Brands as Catalysts: Enhancing Business Value

Many marketers like to refer to brands as assets in the hopes of positioning marketing as an investment rather than a cost. However, this approach often does not sway the CEO, CFO, or chief accountant.

Let's begin with the second point. According to accounting rules, an asset is defined as "a resource owned or controlled by the business." Brand equity does not qualify as it is not legally enforceable property, only the trademark is.

Likewise, the CFO looks for an asset to generate earnings. They note that customers purchase branded products and services, but not the brands themselves.

To create value, a brand needs to have a strong service offering and a well-functioning business model.

The CEO focuses on the overall performance of the business, especially looking at how successful it is in the market in terms of revenue and profit, as well as in the operations section of the cash flow statement. While assets are listed on the balance sheet, they are often not highlighted in earnings calls.

It is better to think of brands as multipliers rather than assets.

Tim Ambler, the former CMO of the company that came before Diageo and a senior fellow at London Business School, once said that marketing is about generating cash flow. The CEO and CFO are focused on ways to speed up and increase the company's conversion of invested capital into cash flow.

Innovation is a crucial topic discussed on earnings calls because it has a significant impact on both current and future earnings. For instance, the use of AI is often mentioned as a way to save costs, influencing present earnings. Similarly, the introduction of GLP1 drugs like Ozempic can affect the demand for snacks and processed foods in the future, potentially impacting the cash flows of companies like Kellogg and Kraft Heinz.

When it comes to marketing, brands should be seen as accelerants rather than just assets. Brands play a vital role in increasing and sustaining cash flow by attracting more customers to make more frequent purchases at higher prices. Essentially, brands have the power to enhance the value of the underlying business model.

Twenty years ago, I had the opportunity to merge two sets of data to study how brand strength impacts operational performance.

At BrandEconomics, where I served as senior vice president, we brought together Young & Rubicam, a renowned advertising agency known for developing the BAV method to assess brand health, and Stern Stewart, a financial advisory firm famous for creating the EVA method to evaluate financial performance.

We analyzed a large number of companies by combining their BAV and EVA data to determine how much a business's value depends on its operational efficiency and customer loyalty.

The findings from this complex analysis are presented in a straightforward two by two grid, illustrating the effects of enhancing operational efficiency versus building a strong customer base.

In the bottom left quadrant, you'll find the companies that didn't do so well in terms of both dimensions. We set their value to sales ratio at 1.0 to see how their value changed when compared to companies in the other quadrants.

We found that companies who prioritized enhancing their operational efficiency saw their value almost double (their value to sales ratio increased to 1.9).

On the other hand, companies that focused on building their customer loyalty without improving their operational efficiency only experienced a 20% increase in value (their value to sales ratio rose to 1.2).

Businesses that were able to enhance their performance in both areas saw a significant increase in their value, nearly tripling it (their value to sales ratio rose to 2.9).

In the 1.2 quadrant are companies that successfully built strong brands but faced challenges in creating a business model that allowed them to capitalize on this brand power.

The 1.2 quadrant is not good news for marketers who believe that having a strong brand automatically leads to a successful business. The stock market values companies that generate cash flow, not those that focus solely on building a strong brand without a sustainable business model to make money from it.

A prime example of this situation is Bed Bath & Beyond. The popular household goods retailer has been a household name in the US for over 50 years and once operated more than 1,500 stores. However, the company filed for bankruptcy last year. Overstock.com, an ecommerce company, acquired the Bed Bath & Beyond brand and decided to rebrand its entire business under that name. Overstock.com's CEO described Bed Bath & Beyond as a beloved brand with an outdated business model.

Finance is concerned with the performance of the entire business system, rather than the value of individual assets.

In order to create value, it is important for a brand to be associated with a quality service offering and a streamlined business model.

A good service offering and an efficient business model can create value on its own. In the 1.9 quadrant, there are companies without well-known names that excel in the technical and operational aspects of their business.

For example, NVR, a company in home building and mortgages, has seen its shares increase by over 5,000% in the last two decades. Another example is IDEXX Laboratories, specializing in veterinary products. These companies are rewarded by the market with high value-to-sales multiples due to their ability to generate cash flow.

In the 2.9 quadrant, you'll find companies that excelled in both operations and building their brand, like Apple and Microsoft.

The most crucial takeaway from this research, which has influenced my thoughts ever since, is that brands enhance the value of the business they represent.

Observing how brand strength impacts company value is crucial. A company with a weak operating model sees a 20% increase in value when brand strength improves, moving from the 1.0 quadrant to the 1.2 quadrant. On the other hand, a well-run company experiences a 50% increase in value, moving from the 1.9 quadrant to the 2.9 quadrant. Strong brands hold more value for companies with solid operating models.

Having worked in the industry for several years, I have developed a skeptical view towards brand valuation practices. Brand valuation treats the brand as a separate asset with its own earnings stream, aligning with accounting principles but falling short in the realm of finance.

Finance focuses on the performance of the entire business system, rather than the value of individual assets.

A common method used to determine the value of a business is the Gordon Constant Growth model. This model calculates the value of the business by dividing its profit by its cost of capital minus its growth rate.

This model shows that there are only three ways to create value for a business - by increasing profit margins, increasing growth rates, or reducing the risk of future profits not being realized.

CMOs can have more effective discussions with their CFO by framing marketing activities and budget requests in terms of enhancing the business's growth, profit margins, and cash flow instead of focusing solely on increasing brand value. In simpler terms, it's better to talk about the brand as a multiplier rather than just an asset.

Jonathan Knowles leads Type 2 Consulting, a company that focuses on creating market strategies for businesses in the 1.9 quadrant. He is also the writer of the "The Strategy of Change" series featured in the MIT Sloan Management Review.

Editor's P/S:

The article presents a compelling argument that brands should be viewed as multipliers rather than assets. While accounting rules may not classify brand equity as an asset, it plays a crucial role in enhancing the value of a business by attracting more customers, increasing purchase frequency, and commanding higher prices. By understanding the impact of brand strength on operational efficiency and customer loyalty, marketers can better position marketing as an investment that drives cash flow and ultimately creates value for the business.

The research discussed in the article highlights the importance of both brand building and operational excellence. Companies that focus solely on brand building without addressing underlying business issues may struggle to capitalize on their brand power, while those that excel in operations may be undervalued due to a lack of brand recognition. The key is to strike a balance between these two aspects, creating a strong brand that is backed by a well-functioning business model. This approach not only drives financial performance but also enhances the long-term sustainability of the business.