With companies spending hundreds of billions of dollars on marketing each year, executives, business school students and the SEC all want to evaluate the impact of intangible assets on firms’ market values. Professor Sunil Gupta shows a quantifiable link between spending and returns and argues that marketing will become even more important as markets mature and competition intensifies.
When I started my MBA program at the Indian Institute of Management, having just earned an undergraduate degree in engineering, I had no idea what marketing was. Clearly, neither had I any intention of pursuing a career in this field. But all that changed after I took a marketing course with Professor Labdhi Bhandari, PhD ’76, who happened to be a graduate of Columbia Business School. Marketing, I realized, is paramount — arguably more important than any business function other than innovation. Peter Drucker, one of the most influential management gurus, said, “Innovation and marketing are the only two valuable activities of a firm. The rest are costs.”
Every year companies spend billions of dollars on marketing. In 2003, General Motors spent more than $3 billion on advertising alone. Total advertising spending in the United States reached almost $146 billion during that year. And worldwide, advertising expenditures exceeded $400 billion — more than the GDP of Thailand, Hong Kong and New Zealand combined. Yet the value of marketing has been seriously questioned by many firms. What, they ask, does millions or even billions of dollars really buy?
Big Gains, Bigger Costs
As markets mature and competition intensifies, marketing has become more critical even in such industries as high tech and pharmaceuticals, which historically have been dominated by R&D. Take the case of Lipitor, Pfizer’s blockbuster drug for reducing cholesterol, one of a group of drugs known as statins. It was launched almost 10 years after the first statin, Mevacor, was introduced by Merck. At the time of Lipitor’s launch, four drugs were available in the market. Zocor, also from Merck, was the undisputed leader, with worldwide sales of almost $2 billion.
Not only did Lipitor miss the first-mover advantage and consequently face major competitors, but its clinical trials showed only slight superiority over other statins. Surely Lipitor had no chance of succeeding. Yet, with an astute marketing strategy and its highly skilled sales force, Pfizer managed to make Lipitor the best-selling drug in the entire pharmaceutical industry. It currently has annual sales of about $10 billion.
Despite success stories like Lipitor, marketing has been subject to increasing skepticism by business school students. MBA students find marketing soft and fuzzy. Their sentiments are doubly felt by many company executives who have difficulty showing returns on marketing spending. It is easy for marketing executives to ask for millions of dollars for advertising or improving customer satisfaction, but it is much harder to show how this investment affects the firm’s profits or shareholder value.
Consider the case of Hoover, a company so well known for its vacuum cleaners that in the British vernacular, you Hoover your dining room carpet. In the early 1990s, the U.K. division of Hoover was evaluating its options for growth. To increase sales, executives decided to offer customers a short-term incentive. In the summer of 1992, Hoover offered a sales promotion: anyone who bought £100 worth of products would be entitled to two free airline tickets to travel from the United Kingdom to Europe. Company executives were so encouraged by consumer response and sales growth that they decided to sweeten the deal in December. Consumers who spent £250 on Hoover products would get free air travel to the United States.
The response was phenomenal. More than 200,000 customers applied for the promotion within a few months. While sales skyrocketed and customer growth was unprecedented, the impact on Hoover’s profits was disastrous. The company took a charge of £48.8 million against its earnings, and many senior executives were fired.
Eyeballs, Stickiness and Other Measures
This case may be an extreme example, but Hoover is not the only company that has relied heavily on sales promotions. Since the 1980s companies have spent an increasingly large portion of their budget on short-term discounts for the obvious reason that the impact on sales is immediate. But an equally obvious question — whether these promotions are truly beneficial to the company — follows. In 1988, I developed a model to find out how much of the sales increase resulting from short-term discounts is truly incremental and how much is borrowed from the future. In other words, if Coca-Cola offers a promotion, some consumers may switch from competitive brands but others, die-hard Coke fans, may simply stock up their favorite brand.
Even if a promotion generates a substantial incremental volume in the short run, the long run can tell a very different story. Using an eight-year-long data series from a consumer packaged-goods company, we found that the long-run effects of promotions on sales are negative: they amount to about two-fifths of the magnitude of the positive short-term effects. The models we developed could be used for optimal allocation of resources between advertising and temporary price discounts.
While consumer-goods companies were becoming more sophisticated over the years, and many even adopted this kind of analytical thinking, another phenomenon happened during the late 1990s, the Internet boom. As the dot-coms flourished, financial analysts found it difficult to use traditional models to value these firms. For example, it is hard to use the discounted cash flow approach for valuing a firm that has negative cash flows or to talk about a firm’s P/E ratio when it has no E.
This led many analysts and academics in finance and accounting to focus on the number of customers, customers’ “stickiness” on the Web and other nonfinancial measures. But when many high-flying Internet companies were driven into the ground, the financial community blamed the Internet bubble itself on the use and popularization of such nonfinancial measures as “eyeballs” and “page views.” Finance had been doing just fine, they thought, until marketing influenced it and caused problems.
Today the business world is increasingly facing another reality that echoes the phenomenon that developed during the bubble years. Intangible assets increasingly form a very large part of any company’s market value. Some recent studies show that for every dollar of asset value indicated on the balance sheet of a company, three to four dollars in intangible assets are typically not reported. This led the Securities and Exchange Commission to appoint a task force to encourage companies to measure and report these intangible assets. Two of the intangibles highlighted by the task force are brands and customers.
From the Four Ps to the Big P
Are customers truly the critical intangible asset of a firm as suggested by the SEC, or is the focus on customer-based metrics misguided? After all, in many people’s view, this customer focus led to the Internet bubble. In the last several years, my research has shifted from understanding the impact of the four Ps (product, price, promotion and place) to measuring and managing customers as assets.
Customer management requires an assessment of each customer’s lifetime value, which is the present value of all current and future profits generated from a customer over the life of his or her business with a firm. This concept has been used for many years in database marketing for tactical marketing decisions, such as how much money to spend on acquiring a customer.
If customers are the key generators of revenue and profit — the big P — then the cumulative value of all current and future customers should be a strong proxy for the firm’s market value. In a recent research paper, my colleagues and I showed this link. Not only does this finding provide an approach to valuing firms with high growth potential and limited or negative current income, it also shows what drives customer and firm value. We found that, on average, a 1 percent change in customer retention improves customer and firm value by almost 5 percent. In contrast, a 1 percent improvement in a company’s cost of capital improves its value by only 0.9 percent.
This finding not only makes the impact of marketing more quantifiable but also highlights marketing’s critical role in improving a firm’s market value. Along with my research colleague, I have put many of these ideas into a forthcoming book. We have also modified Columbia Business School’s core marketing course to reflect many of these ideas. Our marketing course now highlights our finding that marketing does matter — because it creates value not only for a firm’s customers but for shareholders and the firm itself.
Sunil Gupta is the Meyer Feldberg Professor of Business, with expertise in marketing strategy, pricing and customer management. He is frequently consulted for commentary by the business press, and his research has won numerous awards, most notably the Journal of Marketing Research’s O’Dell Award in 1993 and 2002. In 1999, he was selected as the best core course teacher at the School. His new book, Managing Customers as Assets, will be published by Wharton Publishing/Financial Times in 2005.