Finding the Value in IPOs: Why Customer Behavior Holds the Key

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Wharton's Peter Fader and Emory's Dan McCarthy explain why customer-based corporate valuation is a novel -- and very accurate -- way of determining a firm’s worth.

Spurred by tech companies such as Uber, 2019 is expected to be a record year for initial public offerings (IPOs). But what are these firms really worth? Financial analysts use a variety of formulas to reach that number, looking primarily at the success the business has already had. But future success is harder to determine, especially when fickle customer behavior can significantly change the value.

That’s why Theta Equity Partners takes an approach called customer-based corporate valuation. Co-founders Pete Fader, a Wharton marketing professor, and Dan McCarthy, a marketing professor at Emory University, believe their method is more precise and can help build a bridge between finance and marketing. Fader and McCarthy have written a paper on this topic titled, “Customer-based Corporate Valuation for Publicly Traded Non-contractual Firms.” They joined the Knowledge@Wharton radio show on Sirius XM to discuss why customer-based corporate valuation is the “revolution” that business has been waiting for.

An edited transcript of the conversation follows.

Knowledge@Wharton: How did you come to look at customer-based corporate value? Peter, you wrote a book titled, Customer Centricity. Does this play off the findings in that book?

Peter Fader: Very much so. I came to it from two different directions. One is these statistical models that I’ve been developing from my 33 years as a Wharton faculty member that help us do a very good job of predicting how many customers we’re going to acquire, how long we’re going to hold on to them, and what they are going to do over that horizon. Being able to predict customer behavior at a granular level and over long horizons, that’s part one.

Part two, you mentioned my books on customer centricity. Part of my goal has been to win over not just the marketing people but the accounting and finance and supply chain across the organization. For years, I’ve been talking about this idea of customer-based corporate valuation, but it was kind of conceptual, like, “Hey, if we can project the future value of all of our customers and add all that up, that should be like the value of the firm.” I put it out there more as an idea, a motivation. Then I met Dan McCarthy, who took some of these ideas and made them come to life for real, both in his academic work as a Ph.D. student here and as a professor at Emory, and through these two different startups that we’ve had. He can say more about how it really comes to life.

Dan McCarthy: If you speak with an investment banker working on an IPO, they’ll often come up with some sort of IPO price based on things like future revenue growth. Oftentimes, these companies would be losing money, but they’ll say, “We’ve only penetrated our market 2%. If we’re able to continue to grow our share, we’re going to grow our way out of unprofitability.” We would say, “Yes, but maybe.” It’s really going to be a function of how they’re doing after they’ve acquired the customers that they’ve brought in. If they have customers who stay around for a long time and/or increase their relationship with the firm, spending more over time while they’re alive, that would be very supportive of being able to generate the operating leverage that they are going to need to grow their way out of unprofitability.

“Not all revenue growth is created equal.” –Dan McCarthy

We’ve seen a number of companies that fit that bill — their unit economic profile looks very good. But we’ve also seen a number of other companies where they look almost the same. They’ve got very similar revenue growth, very similar penetration figures. But we look at them from the bottom up, from the vantage point of customers, and we see that they are not doing a very good job of being able to the retain customers they have brought in. Or they’re spending a lot more to bring them in. Or the amount of revenue that they’re generating from those customers while they’re alive is flat or down. It’s those latter companies that we would be a little bit more skeptical about…. It really speaks to the fact that not all revenue growth is created equal.

Knowledge@Wharton: I was looking at your blogposts, and one from 2018 caught my eye. You were talking about customer-based corporate valuation and referred to it as a revolution. Why so?

Fader: Number one, it is just a fundamentally different way of doing corporate valuation. Not just a tweak on it. Not just a slight improvement on existing methods. It’s coming from a completely different direction, instead of doing things from the top down. “Let’s just look down at the revenue and come up with some multiplier or something to say what the company is worth.” It really is, as Dan said, decomposing the revenue into the underlying customer behaviors. It’s just a completely different approach, but very often it does lead to consistent answers, which is great.

Number two, it helps build a really great bridge between the folks in finance and the folks in marketing. We can take the same models that we would usually use to figure out which email we should send to which person at which time, and put them in the hands of the chief financial officer. But also it goes the other way, that the CFO can start with these models for valuation purposes and then toss them over to the marketing person to say, “Now that we’ve bought this business, and now that we have a sense of how healthy it is, let’s align on what our next step is. Do we need to bring in more customers or to have them stay around longer?” There can be a complete connection and complete standards set for metrics and models to be able to evaluate the actions that we take.

