Excerpt

## Index

Index of abbreviations

Table of figures

1. Introduction

2. Customers as an asset?

3. The value of a single customer: the customer lifetime value

**3.1 Definitions and boundaries**

**3.2 Components of customer value**

4. The value of all customers: the customer equity

**4.1 Definitions and boundaries**

**4.2 Measurement**

5. Link between customer equity and profitability

6. A case study on customer based valuation: Netflix

Conclusion

Appendix

References

## Index of abbreviations

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## Table of figures

Table 1: Customer value models

Table 2: Customer equity models

Table 3: Customer based valuation of Netflix

## 1. Introduction

This seminar paper gives an overview on the literature of measuring customer value. A lot of companies have a very low book to market value e.g. Apple (0.15), Microsoft (0.14), Amazon (0.04!) and Facebook (0.14) as of December 2017. Though according to US-GAAP and IFRS annual reports should provide investors and prospect investors with decision useful information the balance sheet lacks certain intangible assets that are obviously driving the value of the firm (Baruch Lev, p. 299). That are for example brand equity (Aaker, 1996), organizational capital (Lev, Radhakrishnan, & Zhang Weining, 2009) and customer equity (Bonacchi, Kolev, & Lev, 2015). Such assets became more important so that not only for researchers but also for practitioners and standard setters there is an incentive to identify possibilities to measure such assets reliably to make better investment decisions or, for the latter, to increase the decision usefulness of the information provided in the annual reports.

There is an increasing number of SBE (subscription based enterprises) or at least SB offerings which leads to an increasing number of balance sheets that do not sufficiently reflect the value of the firm. For a long time the value of customers was just a marketing issue and not in the focus of accounting researchers but due to the development described above it is getting into focus of accounting literature in the past decades (Gleaves, Burton, Kitshoff, Bates, & Whittington, 2008, pp. 827–832). There are several approaches to value customers, but they have in common that first the value of a single customer is derived the so called CLV (customer lifetime value), sometimes also referred to as CV (customer value). To value the customer base of a firm all CLVs are aggregate to derive the so-called CE (customer equity). The value a customer has for a firm is the sum of all discounted future contribution margins the firm can obtain from him (Berger & Nasr, 1998, pp. 18–19). Therefore, I first look at the eligibility of customer value as an asset. Afterwards I compare different approaches to derive the CLV then the approaches to derive the CE. Next, I analyze the literature concerning the link between performance and customer and show a possible calculation on the example of Netflix.

## 2. Customers as an asset?

First, I determine if customers can be an asset at all. The IASB defines an asset as follows:

“An Asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity” (IASB Framework).

I admit that it is debatable if customers are controlled by an entity but there has been a past event, the acquisition, which led to probable future economic benefits, the future revenues the entity will receive from this customer. If the customer would not lead to future economic benefits the entity would not have acquired him.

Due to its nature of no physical substance and because it is non-monetary it would classify as an intangible asset (IAS 38). But according to accountants the absence of property rights and markets disqualify them to be recognized on corporate balance sheets as such (Baruch Lev, p. 301). They maybe are inappropriate for disclosure purposes but if they as expected have a positive effect on the performance of the firm as a performance driver, due to increase of future revenue, to value them holds important insights for various valuation purposes.

Because there is no active market and it is not guaranteed that the costs to acquire a customer really pay off market value and cost-based valuations are not possible.

The best way to measure an asset is to get the future benefit the firm will derive from it. In other words, the net cash flows. To derive future cash flows from a single customer is already a widely established practice in the marketing field and expressed in the customer life time value.

## 3. The value of a single customer: the customer lifetime value

### 3.1 Definitions and boundaries

There is no clear definition of CLV and some researchers use customer lifetime value, customer equity and customer profitability interchangeable. Due to the complexity and many possible variables that can play a rule there are a lot of different approaches to calculate the CLV (Gleaves *et al.*, 2008, pp. 827–828). For this seminar paper I define CLV as the single economic value of a customer and the CE (sometimes also referred to as customer asset) as the aggregated CLV of all customers as e.g. suggested by Blattberg and Deighton (1996, pp. 136–137). Customer-based valuation is the use of customer value/ customer equity for valuation purposes (Schulze, Skiera, & Wiesel, 2012, p. 17). According to Jain and Singh (2002, p. 36) there are three mainstreams in research regarding the CLV the first are *models to calculate the CLV* the second are *analysis of current customers* and their possible future transaction and the third stream is research concerning the *implication for management decisions*. I will focus more on the first two and less on the latter. According to Berger & Nasr (1998, pp. 18-20) the CLV is the *economic valueof a customer* or more precisely the CLV are all discounted cash flows arising through transactions between a company and a customer including promotion cost to retain current customers (retention costs) but excluding acquisition costs. In contrast to that Jain & Singh (2002, p. 38) state that the acquisition costs should be part of the definition of CLV.

