blinders.
PRODUCT MARKETS
Product markets interact systematically with stock markets in creating value. Surprisingly we knew little about this interaction until I discovered the value-sales principles that are the topic of Chapter 2: Y’all Buckle That Seat Belt.
Consider this point of reference. If you were to search JUSTOR for all the scholarly articles published in economics journals (48 of them are listed), business journals (71), and finance journals (6) which include the words “value” and “revenues” in the same paper how many you find? Out of the thousands of articles in this data base, only forty (40) use both these words in any combination. And only two of these articles use both “value” and “revenue” in the way I use them in my book. One of these is my own 1985 paper on The Net Present Value of Market Share. A link to this paper is included in the index to this Book Discussion under Background Materials: http://www.marketonomy.com/marketonomy/competing.html .
The other one that uses the words “value” and “revenue” in the way I do is a paper in the Journal of Accounting Research published in 2000 — The Eyeballs Have It: Searching for the Value of Internet Stocks. This paper by Brett Trueman, M. H. Franco Wong, and Xio-Jun Zhang is the only article in that vast literature that reports value/revenue ratios. In 2000 the mean v/r ratio was 181 among ninety-eight E-Tailers. Or, before the bubble burst, these companies created $181 in market value for every $1 in revenue. The mean v/r ratio of 119 protal and content firms was 160.
What’s the point? Product market performance is missing not only from the investor’s tool kit; it also was missing from the literature they studied in business school.
COMPETITORS
I have a friend who manages a $250 million dollar portfolio for a small group of private investors. Sam is among the most successful managers in the business. On June 8, 2005, I called to ask him what stock he was trading:
He said: “The Home Depot.”
I asked: “What was the closing price?”
“Thirty-nine sixty seven.”
“How many shares were traded?”
“About seven million.”
“What was the low for the year?”
“Thirty two bucks.”
“What’s the company’s P/E ratio trailing twelve months?”
“Sixteen ninety two.”
Then I asked: “Who are Home Depot’s top three competitors?”
Sam said, “Lowe’s.”
“Who’s number two?”
“Just a minute while I look that up.”
A long silence, except for keyboard clicks.
“I’m not sure who that is. What do you think?”
Sometimes even the most astute financial managers forget that performance is relative. Unfortunately, identifying competitors is not as easy as the airline example in Chapter 2 suggests. The answer to the question, “Who’s in my strategic group?” depends on a lot of factors. Check them out Chapter 3. It’s important. For a quick take on the issue go to Chart 3-1 (page 77) showing the distribution of resource equivalence ratios in the pharmaceutical and biotechnology industry.
Sam is typical of intensely focused portfolio managers. They all say that they look at the impact of competitors (they call these “peer” firms) in stock valuation. And they do “look” at the impact of competitors. But, they don’t “study” it in the way they study the balance sheet of individual companies. Because, until now, they simply didn’t have a tool to study it in depth.
To see what a difference including competitors in the analysis of value can make, do this. Go to the chart in slide 27 of my narrated power point presentation on Chapter 2. Compare Southwest’s risk-adjusted rate of return in this chart (using the company’s numbers) with the chart in slide 29 which shows Southwest’s risk-adjusted value-sales differentials in a strategic group with nine other airlines.
What’s the point? When you have a valuation model that includes competitors, even a simple one like my value-sales differential, you get a completely new take on who’s creating the most market value.
PEOPLE
People are the most important missing link of all in the investor’s tool kit. We’ll dig deeply into measuring their impact next week when we take up “Enterprise Marketing Expenses.” We’ll also see how these expenses relate to traditional marketing.
For now just consider this. Your most valuable asset walks out the door every night. Yet, they don’t figure in the investor’s tool kit, because neither the cost nor the contribution of people to market value is reported in the balance sheet.
There’s something profoundly ironic about the lack of metrics to track competitive performance in creating shareholder value. I mean, so much of corporate strategy, and marketing strategy is intensely focused on competition–in fact, many would argue that too much focus on competitors instead of customers stifles innovation. And, in fact, investors do track the performance of industry Sectors–but I guess that’s really just an aggregate view of the collected competitors in the Sector, and not a comparative view such as your metrics provide.
I can understand these comparative competitive metrics only coming into broad view now. I mean, 20 years ago, the difference between a company’s value on the balance sheet in its value on the stock market wasn’t nearly as great as it is today. Now, investors have to understand and explain the tremendous gap in a way that helps them pick winners.
Along that same line (the need for new ways to understand creation of shareholder value), it seems that there’s another dark hole that needs to have a light shined in it: GS&A expenses. If I’m jumping ahead, then steer me away. But it seems that, just as investors haven’t looked at competitive performance or product markets, they haven’t compelled a better accounting for the expenses that make up the black hole of General Administrative and Selling expenditures.
TRACKING COMPETITORS
In general, corporate strategy tracks competitors through the lens of Michael Porter’s five forces model. Which means the strategy guys don’t study the data from competitors’ income statements and balance sheets like Porter recommended in his book — Cases in Competitive Strategy. Neither do investors.
Without the help of a simple model (like my value-sales differential) to guide the way, it’s very difficult to figure out what to do with the data from these two basic financial statements. I hope it will be easier now that there are some guidelines. That’s why on slide 33 in my narrated power point presentation on Chapter 2 I’ve invited visitors to your site to run the value-sales differentials for their company and several competitors in a single period using data from Yahoo or MSN financials. If they find the results interesting, I offered to send an Excel template so they can run the risk-adjusted differentials over ten periods (quarters or years) without having to code a worksheet.
