Satisfying the Two

Here we connect customer value with shareholder value in the shortest time.customer to shareholder 5

SV CA CV

What does “growing shareholder value” mean?
Consider a company with £40m sales revenue a year.   To create the products for that £40m sales, it required machinery and technology and developing processes costing £25m.      That £25m represents the assets of the company and was paid for by shareholders investing their capital into the company.

The shareholders investing their £25m will expect an annual growth rate on that capital.   Typically, they would expect a growth rate of approximately 7% per year.   The reason is because their next best alternative will be a 7% annual growth rate from investing in shared ownership of hundreds of companies listed on the stock market (averaged out over decades, the stock market returns roughly 7% growth on money each year).

With 7% p.a. growth rate being the next best rate of return for an investor’s money, a company is expected to annually generate at least a 7% profit return to the investors on their £25m invested; a £1.75m profit (£25m*0.07) that can be taken out of the company without affecting its competitive position and returned to shareholders.
So it costs the company 7% p.a. to borrow that money from investors for its assets.     7% is the Cost of borrowing Capital or “CoC” for short.

 

 

1. Shareholder value growth requires a RoIC ‘spread’ above CoC.
2. A RoIC ‘spread’ requires the customer demand for a product to exceed supply.
3. That demand requires the product to offer durable, marginally superior, profitable customer value over rivals.
4. To deliver that requires a Competitive Advantage.

A Return on Invested Capital ‘spread’ is key.
Shareholder value is created if a company generates a profit Return on their Invested Capital (RoIC) above the CoC:

  • Shareholder value is created if RoIC is 10% p.a. and therefore greater than 7% CoC.
  • Shareholder value is sustained each year if RoIC 7% = 7% CoC.
  • Shareholder value is destroyed if RoIC % is below 7% CoC.

If RoIC is at 12% and CoC is 7%, then the percentage points difference of 5 points is the RoIC % ‘spread.’   The extent of that RoIC % spread above or below CoC decides the extent to which shareholder value is created, sustained or destroyed:

  • At 10% RoIC, the £25m invested would produce a company worth £36m to a buyer. The company has created £11m economic profit to its owners. (See calc.)
  • At 7% RoIC, the £25m invested would produce a company worth £25m.
  • At 2% RoIC, the £25m invested would produce a company worth far less than £25m. Instead at the resale value of the separate assets sold in the marketplace, since the company is uneconomically viable.

How can a marketer increase sales and profits and yet still not create any shareholder value growth (and even destroy it)?
The increase in sales requires more assets to deliver the sales. Those assets need to be paid for using more invested capital from investors.
If the new sales only earn a 7% profit Return on that Invested Capital (RoIC) which merely matches 7% CoC, then the RoIC ‘spread’ is 0% and no growth in shareholder value is achieved.

£20m extra invested capital x 0% (1.00) = £20m.

“Investing in projects that do not earn the cost of capital may drive [sales and] profit earnings per share growth, but will clearly destroy shareholder value.
This type of investing goes on every day in corporations around the world”              Michael Mauboussin – Thoughts on Valuation.  1997.

Given the importance of a % RoIC ‘spread’ to grow shareholder value, how is a spread created?

 

 

CV CA SV

1. Shareholder value growth requires a RoIC ‘spread’ above CoC.
2. A RoIC ‘spread’ requires the customer demand for a product to exceed supply.
3. That demand requires the product to offer durable, marginally superior, profitable customer value over rivals.
4. To deliver that requires a Competitive Advantage.

The Demand for a product to exceed Supply.
RoIC % spread is achieved when a company creates a customer demand for its product that is greater than the supply of the product.
Specifically, creating a demand for your customer value that exceeds the constrained supply of only one company (yours) offering that customer value.

“The marketing 4Ps are demand-shaping forces and should be part of basic economic theory.    ‘Behavioural economics’ [i.e. psychological factors influencing economic decisions] is just another name for ‘marketing’ and what marketing has been researching for 100 years.”

Philip Kotler- Professor of Marketing at Northwestern University’s Kellogg Graduate School of Management.

The constrained supply of high customer value delivered by one company means that customers will pay a price premium up to the level of the next best rival alternative offering (a minor ‘monopolistic’ pricing power), as well as sales growth to that one company for offering high customer value.

The price’s profit margin and high sales both lead to generating a profit Return on Invested Capital greater than the normal profit Return expected on that capital (the Cost of Capital), so a RoIC % spread is achieved.