Jain and Singh (2002, pp. 38-40) name four possible models to derive the CLV which can come in different variations, I add a fifth and sixth model, the customer referral value model and the hybrid model.

1. Basic structural model of CLV (e.g. Berger & Nasr, 1998; Gupta, 2009):

It determines the CLV as the NPV of the future cash flows from the customers.

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The basic structural model is calculated by substracting the acquisition costs of a customer to the sum of the respectively discounted product of all yearly net cashflows (profit margin) and the customer retention rate. This model comes with certain drawback, so it assumes that there is just a single cash flow per customer which takes place at the end of the respective year, furthermore it ignores past and future customers because it is just taking into account the current customer base. Some of them also ignore acquisition costs (Jain and Singh, 2002, p.38). On the other hand, these models are comparably easy to use. There are many variations of this model in any kind of complexity.

2. Customer migration model ( Dwyer, 1997):

This model adds customer heterogeneity to the basic structural model and is considering the buying process. Customers are divided into two groups, loyal and not loyal ones. For the loyal customers a variation of the first model is used but for the second group a migration model is used where customers decide each season if they do purchase or not. Rust, Lemon, & Zeithaml (2004) developed an algebraic approach of the migration model: .

This is the sum of all discounted contribution margins of customer i for brand j at time t times his expected purchase volume of brand j at occasion t times the probability that customer i buys brand j at time t. For all occasions t = 0 until T.

This model does not assume a single transaction at the end of the year but is discounting concerning the purchase frequency of customer i.

This model has the advantage that it takes into account the buying decision which leads to a more realistic but also a more complex model. Berger & Nasr (pp. 18-19, 1998) suggest a combination of the basic structural model and the migration model.

3. Optimal resource allocation model (Blattberg & Deighton, 1996):

This model finds the optimal balance between expenditures for acquisition and retention. It is therefore calculated by adding the NPV of returns from acquisition spending and the returns from retention spending. CLV is maximized when this NPV is maximized.

The value of a single customer can be calculated by multiplying the acquisition rate with the contribution margin , substracting the acquisition cost and adding the product of acquisition rate , contribution margin minus retention cost divided by retention rate and the discounted retention rate divided by one minus the discounted retention rate. It considers the tradeoff between acquisition cost and retention cost. Therefore, it carries useful information for managers. It is less informative for valuation purposes though.

4. Customer relationship models:

This model by Pfeifer & Carraway (2000) uses Markov chain models to combine all above mentioned models but Jain and Singh criticize the critical assumptions underlying this model and the necessity of the probabilities of transaction which are very hard to compute.

The net present value of a customer can be calculated by multiplying his recency matrix with the inverse of the identitiy matrix substracted by his discounted probability matrix . The problem with this model is that very specific information about every single customer is needed. The advantage of this approach is that due to its flexibility it can handle many different customer relationship situations as shown by Pfeifer & Carraway (2000). Furthermore, it can handle complex customer relationships that cannot be calculated with algebraic approaches.

5. Customer referral value (CRV) model ( V. Kumar *et al.*, 2007):

This model questions the assumption that the most valuable customers are those that generate the most revenue by them own but rather those customers who attract more new customers. The basic idea is to determine the value of a customer by adding the CLV of all customer which would not have been acquired without him to this customer also the saving of acquisition costs is added to his CLV. The so calculated CRV value can differ significantly from the CLV. A firm that has mostly a customer base which is very active in spreading the firms’ product this firms’ customer base could have a higher value than a customer base which is not enthusiastic about the firms’ product at all (V. Kumar, J. Andrew Petersen, Robert P. Leone, 2007, pp. 1–3).

6. Hybrid model (Bauer & Hammerschmidt, 2005):

Bauer & Hammerschmidt (2005) developed a very holistic model for CLV they incorporated the basic structural model and the CRV as well as the optimal resource allocation model. The customer migration model and customer relationship model are not yet fully included. It comes in the structure of a typical NPV model so the starting cash outflow the acquisition costs, then all three revenue types and the referral value are deducted by selling and marketing costs and discounted. Next, the termination value is discounted and deducted from the current CLV.

There are several assumptions underlying this model, e.g. that there is one transaction at the end of the year. Furthermore, its assuming a lost-for-good setting with constant retention rates. Another limitation is that it is not always possibly to reliably forecast cashflows far in the future for very unmatured industries. Despite the number of different models, most marketers stick with the definition of discounted benefits less burdens of a customer (Gleaves *et al.*, 2008, p. 828) so the basic structural model.

