Jobs To Be Done: Business Raison d’Etre

Addressing the jobs that need to be done is true raison d’être for every business, product or service. Knowing what’s the job to be done implies truly understanding the customer and their needs or desires.

In the Strategic Blueprint for Business World Domination I outlined three fundamental questions for each business that wants to achieve sustainable growth. In this post we expand on the first question: the opportunity question.

jobs to be done

Jobs To Be Done

While academics and business leaders have discussed the topic of business fundamentals for decades and likely centuries, I have not come across any theory as simple yet complete as Clayton Christensen’s Jobs to be done.

The Jobs theory links the customer and product by the underlying action, the job that needs to get done. A job usually includes a functional aspect but can also be emotional of nature. The customer who needs to get a job done goes on the market to “hire” a product or service that gets the job done. On the market there are usually a plethora of products or services that get the job done. What gets “hired” to do the job will depend on the customer preference in terms of price, quality, reliability, convenience, or any other factor.

Just like with any other job, your product or service can get “fired” from the job if the performance does not meet the customer’s standard or expectation. Your product or service can get fired after the first-time use or after years of use, if a competitor develops a better offer.

Example 1: McDonald’s Breakfast Milkshakes

mcdonalds breakfast milkshake

One of the most famous examples to demonstrate the thought process behind the jobs to be done is Clayton Christensen’s McDonald’s Milkshakes story.

The case sounds simple: how can McDonald’s improve their breakfast milkshake to increase sales and profit?

This should be particularly straight-forward considering McDonald’s is one of the most successful marketing companies in America. They have all the groundwork done. For each product on their menu, they compiled a detailed profile of the target customer and their likely purchasing behavior. Based on the work of the marketing department, the research and development could then enhance the product on all dimensions of performance of the product. Alas, there was no improvement in sales or profits.

Clayton and team then tried another approach. They camped out at one of the restaurants and made meticulous notes whenever someone bought a milkshake. It turned out that about half the milkshakes were sold before 8.30AM, that it was the only thing the customer bought, that they were always alone, and always got in the car and drove off with it.

So, that begs the question: what job are they hiring this milkshake to do that early in the morning?

The job to done was very simple. All customers have a long commute ahead of them and they needed something to do whilst driving so they wouldn’t fall asleep. Furthermore, they knew that they’d be hungry at 10:30AM if they didn’t eat something before. The milkshake offers exactly the features that get the job done. First, due to the drink’s high viscosity it takes quite some time to empty the cup. And second, thanks to its ingredients you weren’t hungry until lunch time.

Are there no competing products for this job? Sure!

  • Banana: gone in 2 minutes and what to do with the peel?
  • Donuts: crumb all over your clothes and makes your fingers gooey
  • Bagels: too dry without condiments, too dangerous to put on the cheese cream while driving
  • Coffee: it can easily spill if you drive over a bump in the road

While all the products listed above are genuine substitutes or even competitors of the breakfast milkshake, none quite meet the needs of the customers on the product attributes or performance dimensions they care about.

Example 2: Google Ads

google ads

In the age of the world wide web, small domestic businesses sell to customers around the world in a global marketplace dominated by multi-national corporations. An important job to get done for any business, small or large, is to attract new customers. While large corporations usually have the advantage of deep pockets and strong brand recognition, small businesses are limited and must carefully deploy its communications to the right target customer.

The job to get done is to help small businesses reach the right customer within their advertising budgets. The job requirements include:

  • Clear and transparent link between advertisement spent and resulting sales increase
  • Highest probability of reaching the target customer so that no dollar is spent on customers that are not interested in the product
  • Total advertising cost that is bearable for a small business

Traditional advertising channels include direct mail, broadcast television, magazines, newspapers, radio, and billboards. To use any of these channels you need to hire an advertising agency that helps you publish your communications in the relevant media. The advertisement agencies are usually expensive to work with, implying a large up-front cost. Furthermore, this up-front cost does not include the ad placement cost. Furthermore, the channels have very limited advertisement space available meaning there’s competition will drive up the cost for the placement. In other words, this service is not viable for “hiring” to get the job done.

On the other hand, Google Ads offers exactly the features a small business requires to reach potential new customers around the world. Not only are you able to specify very detailed what type of customer you’re after in which region (down to city level), you can link the marketing campaign to your online web store to measure traffic and resulting sales, and to top it all off you can start from a measly budget of US $5 per day.

Imagine going to an advertising agency thirty years ago and telling them you’re a small American business trying to sell to vegan aspiring athletes in their early twenties from Latin America, and are willing to spend $5 per day. What do you think would’ve been the response?

From Jobs to Business Strategy Formulation

To get a full perspective on all aspects relating to the job to be done, you can ask the following questions:

  • What is the job to be done?
  • Are we able to get that job done?
  • Are others already getting that job done?
  • How are they getting the job done?
  • Can we get the job done better?

Once you understand the job to be done, the relevant and important performance dimensions, and potential competing products and services, you’re ready to take the next step and formulate your business strategy.

For those who would like to learn more about Clayton Christensen and the jobs to be done, I highly recommend watching his talk at Google from 2016.

Clayton Christensen: “Where does Growth come from?” | Talks at Google

Strategic Blueprint for Business World Domination

The strategic blueprint for business world domination is a framework to help you plan your business. Whether you’re running a small business or a multinational corporation, as a business leader it’s your responsibility to figure out how to grow sustainably. There are hundreds or even thousands of books and papers covering the topic of how to approach that challenge and this series of posts are not any different. Over the next couple of weeks and months I aim to cover a big picture strategic blueprint or framework that can help you figure out how to achieve business world domination.

Strategic Blueprint Structure

The strategic blueprint consists of 3 fundamental pillars or questions. The three questions form the essence of deciding what business you’re in, how to get the business going, and how to create a prosperous organization.

  1. What are the opportunities?
  2. How do we make it happen?
  3. How do we ensure good execution?
Blueprint for business world domination

Opportunities

The opportunity question is the first step in starting a business. It challenges you not only to choose an industry, market, or segment, but also clearly define what it is that makes you stand out against existing and potential competitors. The question fundamentally demands you to clearly state or outline what it is you’re trying to get done.

Many entrepreneurs and business leaders tend to skip or fast-forward the process of answering the opportunity question. An entrepreneur might find it more useful to just get started and figure out the details later, while a business leader running a successful company may think they’re merely stating the obvious. In both cases it feels natural to skip straight to the second question and start working to get it done.

However, I urge the reader to spend enough time on the opportunity question. A careful study of the business environment and thoroughly thought out business strategy enables you to focus on the things that matter the most to your business. Improper analysis and planning will come back to haunt you when it’s time to allocate the company’s limited resources.

