Kenton's Interview

March 08, 2007

Cook on Shareholder Value

The week of October 30, 2006 Chris Kenton interviewed me on his web log Marketonomy. The question was how marketing creates shareholder value. What follows is an edited transcript of that interview.

CK: Today we're going to look at some new ways to understand how marketing creates shareholder value. But instead of looking at financial measures of stock performance like, say, price/earnings ratios, we’ll look at a company's performance within a competitive group and at how marketing impacts performance. I’ll begin with this question: Vic, what’s missing from the investor's tool kit in measuring the value of a company on the stock market and how does that relate to marketing?

VC: The answer to this question is pretty simple. What’s missing is the effects of product markets, competitors and people on a company’s stock price. The lion's share of the value creators in the investor's tool kit come from the balance sheet. Product markets interact systematically with stock markets in creating value. But we know surprisingly little about this interaction. Consider this fact. If you searched all the scholarly articles published in economics, business, and finance journals with the words "value" and "revenues" in the same paper how many would you find? Out of thousands of articles only forty use both these words in any combination. And only one refers to the “value/revenue ratio.” What's the point? Product market performance relative to stock market performance is missing from the investor's tool kit because it was missing from the literature they studied in business school. Investor’s also overlook the impact of competitors on stock price. And they have no rules for maximizing the contributions people make to the market value of their company. These are missing from the investor's tool kit.

CK: 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 is intensely focused on competition--in fact, many would argue too much focus on competitors, instead of customers, stifles innovation.

VC: 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 lesser known but important book -- "Cases in Competitive Strategy." Neither do investors. Without the help of a simple model to guide the way it's very difficult to figure out what to do with the data from these two basic financial statements.

CK: Twenty years ago, the difference between a company's value on the balance sheet and 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.

VC: 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 value to revenue (v/r) ratio is a good way to answer this question. Because the combined sales revenues of companies propel the economy and also because there is very little wiggle room in reporting sales revenues to the SEC. 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.

CK: Do you happen to know how the ratio of market value to sales revenue has changed over the years?

VC: Yes, it varied a lot over the years between 1950 and 2005. I just finished a study on the v/r ratio. In the 1950s it was 0.95. In the decade of the 1960s the ratio was 1.29. In the 1970s and 1980s the v/r ratio was less than 1.0 (actually 0.57 and 0.58 respectively). Then in the go-go 1990s it rebounded to 1.28. In the first five years on this century it was 1.32. Over the entire fifty-five year period the value/revenue ratio stood at just over one (1.10). In relative terms, the pie is 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 market cap.

CK: Along that same line it seems to me that there's a dark hole that needs to have a light shined in it: SG&A expenses in the income statement. 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 Selling, General and Administrative expenditures.

VC: Those selling, general and administrative expenses will soon become the brightest light in the income statement. Because in manufacturing organizations, SG&A expenses account for the costs of most of the people who create a company's intangible market value.

CK: So, if I understand this correctly 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 creating the value of those companies. As a kind of analogy, would that be similar to saying that a company today could drive the same revenue relative to market value, but have vastly fewer tangible assets? Instead of creating value primarily with machinery, equipment and inventories, more 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.

VC: 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. When a company maximizes the return on these expenses, its rewarded by investors with a higher market cap relative to competitors.

Editorial note: I want to thank Chris for asking these questions, because I would never have thought to ask them myslef. And also for teaching me the art of blogging!