MARKET v. BOOK VALUE
Chris, you say in your last comment “20 years ago, the difference between a company’s value on the balance sheet in its value on the stock market wasn’t nearly as great as it is today.” Yes, but where does this difference come from? Is it due to a relative expansion in market value? Or, is the size of the pie unchanged relative to the growth in the economy? The answer is important, because if the pie is relatively unchanged, than the increased importance of intangible market value is far more significant than if the pie has gotten bigger.
The value revenue (v/r) ratio is a good way to answer this question. For two reasons. First, the combined sales revenues of companies propel the economy. Second, there is very little wiggle room in reporting sales revenues to the SEC. While book value is far more subject to manipulation and/or deterioration. In an earlier post (October 24) I promised to find an answer to this question: over the long-run how does the v/r ratio behave?
Well, I’ve now run the numbers and the results are surprising. Using all the companies that reported market value and sales revenue numbers (greater than zero) in the COMPUSTAT data base I compiled a sample of 230,462 company annual reports from the end of their fiscal years beginning in 1950 and ending in 2005. I think everyone will agree that fifty-five years is a long-run.
In the decade of the 1950s total market cap of the reporting firms was $2.0 trillion. In the period 2000-2005 the total market cap of the reporting firms was $124.7 trillion. This sixty-fold increase in market cap represents the creation of enormous new shareholder wealth.
In the decade of the 1950s total sales revenues of the reporting firms was $2.1 trillion. In the period 2000-2005 the combined sales revenues of the reporting firms was $92.7 trillion. This over forty-fold increase in sales revenues represents an enormous expansion in the size of our economy.
From these data you can calculate the v/r ratio in the decade of the 1950s was 0.95. In the first five years on this century it was 1.35. But it varied a lot over the years between. In the decade of the 1960s the v/r ratio was 1.10. In the 1970s and 1980s the v/r ratio was less than 1.0 (actually 0.50 and 0.60 respectively). The in the go-go 1990s it rebounded to 1.10. But over the entire fifty-five year period the value/revenue ratio stood at just over one (1.07). In relative terms, the pie was the same size.
What does this mean? Two things. The first is obvious: market value is driven by sales revenues. By the way, this often is forgotten by everyone except sales VPs, CFOs, and CEOs! Second, the shift from tangible to intangible market values takes on much greater significance. Whether it was from 25% to 75% or 30% to 70% doesn’t really matter all that much.
What matters is this: relative to the size of the economy, intangible assets have become the driving force behind intangible market value.
A BRIGHT LIGHT
What was considered for years to be the black hole in the income statement – those selling, general and administrative expenses – will soon become its brightest light. Because it’s in the SG&A expense account that the costs of all the people who create a company’s intangible market value are recorded. It’s these expenses that I will examine closely in Chapter 4: Enterprise Marketing Expenses. Then, later on, I will link them to shareholder value.
So, if I understand this correctly, what it means is that over 50 years, the relationship between what companies earn in revenue and how those companies are valued on the stock market hasn’t changed. But intangibles have grown to greatly outweigh tangible assets in describing the total value of those companies.
As a kind of analogy, would that be similar to saying that a company today could drive the same revenue and the same market value, but have vastly fewere tangible assets? Instead of creating value with expensive machinery, value is being created with people, processes, knowledge and other intangibles. Is that a valid analogy? If it is, than it sounds like you’ve quantified the shift to an information economy.
Exactly. That’s why selling, general and administrative (SG&A) expenses have become so important. This is the account that reports the cost of the people, processes, knowledge and other contributions to intangible market value. And it really doesn’t matter if these contributions show up on the balance sheet. They’re recognized in the stock market.
Taking on leadership of SG&A expenses represents an extraordinary opportunity for existing and future CMOs. Next week I’ll dig into the income statement to show you the sources of intangible market value created by the expenses reported in this account. But, let me give you a taste of where traditional marketing fits in the larger picture of enterprise marketing (see Table 4-2, page 88 in Competing for Customers and Capital).
The big pharmaceutical companies, among the heaviest hitters in the game, allocated only about 8% of their SG&A budgets to advertising and promotion, even though those budgets represented about 80% of their sales revenues. Where is the lions share spent? On people.
Let’s put this in perspective: pharmaceutical companies held down eleven of the top twenty-five positions among firms that captured the most intangible market value in 2003. They were right up there with Microsoft, Cisco, Coke and P&G.
I outlined THE CMO CHALLENGE in my comment of October 29. At the risk be being redundant I’ll repeat that challenge here:
Each of these (SG&A) expenses affects the way customers and investors feel, think, and act toward your company. The job of a chief enterprise marketing officer is to provide leadership for all of the functional areas in searching for ways to maximize earnings after deducting the cost of enterprise marketing resources. In short to maximize EBITDA.
This is very TALL order. It means partnering with the VPs of research & development, operations, sales, human resources, and strategy as well as mastering the financial accounting data.
How can I drive this point home? Try this on for size. Anyone who accepts this challenge, and delivers the goods, will be rewarded by paying more in future taxes than they’re earning today.
hello ,i have a question for you,how strategic marketing contributer to creating shareholder value?
how strategic marketing contributes to creating shareholder value?
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