Relevant blog posts:

  • Jobs To Be Done: Business Raison d’Etre (link)
  • Attributes and Values: Business Strategy Core (link)
  • Business Theory of Disruption Innovation (link)

Resources and Capabilities

The second question primarily deals with allocating the organization’s available resources. Traditionally we think of resources as primarily the people, technology, cash, equipment, and so on. However, it may be useful to expand this to also include the capabilities of the organization and its people.

Traditionally, when a firm expands its business scope beyond its initial product or service, a firm is organized in a single corporate unit and multiple business units. To a varying degree the business units operate independent from each other, but are linked by resources shared by the corporate. However, in today’s fast-changing and sometimes volatile marketplace, the rigidity of a corporate backbone may be too restrictive.

With this in mind, from the perspective of organizational structure I follow the idea of authors Andrew Yeung and Dave Ulrich set out in their book Reinventing the Organization: How Companies Can Deliver Radically Greater Value in Fast-Changing Markets and make a strict distinction between the corporate substrate and the business teams. While the business teams are entirely independent in striving to win in their respective markets employing the available resources, the corporate substrate ensures the teams align. You could say the substrate is the glue that binds everything together. It acts and reacts on inputs from the business teams, provides a rigid structure on the short-term but inevitably changes over the long term.

The key challenge of the resource and capabilities question is to find the right balance between business teams in the marketplace and a corporate substrate that both provides a strong structure and the ability to change over time.

Good Execution

The third and last question deals with the long-term prosperity of the organization. It challenges the business leader to think about the governance processes and leadership needed to help the firm expand the business scope.

Governance processes includes developing and nurturing the right organizational culture, motivate and hold people responsible for their job performance, encourage and support the generation of new ideas as well as foster them, attract and retain talents, the sharing of information with peers and partners, and the collaboration across the entire organization ecosphere.

The leadership challenge boils down to four words: learn, grow, change, and create.

In the coming weeks and months, I hope to provide more context with each of the topics. I will add the links to the relevant blog posts in the sections above.

Investment Decision (5): Sensitivity Analysis

sensitivity analysis

In this post we will cover the topic of sensitivity analysis and uncertainty related to expected return of an investment.

Uncertainty

When evaluating an investment, it’s important to do as much data gathering and analysis as possible. Good analysis will help you have a greater understanding of the associated costs and returns. However, even the most well-prepared analysis must face the uncertainty of the future. No matter how large your spreadsheet is, no one can predict the future with certainty.

Uncertainty means that some of your assumptions regarding costs, reinvestment, expenses, returns, etc. may be over- or under-estimated. No. It is almost certain your assumption will be wrong. But if we’re certain that we’ll be wrong, how can we make a useful evaluation?

With uncertainty or sensitivity analysis we can use statistical models to tell us which of the parameters in our model will have the biggest impact on the investment evaluation. Furthermore, statistical analysis will help us have a better understanding of the variance in outcomes

What-If Scenario

Simply put, sensitivity analysis is nothing more than setting up several “What-if” scenarios, testing those assumptions and see how they impact the outcome of the evaluation. For example:

  • What if the revenue is 15% lower than expected?
  • What is the impact if our margin is 5 base points lower than expected?
  • What happens if we’re only able to raise 60% of the funds we need?

Defining a what if scenario allows you to reconsider your assumptions. It’s likely that you have a gut feeling which of the parameters will influence your evaluation most. But to increase confidence you can run the numbers.

There are many ways to do sensitivity analysis. For small projects, simply running the numbers manually in an excel sheet will work just fine. For larger projects you may want to consider professional software.

Below you can find one example of a basic sensitivity analysis and a more advanced sensitivity analysis.

Sensitivity Analysis Example (Basic)

basic sensitivity analysis

For the basic sensitivity analysis, I use an example of an equity valuation of a Singaporean mobile app. For this project, it was important to make assumptions about all related costs on an annual basis. The result was an equity valuation using the discounted cash flow model.

In my base model, the valuation of the project was approximately SG $35.6M.

To do sensitivity analysis, I described 10 additional scenarios varying one or more of the eight different parameters. I ran the numbers for each scenario and laid them out in a separate excel sheet. As you can see, the equity valuation now ranges between SG -$8.5M and SG $35.6M with an average value of SG $18.8M.

Sensitivity Analysis Example (Advanced)

basic sensitivity analysis

For the advanced sensitivity analysis, I use a share valuation of AMD I made in February 2019. This share valuation is a lot less detailed than the equity valuation for the Singaporean app as I use only three value drivers: growth rate, operating margin and re-investment rate.

  • Growth rate: expected average annual revenue growth for the next 5 years, then converging to inflation rate by year 10.
  • Operating margin: targeted pre-tax operating margin, converging from the current margin to target margin by year 10
  • Sales to capital ratio: the required reinvestment cost to support the revenue growth

The share valuation is based on the current value of the company and number of outstanding shares.

Using Oracle Crystal Ball we create assumptions for each of the three parameters by determining the distribution and its factors. Then we run 1,000 to 20,000 trials. The software will use random values for the three parameters and calculate the share value.

As output, we get an expected distribution of share value as well as the associated statistical information. In addition, Crystal Ball also provides additional information on which of the three parameters impact the valuation most. In this case, operating margin is the dominant parameter.

Investment Decision (4): Return

return on investment

The return on an investment is perhaps the most obvious aspect of the investment decision for corporate finance. However, there’s more to evaluating an investment than just looking at the earnings. In this post we will talk more in detail about how to evaluate an investment in light of its potential returns.

First Things First: Cash flow

Before we get into the process of evaluating returns, we must consider how we are measuring returns. There are various ways of quantifying earnings, but which one makes sense?

We use cash flow to calculate the returns of an investment. Cash flow allows us to both quantify the returns and evaluate the timing of the returns. Furthermore, cash is something we can actually spend as opposed to earnings which are merely available on the books.

Return mantra: time-weighted, incremental, cash flow return

  • Cash flows, because you cannot “spend” earnings
  • Incremental, because you want to evaluate returns related to the investment
  • Time-weighted, because early returns are more convenient than later returns

What Impacts Returns?

The next question to ask is what actually impacts returns. Turns out there are several factors:

  • Revenues may be overestimated
  • Revenues may be delayed
  • Operating costs and capital expenditure may be underestimated
  • Tax rate may increase
  • Interest rates may increase
  • Risk premiums and default spreads may increase
  • There may be unanticipated opportunity costs
  • Synergy within the company may be overestimated

All of the variables above will have an impact on the evaluation of the return of an investment and must be considered before approving a new investment

Estimating Cash flow Returns

The two main drivers of estimating the return are projected revenues and projected expenses.

