How much is a company worth? What is its “proper” market capitalization? After adjusting for debt, receivables, etc., one formal way to think about the company’s value (its equity) is that it is the net present value of the profits from all future products. That is, the company will generate profits now and into the indeterminate future. If you knew with certainty what those profits were going to be then you could ask, what am I willing to spend today for that future annuity stream? You could just sum up all of those profits, but that isn’t quite right. After all, you could choose to buy your future profit stream from the company or from, say, US Treasury bills. As of this writing, US Treasury bills give about 4.5% per year interest and they have essentially no risk [e.g., see bloomberg for an up-to-date value]. So just to make the company’s profit stream worth buying it would have to give at least 4.5% just to be as good a deal as a risk-free investment. Mathematically, what that would say is you should discount the company’s future earnings by some percentage. If that discount rate is d, then starting at today at year n=0, future year’s earnings for year n should be discounted by (i.e., divided by) (1+d)n.
What should we use for d? A company is certainly not risk free. Thus you would expect our investors to demand a risk premium for owning the company stock above and beyond that for risk-free treasuries. A risk premium for a solid and predictable company might be 8%, so we might use d = 12% for our discount rate. We can see that profits today are worth a lot more than profits 5 years from now! You heard the expression, “time is money.” Now you can calculate it. For instance, at a 16% discount rate, $1 next year is worth $0.862 today. A $1 two years from now is worth only $0.743 today. In fact, if the company earns one dollar every year starting now at year zero out to infinity, the net present value of that whole earning stream, including year 0, is $7.25. (If you enjoy math, there is a simple closed form solution for the sum of this infinite geometric series. It is simply earnings at year zero times (1+1/d), where 1 is the present earnings and 1/d is the sum of all future earnings.)
If you take a finance course they will teach you that you can never just add up profits from different years without taking into account the appropriate discount rate. (These same courses are a lot less precise on figuring out what the right discount rate is, however.) By the way, when companies considers buying another company, computing this discounted cash flow, under a variety of assumptions to be tested during due diligence, is one of the key exercises one goes through. Since one generally has to pay a premium over the stock price for a public company, say 20-30%, one has to convince oneself that one can pay for that premium by, for instance, lowering costs by eliminating redundancy or increasing sales because of an improved sales channel.
There is another way to look at the value of a company. It is mathematically equivalent to what we just described, but it requires twisting your head sideways. Our first view was, “we are our products.” A second equally valid view is, “we are our customers.” After all, who buys the products? So instead of adding up the future profits from the product portfolio, including products not yet invented, we could say that the company’s net present value is the sum of the profits from each of the customers, from now to eternity, including from customers to whom the company does not yet sell and subtracting off customers that the company loses. With this point of view, the company’s market capitalization should be the sum of the customer equity from each of the customers. I like this view because it drives a customer-oriented viewpoint. Thinking about it this way says that there are certain ways you must treat customers because you are trying to maximize the net present value of the profits one achieves from them, forever. Of course, profits today are worth more that profits tomorrow, as approximately given by the discount rate. If we call this “customer equity,” as is done by the service industry [see, for instance, Driving Customer Equity : How Customer Lifetime Value is Reshaping Corporate Strategy], then classically that equity is made up of several parts. The first is product equity, meaning how much would we make if each customer behaved 100% rationally based on the relative value of our product to the competition for their job at each decision point with no memory of previous experiences. This kind of thinking drives a lot of product development, as it should. Of course customer do not behave 100% rationally and people also make rational decisions based on experience, so there are other parts of the customer equity. This next part is called brand or reputation equity. This equity covers the part of the customer decision that is based on emotion and general experience. Clearly how we treated our customer the last time has a big impact on how much profit we will get from them in the future. This is brand equity. The third type of equity is retention equity. That is, if my customer bought my widget last time he is more likely to buy from me next time than if he bought his last widget from someone else, all else being equal. It is several times harder to get a new customer than to keep an old one. Sometimes we talk about this in terms of repurchase intent.
This concept of different flavors of equity can be extended in several directions. Another concept I like, I read about in IBM’s Global Innovation Outlook . It is “reputation capital.” Examples include the rating systems on eBay and Wikipedia . I was amused to read that some students are even putting their eBay ratings on their resumes. In a highly connected world, ones reputation is worth more than gold. How are you doing on growing your reputation capital? What color would the company’s star be on eBay? How many stars would the company have on Yahoo shopping ?
Many companies invest a lot in product development. They do this because they believe they will have a great return on those products that will more than make up for the discount rate that one must apply to those future returns. Companies also invest in their customers. It is often tracked less precisely, but companies also invest in winning a customer today so that they can get those future profits from them tomorrow, for instance with special support or discounts. The classic example of this is giving away shavers to sell razor blades. The trick is making sure the return on that investment materializes. It is a lot easier to give away profits today than reap them tomorrow.
So now we now have two ways of thinking about a company’s equity: “we are our products” and “we are our customers.” Both are right, but turning your head from one to the other helps you think more clearly about what actions you should be taking to make that equity grow.