Open Letter to Wall Street: Start Thinking About Long-Term Value

by Don Peppers, Martha Rogers, Ph.D.

Why is it that public firms feel so whipsawed by Wall Street? Are companies really penalized for taking a long-term perspective if it means sacrificing short-term profits? Most public company CEOs certainly think so.

An obsession with current earnings at many firms has created a culture of bad management. Executive scandals and questionable accounting are only the most noteworthy symptoms. Far more insidious is the corrosive effect this obsession has on management decision making. Focusing on the short term to the exclusion of other concerns allows managers to shirk their primary responsibility altogether – which is to preserve and increase the value of the enterprise.

Think about it: Almost any senior manager at any public company has had the experience of attending a meeting called for the express purpose of meeting year-end numbers, or even quarter-end numbers, that weren’t otherwise going to come in as planned. Perhaps at this meeting the executives decided to put off some valuable R&D work, or maybe trim a costly but important service improvement somewhere. Chances are, all the meeting attendees knew full well that taking these actions did more actual harm to the company than good, but they went ahead anyway – because they weren’t being held accountable for creating enterprise value; they were being held accountable for short-term results.

Google’s recent IPO illustrates nicely how familiar this problem is to everyone in business. By designating Series B shares for themselves that have 10 times the voting power of the shares being sold to the public, founders Larry Page and Sergey Brin served notice that they won’t allow their firm to be held hostage to the short-term whims and demands of the financial community. Their explicitly stated purpose is to have the freedom to continue to focus on the long-term health and growth of the Google enterprise. (This must be their real reason, because it was in their public filing!) They even said they won’t be giving guidance to Wall Street, either, in the way that virtually all other public companies do.

Their goal is admirable, and it undoubtedly rings true to many of the public company managers who, as retail investors, might be considering whether to entrust part of their own savings to Google’s management team. What shareholders must do to achieve this long-term focus, however, is surrender. Completely. Google’s proposed capital structure literally means that it will never be possible for a fed-up Series A shareholder population to get rid of Page or Brin, or whatever tax-free foundations or errant great-grandchildren inherit their stock, no matter how incompetent or unresponsive Google’s management becomes. No, the Series B owners at Google will definitely never have to worry about the short term. But in the long term, it’s possible that Series A shareholders might have reason to worry.

Teaching long term to short-term watchers
It is obvious to everyone that today’s publicly owned businesses have a problem when it comes to reconciling Wall Street’s demand for short-term results with their ultimate task, as managers, of achieving long-term value. In recent issues of more than one business magazine, the most admired and successful companies listed tend to be the privately held firms, not publicly traded, and therefore not subject to Wall Street’s short-term demands. Surely this is a message. Surely this has some significance. Is there anything that financial analysts could do to address this problem? Well, yes, actually. And that’s why we’re addressing this open letter to the analyst community.

The basic problem is that even though shareholders are, in fact, quite interested in the long-term value a company creates for them, at present there is no better, more reliable indicator of long-term value creation than short-term financial performance. The discounted-cash-flow (DCF) method for valuing a business is based on forecasting the firm’s future cash flows, but in the end even the most sophisticated predictions rely mostly on aggregate business trends and market projections, and all future trends begin with today’s events.

On the other hand, all the operating cash flow at any business comes originally from customers. If you add up the lifetime values of all current and future customers, the customer equity you calculate should exactly equal the enterprise’s overall discounted cash flow.

Moreover, when analyzed this way, the firm’s future cash flows can be divided not just into operating entities and business units, but also into the revenues expected from different types of customers. So customer equity can actually be broken down, analyzed, predicted and validated all the way down to the molecular level of the individual customer.

For a business, customers are the scarce resource. They are scarcer than capital. If you have a customer for your business, you can almost certainly obtain the capital needed to serve him. But the market – any market – contains only a finite number of customers, who are difficult to obtain and expensive to replace.

So it is vital for any business to create the most value possible from its customers. Return on Customers (ROC) is a metric designed to gauge the rate at which a business does, in fact, create enterprise value from any customer or group of customers.

Quantifying customer value
If an investment bank were trying to calculate the overall rate at which a business created shareholder value, it would calculate the cash flow thrown off during the year, and then it would add its estimate of any change in the DCF value of the firm during the year. The result is identical to Return on Customer, which is equal to the sum of a firm’s current-period profit from its customers, plus any changes in customer equity, divided by the total customer equity at the beginning of the period:

Rewrite this equation substituting "DCF" for "CE" and it will be obvious that total shareholder return is equal to Return on Customer. Both measure the rate at which an enterprise creates value.

Return on Customer, in other words, is not some wacky new economic principle being advocated as a kind of marketing hype. It is simply a new and different method by which to calculate total shareholder return. ROC can also play an important role in resolving the short-term/long-term dilemma that faces most managers today. It works like this: If you have to use up customer equity to make today’s figures, today’s figures don’t look so good after all.

Return on Customer is a "bottom-up" rather than a "top-down" calculation, and it allows management to incorporate detailed customer insights into an analysis. But in addition to being a more accurate measure of value creation, ROC is also prescriptive, which is important because business managers don’t need to know what enterprise value is as much as they need to know how to create it. How can management have the most positive effect on a firm’s future cash flows – not just this quarter, but over the course of the next decade – and be held accountable for that today? Unlike total shareholder return, ROC can be analyzed at a detailed, customer-specific level, and for that reason it actually provides prescriptive help for a management team trying to make decisions that will optimize the balance between long-term value and short-term profit.

Which is more valuable to your investing clients, the telecom company that cuts its prices dramatically to try to hold on to the customer contracts it has, or the one that produces more satisfied customers who tend to buy more and remain loyal naturally? Which company creates more value from each customer?

So the point of this open letter is as follows: In the not too distant future, when you analysts meet with the companies you follow, we urge you to ask for more than a review of their quarterly results and financial prospects. You should ask to see their Return on Customer. Not only will doing this corroborate and sharpen your own analysis, but it will also directly help the companies themselves, improving their financial stability, their economic performance, and even their management culture.