Estimating operating income

The revenues include all income related to the investment.

The expenses include the capital expenditure required to initiate the project (such as buying land or machines) as well as fixed and variable operating expenses. Also take into account the depreciation, amortization, G&A costs and the taxes to be paid on the operating income as these will directly affect the cash flows.

After-Tax Operating Income = 
+ Revenues
- Operating Expenses
- Depreciation
- Amortization
- G&A expense
- Taxes

From operating income to cash flow to firm

The result of is an estimate of after-tax operating income related to the project. To get the cash flow view of the project we add back the non-cash charges, less the capital expenditures and change in non-cash work capital such as inventory and accounts receivable.

Cash flow to firm = 
+ After-Tax Operating Income
+ Depreciation
+ Amortization
+ Tax benefits received
- Capital Expenditures
- Change in non-cash work capital

From cash flow to incremental cash flow

To calculate the incremental cash flows on the project, we include the pre-project sunk investment, less the tax on depreciation and add back tax on allocated G&A.

Incremental cash flow to firm = 
+ Cash flow to firm
+ Pre-project sunk investment
- Pre-project depreciation * tax rate
+ Non-incremental allocated expense (1 - tax rate)

From incremental to time-weighted cash flow

Now that we have an overview of the incremental cash flows to the firm, it’s time to factor in the time value of the cash flows. As said, we consider the timing of the cash flows because early returns are more convenient than later returns.

Net Present Value (NPV)

To calculate the time-weighted cash flow, we use Net Present Value of the cash flows. The NPV is the sum of the present value of all cash flows on the project including the initial investment.

The cash flows are discounted at the appropriate hurdle rate. Use cost of capital if the cash flows return to the firm, or use cost of equity of the cash flows return to equity investors.

If the Net Present Value is higher than Zero, then the project is acceptable.

Internal Rate of Return (IRR)

The internal rate of return is the discount rate for which the net present value is zero.

If the Internal Rate of Return is higher than the hurdle rate, then the project is acceptable

Salvage Value

If a project or investment is finite and short life, then you can calculate a salvage value. It is the expected proceeds from selling all of the investment in the project at the end of the project life. Typically the salvage value is sum of the book value of fixed assets and the working capital.

Terminal Value

For a project with undetermined or very long life, it is sometimes not reasonable to estimate the present value of all cash flows. It is reasonable to compute a terminal value which constitutes the present value of all cash flows beyond the estimated cash flows.

To calculate the terminal value, it is reasonable to use the inflation rate as growth rate. The terminal value in year n is then:

TV(n) = (Cash Flow in Year n+1) / (cost of capital – growth rate)

Uncertainty and Returns

In the beginning of the post we outlined the various factors that may impact the revenue. At the beginning of a project, we forecast revenues and costs as best as possible. But since we can never be sure about the future, there is always a certain degree of uncertainty. What can we do about it?

A simplistic approach to this problem is to calculate how quickly we earn back our money. Based on the projected cash flows we can determine the timing of investment payback.

Sadly, this method does not help us understand, value and mitigate the uncertainty. What degree of inaccuracy of which assumptions will are NPV and IRR most sensitive to?

With sensitivity analysis and what-if questions we can determine this. As sensitivity analysis can get complicated, we will cover this topic in a different post.

Side Costs and Benefits

Most projects or investments create side costs and benefits to the business that are not directly linked to the project.

The opportunity cost is allocated resources of a firm to a project that could otherwise have been allocated to another project. It represents the loss of opportunity of a project that could not be invested in.

Within the organization, multiple projects could create synergies that are not captured in the traditional capital budgeting analysis.

The returns on a project should incorporate these cost and benefits.


Investment Decision (3): Hurdle Rate and Debt

debt

Debt is not per definition bad as it can help your company finance profitable projects at a lower overall cost to the firm than if you use own equity.

Towards the concluding lines of Investment Decision (1): Hurdle Rate and Risk we already hinted that debt plays an important role in determining the hurdle rate. Even in Investment Decision (2): Hurdle Rate and CAPM, where we discussed how to estimate the cost of equity for a firm, the word debt was brought up in relation to levered and unlevered beta estimates. In this post we dig a little deeper in the topic.

What is Debt?

Debt is a deferred repayment of a sum of money. It is a legal commitment to make fixed payments which have the benefit of being tax deductible. On the flip side, failure to make payments can lead to default or loss of control of the firm.

Debt includes all short-term and long-term interest bearing liabilities such as loans or bonds. Perhaps surprisingly, it should also include any lease obligations as those obligations also match the definition of debt. After all, monthly rent is not only a (1) legal commitment to make (2) fixed payments but also impacts your (3) working capital. Furthermore, (4) failure to make payments may lead to loss of control of the firm.

The cost of servicing debt matters in two major decisions of corporate finance:

  1. Investment Decision: what is the cost of debt?
  2. Finance Decision: what is the optimal and right kind of debt?

In this post we will talk about the impact of debt on the investment decision and we’ll cover the finance decision in a different post.

Estimating the Cost of Debt

The first important note is that the cost of debt must always be calculated in the same currency as the cost of equity!

To estimate the cost of debt, there are several options:

  1. Yield to maturity on a long-term corporate bond as interest rate if the firm has issued bonds and those bonds are traded
  2. Default spread associated with a rating if the firm has a rating determined by an external rating agency
  3. Interest rate on a recent long-term borrowing if the firm has recently taken on a loan.
  4. Try to estimate a synthetic rating for the firm

Actual and Synthetic Ratings

During the financial crisis of 2008 the credit rating agencies received a lot of public attention. Nearly everyone now has heard about Standard & Poor’s and Moody’s. These two organizations are world leader in attributing ratings to all kinds of companies. The exact algorithm of the rating is unknown, so it is challenging to determine the actual rating for an unrated company.

Estimate a Synthetic Rating

However, we can estimate a synthetic rating by calculating the interest coverage ratio. The ratio is very simple. It calculates how many times the interest on a debt can be covered with the earnings of a firm.

Interest Coverage Ratio = (Earnings Before Income and Tax) / (Interest Expenses)

Using a reference table we can then determine a typical default spread for a company with a certain interest coverage ratio.