What is required of a product for its demand to exceed supply?

 

 

1. Shareholder value growth requires a RoIC ‘spread’ above CoC.
2. A RoIC ‘spread’ requires the customer demand for a product to exceed supply.
3. That demand requires the product to offer durable, marginally superior, profitable customer value over rivals.
4. To deliver that requires a Competitive Advantage.

Durably superior, profitable customer value.
To create this consumer demand for a product that is greater than supply of the product, it requires that no other rival can offer comparable customer value.
Otherwise, to get a share of the superior profits (and minimise their losses), rivals will meet that demand for your customer value with their own supply of their improved product, until the excess profit creating your RoIC spread above CoC is competed away and both companies’ excess profits drop back to normal RoIC=CoC profit level.

Therefore to grow shareholder value requires a marketer’s product to fulfil 3 criteria:

1. Marginally superior Customer Value over rivals to win and retain customers.
To secure a sale, the customer’s perception of your product’s value has to be marginally superior to that of the customer’s perceived nearest comparable alternative.    Customer Value is:

utility “usefulness” of the product in meeting customer needs
minus
total cost to purchase and use it.

2. Threshold profitable: Superior customer value could be delivered by lowering prices to an unprofitable level.     So the product also has to be priced to generate a profit after all costs have been deducted:

Operating cost (e.g. marketing costs, raw material)
+
Invested capital’s cost (i.e. the next best % annual return that could have been earned on the money spent on assets necessary to deliver the sales: equipment, property, credit to suppliers etc.).

“Threshold profit margin” is the minimum profit margin needed to pay for both operating and invested capital costs.  At that price, the profit Return on Invested Capital (RoIC) matches the Cost of Capital (CoC) and so shareholder value is sustained.

Example: £1 of sales uses 95p of operating cost to deliver, resulting in 5% profit margin.       That £1 sale also required 40p of equipment as invested capital, with investor’s capital cost of 7% return on the 40p = 3.7% threshold profit margin (see calc.).

Since the 5% profit margin is above 3.7% threshold, the sale has increased shareholder value:

Threshold margin diagram

 

3. Durable over years: The product’s above threshold profitable pricing is key to growing shareholder value, but it would contribute little if the profitable pricing only lasted for several months.
Therefore the product has to be durable for a period beyond a year in being both 1. marginally superior customer value over rivals and 2. Priced above threshold profitably.

Importance of barrier.
To achieve this durability, the product’s customer value has to have a barrier preventing rivals from improving their own products perceived value and thereby dragging themselves up to equal customer value parity with itself.
A company’s superior customer value that is dragged back to market parity has the same outcome:CV dragged to parity

In targeting a specific customer niche, it requires just one other company to bring their level of customer value up to your marginally superior value for the result to be the same: a lower chargeable price for you due to offering unexceptional customer value and costs per unit sold rise as fixed costs are spread over fewer units sold.

This leads to no excess profitability from excess demand for constrained supply, since a rival is now also meeting that demand.    The result is nil RoIC % spread and no shareholder value growth.

How do we create durable, marginally superior, threshold profitable Customer Value products?

 

 

CA CV SV

1. Shareholder value growth requires a RoIC ‘spread’ above CoC.
2. A RoIC ‘spread’ requires the customer demand for a product to exceed supply.
3. That demand requires the product to offer durable, marginally superior, profitable customer value over rivals.
4. To deliver that requires a Competitive Advantage.

Competitive Advantage.
Since durable, marginally superior profitable products lead to a RoIC % spread, by grouping together companies with a RoIC % spread and finding out what commonality they all share, that can indicate how they are able to create such superior products.

When a few hundred companies are lined up and ranked by their ability to earn a RoIC % spread over CoC, they are distributed like this:

RoIC charts

This distribution occurs within industries:

RoIC spreads within industries

 

 

 

 

 

 

 

 

 

 

 

 

 

 

And the same distribution across different industries:

Correct Mauboussin RoIC chart

A third of companies with a RoIC of over 11% are able to materially grow shareholder value.    These companies share a common theme- they all have a Competitive Advantage that enables creating superior product value above their rivals.

(One third has RoIC with little spread above CoC; they likely have no competitive advantage and seek to sustain shareholder value.    One third were reducing shareholder value during the period the data was collected).

Sources of Advantage covers how a competitive advantage enables a company’s marketers to create superior product value for customers.