Corporate Finance 101 for marketers
The valuation process is fundamental to learning the new language of marketing.
A colleague in the South African branding community once criticised me in print. It was at the time when accountants were starting to understand the value of intangibles but were reluctant to admit that brands exist in peoples’ memories. That, to my critic, was a soft issue and was one that would have me laughed out of boardrooms, with derision.
I have often thought of that comment, especially now that I spend a great deal of my time with financial people who happily acknowledge that the revenue they push through their income statements owes its origin to groups of people who are willing to pay money for their brands. You only have to mention the sad demise of Andersen – the late Big Six accounting firm, which vanished without trace after the rapid destruction of its reputation – for even doubters to understand this reality. Customers (or clients, consumers, patients) invest their money in brands because they think the brand will work for them – they trust it.
I now realise that it is not the issue that is soft. It is the language we use to describe the issue. There is not a chief executive or financial director these days who will deny the vital importance of establishing and strengthening the bond between the brand and its users. The problem arises in the language used by marketing people to communicate the value of those relationships at management forums.
I find myself listening most evenings to Alec Hogg’s Classic Business. I am normally home by then, a glass of chilled white wine within easy reach, summing up the day’s efforts and planning the next. I am always struck by the financial fluency of the people Alec and his team interview. They seem to have an immediate grip on all sorts of numbers, ratios, covers, net present values and yields. They all understand each other and, going forward (!), communicate with what appears to be consummate ease.
There is a lot of jargon and talking in code, but this is the language of investment, of capital markets and of the boardroom. When the board meets, the agenda has numerous items, but the one that really counts is the one titled finance. That is when the managers learn if they are the shareholders’ heroes or villains. When decisions are taken, or are considered, regarding additional expenditure on new machinery, a building or an increase in the marketing budget, it is these numbers that are used to evaluate the viability of the expenditure. People’s jobs are dictated by those numbers, as are their bonuses and increases.
So when the marketing manager enters the room (he will usually only be there by invitation because only in about one in four cases is there a marketing person on the board of an SA listed company 1), he is listened to with restrained impatience as he motivates his budget increase with phrases such as:
• “A strong icon should be able to contemporise through time without losing its core message or personality.”
• “Once we have distilled the brand essence we are able to construct the architecture that will support segmental variations in consumer relations linkages.”
This is what is soft. Not the thinking behind it. It is the way marketing people try to communicate the complex ideas about the sensitive work they do in creating bonds between brands and their users. This is the language used to motivate an increase in marketing investment. I have frequently been told that if we could only prepare analyses and schedules that support a request for a budget increase in the same way the factory manager motivates money for a new piece of machinery; we would have a smoother ride.
But we persist in trying to communicate in “soft” terms that confuse more than explain, and which marginalises marketing rather than raising the standing of its practitioners to where they belong, which is at the very front line of income generation. The gatekeepers of the shareholders’ purse strings want to hear how the new branding programme will affect the bottom line and what return it will achieve rather than be told about the consumer psychology behind the campaign. And they want to hear it stated in financial terms not the obtuse coded vernacular of the world of branding.
So here is a crash course in what should be the new boardroom language of branding.
1. We start by recognising that a brand is an asset. Not in the casual way the word is used in marketing journalism, but in the real accounting sense. An asset is a resource, controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. Quite clearly that is what a brand is. The definition implies that the enterprise has legal title to the trademark. It either invented or built the brand or it bought it and continues to develop it. Whichever is the case the company stands to benefit financially from the income stream the brand will generate far into the future.
2. The value of an asset is usually determined by the capitalised present value of the discounted flow of future earnings that it will generate. That is its present value or PV. If you subtract the investment needed to generate these future cash flows from the PV you now have Net Present Value or NPV. To arrive at the PV you work out a suitable discount rate which takes account of the risk inherent in the investment. The future stream of income is discounted by this rate to present value. That simply means that for each year into the future you are working, the present value of each year’s projection must be discounted because it is worth less than it was in the previous year. So if a group of consumers is willing to pay, collectively, R30 million this year to buy your brand and you can anticipate that they will spend the same next year and the year after, the time value of this projected stream of revenue can be calculated using the Discounted Cash Flow (DCF) formula.