Interest Coverage Ratios, Ratings and Default Spreads, table by Mr. Aswath Damodaran

From Synthetic Rating to Cost of Debt

To determine the cost of debt from the synthetic rating, we return to the description of hurdle rate. The hurdle rate is the riskfree rate with added risk premium. In the case of a synthetic rate, we can say the cost of debt is then the riskfree rate + default spread associated with the synthetic rating. However, we should factor in that interest expense on debt is tax deductible. So,

  • Pre-tax cost of debt = riskfree rate of local currency + default spread of synthetic rating
  • After-tax cost of debt = (pre-tax cost of debt) x (1 – tax rate)

Be careful when using actual ratings from different rating agencies. Some may or may not include the country risk in their evaluation. That case, remember that the total risk for a firm is the sum of the riskfree rate, the country risk, and the firm risk.

Market Value of Debt

For the calculation of the cost of capital, it is preferred to use market value for both the cost of equity and cost of debt. For public companies, the market value of equity is determined by its stock prices. However, it’s a bit more challenging to determine the market value of debt.

One way to determine the market value of debt is to consider the entire debt as one coupon bond. The coupon payment is set equal to the interest expenses on all debt, and maturity set to the (face-value) weighted average maturity of debt. Then, it’s easy to calculate the present value of the annuity. Add to that the coupon bond at current cost of debt for the firm.

You can find an example by Mr. Aswath Damodaran here.

Market Value of Operating Leases

As mentioned, we should include any operating leases in the debt calculation. To calculate the value of the operating leases, simply calculate the present value of the lease payments at a rate that reflects their risk. This rate is usually the pre-tax cost of debt.

Investment Decision (2): Hurdle Rate and CAPM

CAPM

The CAPM, or Capital Asset Pricing Model, is one of the models that describe the relationship between market risk and expected returns for an asset. We can use CAPM to determine how much of the expected return can be explained by the associated market risks. It is an important tool to determine the cost of equity for a firm. The cost of equity is used to determine the hurdle rate in the investment decision.

The formula of CAPM is:

Expected Return = Riskfree Rate + Beta x (Expected Return on Market Portfolio – Risk-free Rate)

The difference between expected return on market portfolio and the risk-free rate is called the market risk premium. It is the premium that investors demand for an investment riskier than the risk-free rate.

Thus, to use the model we need three inputs:

  • The current risk-free rate
  • The expected market risk premium
  • The beta of the analyzed asset

Risk-free rate

A risk-free asset is an asset where the future return is both certain and known. That means the actual return is equal to the expected return. Of course strictly speaking there are no risk-free assets but for practical purposes we assume that for some very safe investments the risk is so low that it can be ignored.

The conventional practice to estimate risk-free rates is to use the government bond rate, with government being the one that controls issuing the currency. For example, for US dollar we use the rate on a ten-year US treasury bond.

Note that not all government securities are risk-free. Some governments face risk of default so the rates on the bonds they issue will not be risk-free.

In case of a government with default risk, you can include the local currency default spread in your calculation. The risk-free rate will then be the government bond rate adjusted for (subtracted by) the default spread for the local currency as determined by the currency rating.

Market Risk Premium

The second input required by the CAPM is the (market) Equity Risk Premium. This is the premium of an investment relative to a risk-free investment. Thus, (1) the premium is greater than 0, (2) the premium increases with risk aversion of investors and (3) the premium increases with the riskiness of the investment.

There are two ways of estimating the Equity Risk Premium. Either (1) use historical data or (2) use future expectations as input.

Historical Equity Risk Premium

Historical data has as main advantage that factual information is available. If you choose to use historical data, make sure to use a long enough time window, as well as ensure it’s consistent with the risk-free rate and use a compounded average. However, always be aware that historical data is backward looking, noisy and subject to selection bias.

Implied Equity Risk Premium

A relatively new approach to estimating the Equity Risk Premium is the forward looking “Implied ERP” by Mr. Aswath Damodaran.

an implied equity risk premium
An implied equity risk premium, by Mr. Aswath Damodaran

The implied ERP model employs a basic discounted cash flow model. It equates the current value of the market with the expected future cash flow growth and solves the equation for the expected return rate.

The inputs needed to calculate the implied ERP are:

  • Current value of the market
  • Expected cash flow growth of the market
  • Terminal growth rate of the market

To practically calculate the implied ERP, you need a proxy for the market. One option is to use the S&P 500 index as proxy for the market. The S&P 500 is a stock market index based on the market cap of 500 large companies having common stock listed on the NYSE, NASDAQ, or the Cboe BZX Exchange.

To calculate the expected cash flow growth, Mr. Damodaran relies on analysts to forecast future retained earnings as well as future returns to shareholder in the form of dividends and buybacks. The time window is set to the next 5 years

The terminal growth rate is set equal to the risk-free rate.

The implied expected return on the stocks is then subtracted by the risk-free rate to come to the implied equity risk premium. In the example of using the S&P 500 as market proxy, we have the implied equity risk premium for the US.

Country Risk

In the example above, we assume the S&P 500 is a good proxy for the US market in general. But what about other countries?

If we follow the theory of the implied equity risk premium, we should calculate the implied ERP for any country using a proxy similar to the S&P 500. However, this is not very practical. Mr. Damodaran proposes a composite way of estimating ERP for countries. The composite way adds the risk of a specific country relative to the risk of a mature market.

First, you estimate an equity risk premium for a mature market either by using the backward looking historical ERP or a forward looking implied ERP.

Then, define what you consider to be a mature market. One option would be to go by country’s local currency rating and associated default spread. In that case, any AAA rated country is considered mature.

Finally, estimate the additional risk premium for non-mature markets. There are two options:

  1. Default spread for the country, estimated based on the sovereign ratings or the CDS market
  2. Scaled up default spread, where you adjust the default spread upwards for the additional risk in equity markets.

Beta

The beta of a firm or stock (asset) measures its exposure to the market risk. It indicates both the volatility of the asset as well as how the volatility correlates to the general market. The beta is normalized around 1, meaning that the weighted average of all betas of firms in the market is 1.

  • Beta > 1: either returns that are more volatile than the market, or returns that are not very correlated with the market
    • Example: cutting-edge technology companies are typically more volatile than the market because they have a faster innovation pace
  • Beta = 1: the returns are as volatile as the market, or correlated strongly with the market
    • Example: large and mature companies tend to follow the market behavior
  • Beta < 1: the returns are less volatile than the market, or are not very correlated with the market
    • Example: firms that operate in stable industries which produce common-use products will typically have a low beta
  • Beta <= 0: the asset is market risk inducing
    • Example: the price of gold typically correlates inversely with the market and thus firms operating in this industry will have a negative beta.

What Impacts Beta?

There are three main factors that will impact the beta of an asset.