McCarthy: It’s a revolution in some ways, and in some ways it’s the opposite. It’s a revolution in how people are performing corporate valuation and thinking about where the value is coming from, exactly as Pete is saying. We’re not thinking about it from the top down. It’s going to inform how we think about it from the bottom up. And I think that’s a really big change that a lot of people are still in the process of digesting.

What has held up some of the previous work is in the actual mechanics of how the valuation comes about. We’ll come up with revenue forecasts for the firm by decomposing revenues into “How many customers I am going to acquire. How long are they going to stay with me? How many orders are they going to place, and how much are they going to spend?” That gives us our new and improved forecast of revenues and informs our view for the durability of the revenues and for the rest of the cost structure.

“It’s not that these metrics are nice-to-know when you can get them, but they’re starting to become part of expectations.” –Peter Fader

But ultimately, all of that is going to trickle its way down into a very standard DCF (discounted cash flow) model. So, it’s something that will allow the finance person to really understand where the value is coming from and not have to change their fundamental approach when it comes to the Excel spreadsheet that they’re working on.

Knowledge@Wharton: How do you think this is going to change the concept of corporate valuations moving forward?

McCarthy: Very simply, it’s going to be replacing that revenue line on the DCF model revenue spreadsheet, and just having that come from our model instead. It would be a different tab on the spreadsheet — where that forecast is coming from all of those underlying behaviors, which would also be additional rows that show up there. But otherwise, in terms of the actual process that’s coming to a point estimate for the share valuation of the firm, everything else would stay pretty much the same.

Fader: We’re already starting to see some good signs of it. Even though we’re starting with established firms and private equity and so on, we’re already seeing the revolution taking place when it comes to early-stage venture capital. As any investor or any fan of venture capital knows out there, one of the big things that companies live and die by these days is the LTV:CAC ratio, the idea of the lifetime value of customers relative to the cost of customer acquisition. This by itself is now somewhat commonplace, but it was not part of the vocabulary, let’s say, with the first dot-com revolution 20 years ago. We didn’t have the good data sources. We didn’t have the analytical capabilities. We just weren’t thinking along those lines. That’s sort of become conventional thinking for venture capitalists.

All we’re trying to do is two or three things. Number one, let’s refine the way that we do that. Let’s make sure that when we’re talking about lifetime value or customer acquisition costs, that we’re doing it really well, using standard, well-validated approaches that will be very consistent. Number two, let’s not stop with early-stage venture capital. Let’s take that same mindset of the value of our customers relative to the cost of them and make that as commonplace for established companies as it is for startups.

Knowledge@Wharton: How does your work looking at customer-based corporate valuation play into a company like Uber or Lyft? They drew a lot of attention earlier this year with their IPOs, and Uber has been carrying about a $70 billion valuation for the last couple of years now. (Uber reported a $5.2 billion quarterly loss on August 8.)

McCarthy: We took a very close look at Lyft because they happened to put some really informative customer data in their pre-IPO filing, which was a very good sign that the future is bright for these sorts of methodologies. Specifically, they put in figures about cohorted revenues by rider, and we were able to use that and connect the dots with some of the other measures that they put in the filing. I had to come up with assessments of how healthy that business is. Long story short, we found that there was a lot of value in the business, but not nearly to the extent that they’re currently trading at.

Uber, unfortunately, disclosed very little. They disclosed a lot of interesting data, but it was not a whole lot at the customer level. We had expressed disappointment publicly about the lack of disclosure that they had. They’ve even got this direct competitor of theirs that’s putting just the right sort of things in their filing. What was funny was, when we put that out over the social media, there were a lot of people who expressed exactly the same feelings, that we’re not being given enough information to form a sound assessment of the health of this business.

Fader: It’s really interesting that a lot of people looked at Uber’s — I don’t want to say poor disclosures — but the lack of customer-level disclosures, and immediately jumped to the conclusion that they have something to hide. They’d say, “Hey, they’re hiding something.” And we said, “Well, we don’t know. We have no idea what their metrics are. We have no idea what their strategic intents are.” But it’s nice that we’re starting to get to the point where investors and the interested public expect to see some of these disclosures and have these suspicions when they don’t see them. That’s part of the revolution.

It’s not that these metrics are nice-to-know when you can get them, but they’re starting to become part of expectations. As companies are trained to do that, or as investors demand it, that’s where we’re going to start to see massive changes in the way valuation happens and the way that valuation is tied in with other ongoing operational activities.

Knowledge@Wharton: Two of the other companies that you’ve evaluated are online furniture seller Wayfair and Blue Apron, the meal kit company. Are there some concerns about return of customer for both of those companies?