### 3.2 Components of customer value

To evaluate the different models it is important to know all necessary components to finally determine how they can be derived for valuation purposes.

Bauer & Hammerschmidt (2005) developed a model which incorporates all other models. They break down the components of all models to three basic components. All models consist of: *retention rate*, *revenue* and *costs*.

The *retention rate* displays the loyalty of a customer, so the probability that the customer who purchased in every previous period will buy the product in the next period again, if he did not buy for one period he is considered a new customer if he buys again. This reflects the “lost-for-good” model. When applying the “always-a-share” model the customer migration models or customer relationship models must be used. They classify four types of *revenue*, three direct types: autonomous revenue, up- selling revenue, cross selling revenue and one indirect type: contribution margins due to referral value. Cross selling is defined as the increase in buying frequency of the same product while up-selling refers to the buying of other products of the same vendor. Both are triggered by customer loyalty which can be increased through marketing activities. On the other hand, the autonomous revenue cannot be increased by marketing and is just determined by customer demand. The revenue of the referral value is revenue which occurred by new customers acquired through current enthusiastic customers. They identified four cost components, three derived from other models and one they developed themselves. That are acquisition cost, marketing cost, sales cost and termination cost. The acquisition costs (AC) are the costs to attract customers. There is actually an ongoing debate if AC should be implemented or not, because they are sunk cost they are not relevant for managerial decisions, but they are relevant future customers and therefore relevant for valuation purposes. (Gupta, 2009, p. 171). Marketing costs are costs to increase customer retention and to build customer loyalty to enhance up- and cross selling. The sales costs are all costs for producing and delivering the product to the customer. The termination costs were developed by Bauer & Hammerschmidt ( 2005, pp. 336-336), they define them as the costs which incur if a company loses a customer permanently.

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Table 1: Customer value models

## 4. The value of all customers: the customer equity

### 4.1 Definitions and boundaries

According to Gupta (2009) the *customer equity is defined as the sum of all current and future customer values*. Bonacchi *et al.* (2015, p. 1027) define the customer equity just as the value of current customers. According to them including the future customer values would be to complex and to uncertain. Bauer & Hammerschmidt (2005, p. 338) criticize that neglecting future customers value in calculating customer equity assumes a terminal value of the customer base of zero because due to the retention rate in the long run all customers would migrate. They therefore state that the CLV of future customers must be considered. It is sometimes also referred to as customer-base value (e.g. Jain & Singh, 2002).

### 4.2 Measurement

For the customer equity I focused on the basic structural model and the hybrid model because the other models are to complex when expending them to all customers and therefore they are not useful for valuation practice (Bauer & Hammerschmidt, 2005, p.345).

1. Basic structural models (Gupta, 2009):

He expanded the basic structural CLV model to a CE model. It is derived by multiplying the number of customers in cohort k times the annual contribution margin provided by a customer at time t discounted with the discount rate i (cost of capital of the firm) minus the number of customers in cohort k times the acquisition cost of cohort k discounted with the discount rate i. This Model has the advantage that it is not assuming periodic cash flows from transactions with customers but continuous transactions. The downside is that is not as easy to use as the other models.

For the customer equity formulas also the approach used by Bonacchi *et al.* (2015) is promising, they omit the future customers to keep the model simple and useable in practice they have the assumption that the net present value of future acquired customers is 0.

They furthermore assume that churn rate and profit margin stay constant.

They multiply the number of current customers times the sum of all discounted future profit margins times the retention rate to the power of the respective period . Since the retention rate is always <1 the future profits from the current customer base will decrease over time because the current customers are migrating.

2. Hybrid model (Bauer & Hammerschmidt, 2005):

They simplified their very holistic CLV model to make it suitable for practicable usage. In this model the customer equity is calculated by discounting the number of

customers acquired in period s times their discounted contribution margin for all future periods. The contribution margin is discounted to the acquisition date which is s for cohort s. Due to the retention rate the future payments from the acquired customers is reducing over time since in some point in time all customers will be migrated. When customers come back they are assumed to be newly acquired customers. One benefit of this model is that it is comparably easy to calculate with publicly available information. It differs from the model of Bonacchi *et al.* (2015) in that was that it also considers the future customers which leads to a more holistic and comprehensive approach but implies more assumptions about future customer growth and other metrics. It therefore underlies a higher uncertainty.

3. Customer referral value:

The customer referral value does not carry additional information if it is extended to the CE since it is the sum of all CLV it is not important if some value is attributed to certain customers or others.

**[...]**

- Quote paper
- Tim Ulbricht (Author), 2018, Measuring the value of strategic resources. A literature overview of customers value, Munich, GRIN Verlag, https://www.grin.com/document/415736

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