Firstly, the industry a firm is operating in will impact its beta. Since the beta is a measurement of how exposed a firm is to market risk, firms that produce goods or services that are heavily dependent on the season will have a higher beta. For example: a firm that makes ice-cream cones will have greater volatility in earnings than a company that makes toilet paper. Ice cream is in high demand during the summer, but low demand during the winter, whereas toilet paper is used during all seasons. That higher volatility in earnings will result in a higher beta.

Secondly, the operating leverage will impact a firm’s beta too. Companies with a higher operating leverage, or fixed operating costs, will see their earnings vary more. For example, a ‘bad summer’ will result in lower ice cream sales. A business that has invested in a ice cream stall with inside seating and air conditioning will have higher fixed costs than someone who’s just selling at the side of the street. When revenues are lower, the higher fixed costs means lower earnings.

Thirdly, the financial leverage will impact a firm’s beta as well. A firm with debt has to repay interest fees which are deducted from the firm’s earnings. The interest payments are fixed, regardless of the revenue. Therefore a “bad sales season” will have a larger impact on the firm’s earnings.

Lastly, it’s important to note that the beta of a firm is the market-value weighted average of the businesses of the firm. A large corporate which operates in many industries will have a different beta than the industry-focused firms it competes with in those markets. This principle also applies to your personal investment portfolio; the beta of your total investment will be the weighted average of the betas of your assets.

Measuring Beta: Top-Down or Bottom-Up

When measuring beta, you can either choose a backward looking (top-down) or a forward looking (bottom-up ) approach.

Bottom-Up Beta

The bottom-up beta can be estimated using the following steps:

  • Find the businesses or industries the firm operates in and determine their impact on sales or operating income
  • Find the unlevered betas of other firms in these businesses
  • Determine the weighted average of the unlevered betas
  • Lever up using the firm’s debt/equity ratio

The main advantage of a bottom-up approach is that this approach reflects the current or even future mix of the businesses that the firm is in.

Top-Down Beta

The top-down beta can be estimated by regressing the stock returns against market returns. The formula is:

Rj = a + b x Rm

Where,

  • Rj is the stock returns
  • Rm is the market returns.
  • b, or slope, corresponds to the beta of a stock and measures its riskiness
  • a, or intercept, is a performance measurement of the stock.
  • R², or R-squared, is an estimate of the proportion of the variance attributed to market risk

The key challenge of using regression to estimate the beta is the data selection.

Choosing a larger period to evaluate a stock will yield a larger data set but may not accurately reflect the change a firm is going through during that period. Similarly, choosing shorter interval periods between returns will yield a larger data set, but may be affected by noise caused by lack of trading

Unlevered and Levered Beta

The term (un)levered beta usually refers to the debt of a firm. All top-down beta estimates are levered because the estimate is based on stock prices. Stock prices are set by the market and take into account the mix of equity and debt of a firm.

To calculate the unlevered beta (UB) you can use the following formula:

UB = Levered Beta / (1 + (1 – tax rate) x (D/E))

Where the tax rate is the marginal tax rate for the firm, and D/E is the average debt equity ratio during the regression period

Calculating Cost of Equity using CAPM

Finally, we return to the formula of CAPM:

Expected Return = Riskfree Rate + Beta x (Market Equity Risk Premium)

Where,

  • Risk-free rate is the long-term government bond
  • Beta is the weighted average of the risk exposure of all the firm’s businesses to the general market
  • Market Equity Risk Premium is the weighted average of market risk premium of all the markets the firm operates in

Practically, we can choose to calculate the risk of operating in a mature market like the US and add risk associated with operating in a different country. In that case, we can say:

Expected Return = Country Gov’t Bond Rate + (Levered Beta) x (Mature Market Risk Premium + Country Risk Premium)

Where,

  • Country Government Bond Rate is the government in control of issuing the currency
  • If there’s a default risk associated with the government bond rate, adjust the borrowing rate for the default risk

What About Private Companies?

The methods to estimating the cost of equity discussed above are very useful when evaluating public companies. However, for private companies things are more complicated. The lack of stock prices and historical returns make it difficult to calculate how exposed the company is to market risk (beta).

There are two main ways to estimate a beta for non-traded assets: use comparable firms (bottom-up) or use accounting earnings (top-down).

When evaluating the levered betas of comparable firms, it’s important to still deleverage and releverage using the private firm’s debt equity ratio. Again, it’s difficult to estimate the market value of the firm’s equity or debt, so it’s reasonable to use book value instead.

R-squared

Last but not least, remember that beta is a measure of risk added on to a diversified portfolio. However, the owners of most private companies are not diversified. Therefore using beta only to come to the cost of equity will underestimate the cost of equity of the private firm.

To adjust for the added risk of an undiversified portfolio, we can use R-squared of the regression as it measures the proportion of risk that is market risk.

Beta = Market Beta / Correlation of sector with market

The correlation factor of industries like technology are relatively low compared to more mature industries. If you dig into it, you will quickly find that a private technology company is a risky business!

Investment Decision (1): Hurdle Rate and Risk

risk

Risk is a central element of the business world. Risky but successful projects can give investors an incredible return on their investment. But risky and unsuccessful projects have the potential to leave you with nothing. Estimating the risk associated with an investment is therefore an essential part of business practice.

In this post we cover the first aspect of the Investment Decision for corporate finance: hurdle rate. The hurdle rate reflects the riskiness of an investment and the mix of debt and equity to fund it. Simply put, the hurdle rate sets the minimum expectation of return for a specific investment.

As mentioned in Fundamentals of Corporate Finance, the Risk Premium captures the difference between a safe investment and a risky investment. Thus, we can describe the hurdle rate as follows: Hurdle Rate = Riskless Rate + Risk Premium.

The description outlines three major questions.

  1. What is risk and riskless?
  2. How do we measure risk?
  3. How to quantify risk into a risk premium?

Risk and Riskless

Mathematically, the variance in actual returns around expected returns is the measurement of the risk of an investment. Simply put, it describes the relationship between an expectation and an actual return. The larger the difference between the actual and expected returns, the riskier the investment.

Riskless

A riskless investment is an investment with a certain and known rate of return, and with no chance of default. Strictly speaking there are no riskless investments. In practical terms US treasury securities are considered riskless because the US government is considered the best possible issuer of securities in the market.

Even though riskless strictly speaking does not exist, the level of risk is so small it can be ignored. The downside of a riskless investment is that the rate of return is very low and that the returns are exposed to inflation risk.

Rewarded and Unrewarded Risk

There are two types of risk: rewarded and unrewarded risk.