Here is an example. Say a brand generates income of R60 million this year. It is expected that the brand asset will continue to generate revenue at this level for the foreseeable future at a growth rate linked to the market and inflation. To sustain this the marketing budget has historically been set at a ratio of 15% of turnover, or R9 million in the current year. The marketing people believe that, due to an improvement in the product and a favourable competitive environment the brand could achieve a significant increase in market share. To achieve this they have asked for an additional R4, 2 million in the current year, R2,5 million in the second year sustained at this increased level into the future. The sums look favourable, but is the investment the firm is asked to make truly worthwhile?
A bright spark financial analyst in the firm produces the table above and to the great dismay of the marketing people, their plan is rejected. What is worse they do not understand why it has been shot down because the reason is couched in the language of finance. The investment would produce a negative NPV, or an unfavourable return on the requested marketing investment.
The financial wizard has simply applied the tools of finance. First he valued the brand at R96, 6 million using a DCF approach. Remember, an asset will generate future economic benefits for the owner of the brand. Importantly he did not just use a standard rate of interest for this calculation. He used a discount rate of interest that was based on the return the firm could have earned on this investment, without risk (had they invested in, for example, a government bond such as the RSA 150). To this he added a risk premium. He did this to take account of the level of uncertainty inherent in a marketing investment. There can be no guarantee that the plan will work. We do not know how the competition will react. There is risk in this investment.
Given the increase projected by marketing he calculated a new value for the brand of R111, 1 million. This is an increase in brand value of R14, 5 million. Very healthy. But there is a cost to achieving this increase. If this too is projected into the future and discounted to PV, the firm is being asked to make an investment to achieve this increase which, in today’s money, is R15, 6 million. It is not hard to see that the Net Present Value is negative (14, 5 – 15, 6 = – 1, 1 million). Expressed another way it is a return on marketing investment of only 93% (14, 5/15, 6) , which means the increase falls 7% short of covering the investment. The marketing people are sent away to think again. Given the same circumstances the factory manager will look for a better deal for the machine he wants or he will find an alternative solution.
3. When they return they have re-worked the IMC campaign and now need R2, 4 extra in the first year and R1, 8 thereafter. Not surprisingly this produces better results (14, 5 – 11,1 = 3, 4 million) or a return of 131% (14, 5/11,1). A positive NPV is good business. The board approves the plan.
What has happened here is not a new approach to marketing. The brand people have simply changed their language. Instead of confusing the board with technical marketing patois, they have changed the means of communication. Of course the targets have to be met and the marketers will be measured on the quality of their judgement and skills.
The way brands are valued in the 21st century allow for this type of analysis. Modern methodologies merge survey based data with financial analysis.
Typically this is how it is done:
1. The financial statements that support the brand are examined. From the income statement the brand Net Operating Profit after Tax (NOPAT) is extracted. The balance sheet is examined to find out what capital employed is needed to generate this income. This will normally comprise fixed assets, inventory and the net of accounts payable and receivable.
2. A cost of capital is estimated. A specialist usually calculates this because it requires certain inputs that are only found on complex databases. Companies in South Africa such as McGreggor BFA are often used for this purpose. The cost of capital is applied to the capital employed and the result of this is subtracted from the NOPAT. What remains are what the corporate finance people call “super” profits, or profits over and above the cost of capital.
3. Brand valuers then apply a device that separates from this number the portion of profit that can be directly attributable to the brand. This is called Brand Premium Profit (BPP)
4. The BPP is projected into the future using management forecasts and assumptions about growth in the country’s economy. The growth is constrained by the survey-based data which has been converted into a single metric. The stronger the research shows the relationship between the brand and its user group to be, the more years there are in the model, and vice-verse.
5. The projected profits are discounted to Present Value using the cost of capital as the discount rate and the capitalised total is the brand value.
From this it should be clear that the valuation process is fundamental to learning the new language of marketing. The brand is treated as an asset. Its future economic benefits are related to the relationship between it and its users (or brand equity) and the measurement of its strengths and weaknesses are measured in financial terms. This is the major tool the modern marketing person will use to communicate the mysteries of branding to the disinterested members of the board who hold the purse strings.
Dr. Roger Sinclair is Visiting Professor of Marketing at Wits University and managing director of brand valuation company, BrandMetrics (Pty) Ltd.