Unrewarded risk, or market risk, is a risk that affects all investments across the market. It is unrewarded because taking the risk does not yield any advantage over the rest of the market. For example: risks associated with compliance to safety standards are unrewarded risks because all market players must comply.

Rewarded risk, or firm specific risk, is a risk that is specific to the investment. It is rewarded because it may give you a competitive advantage in the market.

A smart investor should diversify their investment portfolio so that the total firm-specific risk is averaged out across the portfolio. It’s reasonable to assume that any investor holds a “diversified” portfolio, thus investors price only market risk.

Market Risk

When we talk about market risk, it’s important to understand what we mean by ‘market’. The market pertains to not only the country where we sell our goods or services, but also the specific industry we compete in.

Considering the above, we can anticipate some challenges when trying to estimate the market risk.

A lot of businesses and corporations are operating worldwide. That means the risk of the firm depends on which markets they are exposed to and by how much. A firm which collects 90% of their revenue in the US market will be less risky than a firm that performs the same business in South Africa. The exact market risk for a firm depends on the specific mix of markets it operates in.

As a rule of thumb we could argue it’s more sensible to determine the risk based on where the firm is operating as opposed to where it is incorporated.

Furthermore, large corporations are active in different fields. A corporation such as McDonalds is in the business of not only selling food, but also real-estate. The industry risk associated with each business is different. The exact market risk for a firm will depend on the specific mix of industries it is active in

Measuring and Quantifying Risk

There are several methods to measure market risk.

  • CAPM or Capital Asset Pricing Model
  • APM: Asset Pricing Model
  • Multi-Factor Models
  • Proxy Models

While the CAPM is limited in many ways, it has survived as the default model for risk in equity valuation. The alternative models do a better job explaining past returns but are less effective in predicting future returns. Furthermore, they are much more complex and require a lot more information than CAPM. Lastly, the difference in expected returns predicted by the alternative models and CAPM is not significant enough to justify the additional work.

As it is an extensive topic, we will cover the CAPM in a different post.

The CAPM will give us the cost of equity related to an investment. However, a firm can also raise funds for an investment project from debt.

Debt

Simply put, debt is a deferred repayment of a sum of money. It is a commitment to make fixed payments with as main advantage that it is tax deductible. However, failure to make payments can lead to default or loss of control of the firm.

Debt includes short-term and long-term interest-bearing liabilities (i.e. loans or corporate bonds) or any lease obligations.

When we talk about the Cost of Debt, we talk about the cost associated with raising funds from debt.

We will cover debt in more detail in a different post.

Cost of Capital

The weighted average cost of equity and cost of debt is called the cost of capital. To determine the weight for equity and debt, the preferred method is to use market value. It is relatively easy to determine the market value for equity, but can be more difficult for private companies.

Determining the market value of debt is challenging for both public and private companies. Hence most practitioners opt for the book value of debt as a proxy for market value.

Choosing the Hurdle Rate

Finally, the choice of hurdle rate still depends on the preference of the managers. As said, the hurdle rate is the internal benchmark for projects. Using the cost of capital as hurdle rate is a common, solid choice but not mandatory.

If your firm is a start-up which is looking for angel investors to provide equity it is reasonable to use cost of equity as a hurdle rate.

Fundamentals of Corporate Finance

corporate finance

Corporate finance is one of the most challenging topics to master in any business course. However, understanding finance is one of the most important aspects of managing a business. This post contains inputs from Frank Gong and course material by Aswath Damodaran.

What is Corporate Finance?

In any corporate or business we make decisions on a daily basis that have financial implications. Any decision which affects the finances of the business or corporate is a finance decision.

The broad view of corporate finance includes everything from determining the prices of your products, to employee wage increases, and even decisions related to the payment terms of your customers.

In a more practical sense, we can define the financial view of a firm as below

  • Assets
    • Assets in place (existing investments that generate cash flows today)
    • Growth assets (expected value that will be created by future investments)
  • Liabilities
    • Debt (fixed claim on cash flows, not so important for management)
    • Equity (residual claim on cash flows, important for management)

Principles of Corporate Finance

The fundamental principle of business is the shareholder paradigm which states that it is the goal of a firm, business, or corporate to maximize the value of the shareholder. From that fundamental principle flow the three major decisions related to corporate finance: (1) the investment decision, (2) the financing decision, and (3) the dividend decision.

The investment decision

To maximize the value of the firm, we must invest in assets that earn a return greater than the minimum acceptable hurdle rate. The hurdle rate reflects the riskiness of the investment and the mix of debt and equity to fund it. The return reflects the magnitude and timing of the cash flows resulting from the investment, as well as all its side effects.

The financing decision

To maximize the value of the firm, we must find and choose the right kind of debt and the right mix of debt and equity to fund our operations.

The dividend decision

In case you cannot find investments that will further grow the value of the firm, return the cash to the shareholders of the firm. The quantity of the return depends on the current and potential future investment opportunities. The method of returning cash depends on the shareholder preference. Some shareholders prefer dividend payout, others prefer stock buyback programs.

Consequences of the Principles

The purpose of maximizing the value of the firm gives corporate finance its focus.

It is because this single goal that corporate finance can focus on the “right” investment, the “right” mix of debt and equity, and the “right” amount of cash that should be returned to the shareholder. Among a wide range of choices, corporate finance aims to choose that exact option which will maximize the firm’s value.

The focus of the corporate finance will change across the life cycle of the firm. The available sources of capital will be more diverse for a mature business compared to a start-up business. A firm in young growth phase will most likely reinvest all of its earnings into fueling future growth.

The corporate life cycle, by Aswath Damodaran

In the next sections we give you a taste of what’s involved with each of the three major decisions.

The Investment Decision

The investment decision can be summarized with two key terms: hurdle rate and returns.

Hurdle Rate

As the financial resources of any firm are finite, the hurdle rate can be considered the internal benchmark for investment evaluation. If a project does not pass the benchmark it should not be accepted.

Additionally, some projects will be more riskier than others. The risk of a project is represented in its hurdle rate. The hurdle rate for a very risky investment will be much higher than the hurdle rate of a very safe investment. The difference between a safe investment and a risky investment is captured in the risk premium. Thus, we can describe the hurdle rate as follows:

Hurdle Rate = Riskless Rate + Risk Premium

This description outlines three major questions.

  1. What is risk and riskless?
  2. How do we measure risk?
  3. How to quantify risk into a risk premium?

There are several models available that help find answers to these questions. We will discuss the models and dive deeper in the Capital Asset Pricing Model (CAPM) in another post.

Returns

The most obvious aspect of evaluating an investment is its future returns. There are two aspects to this problem.

First, we must decide how we will measure the returns. There are many ways to account for and measure returns. We could consider the accrual basis, where revenue is recorded when it is earned regardless of when the invoices are paid. However, a downside is that until the buyer pays the outstanding invoice the return from the sale cannot be reinvested.

Second, we must consider the timing of the returns. Early returns can be quickly reinvested by the firm, whereas late returns may hamper the firm to undertake other projects. Also, we must consider the time value of money.

Return mantra: “Time-weighted, Incremental, Cash Flow Return”

  • Cash flows, because you cannot “spend” earnings
  • Incremental, because you want to evaluate returns related to the investment
  • Time-weighted, because early returns are more convenient than later returns

In another post we will dive deeper in the topic and discuss terms such as Net Present Value (NPV), Internal Rate of Return (IRR), terminal value, sensitivity analysis and more

The Finance Decision

The finance decision can be summarized with one word: debt.

Debt is a deferred repayment of a sum of money. It is a legal commitment to make fixed payments which have the benefit of being tax deductible. On the flip side, failure to make payments can lead to default or loss of control of the firm.

Debt includes short-term and long-term interest-bearing liabilities (i.e. loans or corporate bonds) or any lease obligations.

When repaying a loan, you pay back the principal and interest on the principal, so the total amount repaid is higher than the amount lent. So you could say that taking on debt destroys value for the shareholder but that’s not necessarily true.

Apart from increasing the capital available to the firm which can be used to invest in profitable projects, there are other reasons why a firm would take on debt.

First and foremost, interest expenses on debt are tax deductible which means a firm can reduce its effective tax rate.

Also, since debt repayment is a directly taken from the firm’s earnings it reduces the available free cash flow. That could inspire the management team to be more disciplined about investments.

There are also some disadvantages: expected bankruptcy cost, agency costs and loss of flexibility.

As there are both advantages and disadvantages, to maximize the value of the firm we can determine what is the optimal debt ratio.

To determine the optimal debt ratio, we must take into account not only the cost of the debt but also the cost of the equity. This is closely linked to the cost of capital calculation and hurdle rate for the Investment Decision.

The Dividend Decision

The dividend decision can be summarized by a single question: to reinvest or to return?

The main purpose of a firm is to maximize the valued created for the shareholder. If the management can no longer grow the value of the firm, it should return the capital to the shareholders. The shareholders are then able to reinvest the capital in other ventures or firms that may increase their wealth.

There are two ways to return value to the shareholder: dividends and buyback programs.

Dividend

A dividend is a periodic return of cash to the shareholders. The dividend payout is the percentage of earnings the firm pays in dividend. The dividend yield is the return an investor can make from the dividends.

It is not always in the best interest of the shareholder to pay dividends as shareholders are taxed on income from capital gains.

Furthermore, firms that pay out dividends are expected to continue to do so in the future at the same rate and yield. Therefore, the payout becomes a measure of success for the management team. Paying dividends now makes it more challenging for the management to stop paying dividends in the future. This is annoying as it directly impacts the cash flow of the firm.

Buyback

In a buyback program the firm uses its cash to repurchase outstanding shares from shareholders.

A buyback program has many advantages.

Most importantly, it is not expected to be a periodic event. That means the management can choose to initiate a buyback when it believes to be the right choice rather than based on the expectation of the market.

Additionally, it allows the management to send a signal to the market. If the management believes the firm is currently undervalued, it will buy back outstanding shares at a much higher price than its currently traded at. This shows confidence as well as indicates what the management believes is a more accurate value of the firm.

Valuation

The main difference between corporate finance and valuation is that the former deals with decisions related to your firm, whereas the latter deals with the evaluation of other firms.

There are many reasons to perform a valuation of a firm. Maybe you are looking to invest in the company by buying shares. Using a proper valuation will help you find those companies that are currently undervalued and are most likely to earn you a good return. Perhaps you are interested in acquiring the firm. Then a proper valuation will help you to determine the correct price for the firm and prevent you from overpaying. Or maybe you are a consultant and want to help the firm improve. In that case a detailed valuation will help you identify problems related to finance you can help alleviate.

There are several methods to do valuation.

The intrinsic valuation will value an asset as function of its fundamentals. The fundamentals are (1) cash flows, (2) growth, and (3) risk. In general, discounted cash flows models are used for intrinsic valuation. In practical terms, it is very similar to the job of corporate finance but for a different company.

The relative valuation values an asset as function of what investors are paying for similar assets. You can use multiples and ratios of all kinds of numbers related to the firm’s financial statements.

The contingent claim valuation values an asset using option pricing models.

We will talk more about valuation and Discounted Cash Flow (DCF) models in a different post.

Understanding Corporate and Business

corporate
Picture by Sean Pollock

In many business courses the material pings back and forth between business and corporate. As the two terms are sometimes used interchangeably, it is not easy to understand the difference between corporate and business. So, what is the difference?

In this post we aim to create a better understanding of corporate and its relation to business.

Business

In a previous post we discussed the topic of business strategy. We outlined that a business is the trade of a good or service in exchange for some money. If demand exceeds supply, simply making the good or doing the service is enough to have a successful business. If supply exceeds demand, you need a business strategy to be competitive and successful.

The business strategy is a plan that defines the unique set of specific attributes the firm chooses to focus on aiming to achieve superior long-term return on invested capital.

The functions and activities within the business support the execution of this plan. The business manager decides how to employ the available capital such that it creates a surplus. For a starting business, the surplus created often is equal to the net profit at the end of the year.

If a business creates profit, or surplus financial capital, the business manager has the choice to either reinvest the capital in the business or return the capital to the shareholders. For a young and growing business it’s important to reinvest all the surplus created to support future growth. The reinvested capital, the available capital and the employed capital helps the firm execute its business strategy and achieve superior long-term return on invested capital.

Returning Capital to Shareholders

In the shareholder business paradigm, it is the goal of a business to maximize the value of the shareholder. The business should return the value to its shareholders if reinvestment creates less return on investment than the cost of capital.

Herein lies a fundamental problem: is it possible to return all excess capital to the shareholders?

For excess financial capital, this is reasonably easy as you can use dividend payments or initiate a buy-back program. But, what about other excess capital?

For example, a business creates value for its shareholder by increasing the operating margin making its manufacturing process 20% more efficient. Thus, to support the manufacturing operations the business only needs 80% of the available machines. The surplus of machines represents excess capital not reinvested in the business. It’s not easy to return this surplus to the shareholder unless you sell the machines and turn them into surplus financial capital.

A common-sense solution to this problem is for the business manager to use the machines for another business activity. This is diversification and represents one of the three available corporate strategies.

Corporate

From the problem described in the previous section emerges the role of the corporate.

The purpose of a corporate is to employ excess capital surplus created by its businesses to maximize the value of the shareholders. It does so by diversifying the business portfolio, deepening the business operations with vertical integration, or expanding the business operations geographically with globalization.

The corporate functions required to support the activities include the COO (operations), CMO (marketing), CTO (technology), CEO (executive team leader), and more. The functions exist to support the corporate drivers of shareholder value:

  • Strategic drivers
    • Revenue growth
    • Duration of revenue growth
  • Operational drivers
    • Operating margin
    • Investment in fixed capital
    • Investment in working capital
  • Financial drivers
    • Effective tax rate
    • Cost of capital (WACC)

Example of Surplus Non-Financial Capital

The example of excess surplus capital that is difficult to return to the shareholder mentioned earlier is not ideal. As pointed out, you can sell the machines and return the value to the shareholders with dividends or buyback.

A more interesting example is to look at human capital. Let’s consider the business employs a talented engineer who turns an idea in a commercial product. Throughout their career at the firm, the engineer will learn about new processes, technologies, applications, etc. Ideally the business would use everything the engineer knows to create more surplus, but that’s hardly ever the case. So, there is excess surplus human capital.

Following the shareholder paradigm, if the return on reinvestment is not an option then the value should be returned to the shareholder. But how to return excess surplus human capital?

Using the corporate strategy of diversification allows you to reinvest this excess human capital. In this example, the engineer could be assigned to work on a product for a related business.

Corporate with One Business

Another interesting topic is to consider a special case: the corporate with only business.

If the purpose of a corporate is to employ excess capital surpluses created by businesses so it maximizes the value of the shareholders, this still holds for a single business. The corporate functions that support the strategic, operational and financial value drivers still exist. It’s just that there’s a lot less to do in a corporate with a single business. You don’t need additional people to perform those functions. The responsibilities can be assigned to people already employed in the business.

Completing the Circle

A consequence of the corporate dedicated to the employment of excess surplus capital is that it encourages good business strategy. After all, in a competitive market the most excess surplus capital will be generated by businesses with successful business strategies. In that regard, we could say that as a rule of thumb the people in leading corporate functions should be concerned with the businesses in the group and their strategies.

Regarding business strategy, feel free to read through What is (Good) Business (Strategy)?.

Value and Price Dynamic

Over the course of the past couple of months I spent a lot of time thinking and talking about the dynamic between value and price. With expert input from Frank Gong, you can read some thoughts in this post.

The premise of the discussion flows from the definition of a business strategy. In the post titled What Is (Good) Business (Strategy) we proposed that any good business strategy involves focusing on those attributes for which the customer is willing to pay some money. In other words, the value created by the business should convince the customer to purchase the good or service for the listed price.

We will discuss the concepts and consequences using the image below.

value and price
Value and price dynamic, inspired by Frédéric Dalsace (HEC Paris)

Value

We can define value as the resulting sum of the benefits of ownership and the costs of ownership.

Benefits and costs of ownership

Benefits of ownership include all tangible and intangible elements or attributes the good or service offered allows the customer to achieve when it operates over the lifetime of the offer.

  • Tangible: increased productivity, better production quality
  • Intangible: status, security

Costs of ownership includes all tangible and intangible elements or attributes, excluding the price, the customer needs to spend to enable the offer to operate over the lifetime of the offer.

  • Acquisition costs: delivery, installation, procurement, …
  • Ownership costs: licensing, servicing, training, insurance, …
  • Operation costs: energy, labor, testing, ordering, …
  • Disposal costs: decommissioning, migration, …

The value of an offer increases if there are more benefits, and the value of an offer decreases if there are more costs.

Value gap

The value gap defines the difference between the value offered by the firm and the perceived value by the customer. In an ideal world the value gap is zero but in the real world the value gap will always exist.

There are a couple of reasons for the value gap to exist.

Firstly, a firm typically creates an offer that covers several use case scenarios and segments of the market. On the contrary, a customer’s use-case is usually very well defined. The value gap captures the difference between the customer need and the firm’s offer.

For example, a mobile carrier may offer a range of plans that includes data, voice and text. The value offered is the total of all minutes, gigabytes and message included in the plan. If I’m a customer who is only interested in a plan with data, the value perceived is determined by the number of gigabytes included in the plan. The value gap consists of the minutes and messages included in the plan but of no interest to me.

Secondly, firms may not understand the customer’s needs very well. In that case it may focus on attributes that the customer simply does not care about.

For example, smartphone makers emphasize and charge a premium for marginally thinner devices. Many customers are not willing to pay much extra for a mm less thickness. In this case the firm believes it has created a lot of value for the customer, but the customer does not perceive it as value. That difference is capture in the value gap

Customer Incentive to Purchase

Central in the dynamic between value and price is a customer’s incentive to purchase (CIP). Sometimes we refer to the CIP as a customer’s willingness to pay (WTP) for a good or service.

A customer’s incentive to purchase is the difference between the value perceived by the customer and the purchase price.

Note that the customer incentive to purchase is function of the customer only! Neither the value offered by the firm nor the firm’s cost of offer have an impact on the incentive. CIP represents the reason why the customer believes the offer is worth it.

Therefore, no offer is too expensive by itself. It may be expensive given a certain set of attributes or a given situation.

Example: consider you are by yourself on a deserted island. You have a lot of scrap wood but nothing to set it on fire to create a source of heat. A single match is worth a lot of money and you will be very willing to pay a lot of money for the match. However, when returning to your daily life in an apartment with central heating that same match will be worth almost nothing.

In the real world you can expect that a customer will seek to maximize the CIP by comparing the value and price of similar offers.

Surplus Created by Firm

Surplus is the difference between the perceived value and the cost of the offer. It is the sum of the CIP and the margin of the offer.

A key challenge for the firm is to decide how to allocate the surplus created. Increasing the margin will increase the profit for the firm but reduce the customer incentive to purchase, and vice versa. As obligated to its shareholders, the firm should aim to maximize the margin.

Therefore, there is a continuous dynamic between a customer’s aim to maximize CIP and a firm’s aim to maximize margin.

The firm has additional challenge from competitors in the market whose products may offer a better CIP or have better margin. Generally, the firm should aim to offer a larger CIP than the one of the competitor’s best

Conclusive thoughts

The dynamic of value and price is function of the customer’s perception and their ability to capture as much value for as little price as possible. A firm should focus on reducing the value gap, increasing customer incentive to purchase, and increasing the surplus created.

In next posts will talk about how to overcome challenges related to the customer incentive to purchase and value gap.