McCarthy: Yes, that’s exactly right. With Wayfair, we obviously have a very long history with them. We put them in the paper that Pete and I had written for the Journal of Marketing Research. In the paper, we came to the conclusion that the volume of repeat business after customers were acquired is not enough to justify the sky-high valuation that they had been getting. We put it out there, and it ended up getting picked up by everyone from The Wall Street Journal to Jim Cramer.

“Certainly, a lot of companies will talk about their retention rates. We would prefer to talk about the whole retention curve.” –Dan McCarthy

To their credit, they’ve continued to grow revenues very quickly. But to our credit, the fundamental assessment of the free cash flows that they were going to generate has only gotten worse and worse and worse. In all, the measures that we had said, “We would expect to see weakness here,” have continued to see weakness. I think that’s partially the reason why every single time they report, we’ve ended up getting some sort of mention in The Wall Street Journal, and there were other mentions in places like Fortune magazine.

At Blue Apron, there’s a similar story but different conclusion. We had inferred that they also were not retaining their customers well and that they weren’t making as much after customers had been acquired as they were spending to bring in those customers in the first place.

Unlike at Wayfair, they caved in on themselves a little bit. The revenues have been dramatically shrinking. I think that would be the ultimate conclusion for Wayfair, too. Once they have penetrated their market so much that there are just not that many additional incremental people to acquire, suddenly they have to fall back on the business they’re getting from everyone they’ve brought in already, and there’s just no continuity there. We’ve gotten probably an analogous amount of visibility from the press on Blue Apron, but the conclusion has been the stock has fallen over 90%.

Fader: Those two examples are interesting. They’ve gotten far more attention for us than anything else. Unfortunately, both of them were basically eviscerating these companies. Some people jumped to a conclusion that it’s kind of our job to take down the high and mighty. That’s not true. Our job is to speak the truth, and it’s nice to see that an equal number of our analyses have shown companies are being undervalued by Wall Street.

One that we’re super proud of is the analysis we did for Slack, the messaging software, when they came out with their filing a number of weeks before they went public. We said, “This is an awesome company, and the numbers being thrown around as the likely valuation stock price are about 40% or 50% too low.” We’ve been proven right on that one. Same thing with retailers FarFetch and Revolve. It ends up being fairly balanced. A lot of times, we hit the mark. But to the extent that we’re off, there’s nothing systematic about it. But it’s just nice to see that, in many of these cases, the stock prices do move in the direction that we suggested.

Knowledge@Wharton: With this type of data, you’re trying to reach the venture capitalists. Who else are you trying to reach? Who benefits the most by having this information?

Fader: It’s investors in general. It’s going to be private equity firms. We’re getting some interest from hedge funds, family offices, but also a lot of companies themselves have been interested. They want to know what they look like through this lens. We’ve worked with a number of firms where they’ve said, “We’re going to give you the same kinds of metrics that you’d be looking at, like on your IPO analyses. We could give you the whole transaction log, but we don’t want to. Not because of data security. We just want to know what we look like, as if we’re on the outside looking in.” So, it has been great to work with companies who are starting to take that perspective and try to ask themselves, “Should we be disclosing some of these metrics or not? What internal action should we be taking to be healthier?”

McCarthy: I think there are many companies right now that feel they can see all of their internal data, so they know exactly where they stand in terms of unit economics. And if they’re making some transition to their business model, or there’s something else that’s disrupting them temporarily, then they feel frustrated that they’re being unfairly penalized. To the extent that they have this method that can help communicate the value of the underlying business, that speaks volumes. We’re seeing a number of companies expressing sentiments along those lines.

Knowledge@Wharton: A statistic that you mention on the website that’s important — and I’ve heard it used quite a bit when talking about the cellular industry — is the churn rate, which is the amount of customers that you will turn over during a period of time. How important is that churn rate for some of these companies that we’ve been talking about?

McCarthy: Tremendously so. We call them the five horsemen of CBCVs (customer-based corporate valuations) — acquisitions, retention, ordering, spend and contribution margins. But retention is probably the more important of those. You don’t want to ignore the other five, but we see a lot of variation from company to company in terms of their retention.

“Let’s take that same mindset of the value of our customers relative to the cost of them and make that as commonplace for established companies as it is for startups.” –Peter Fader

Certainly, a lot of companies will talk about their retention rates. We would prefer to talk about the whole retention curve. There are some good customers and some bad ones, and you can’t infer the mix of good versus bad unless you look at a curve versus a rate. But I think the fact that we’re seeing many more companies outside of telecom disclosing those measures is a testament to the growing mindshare or realization that customer health is extremely important.

That was the key finding going back to Blue Apron. They had not disclosed their retention curve or their retention rate, for that matter. But we were able to connect the dots to triangulate our way back into what the retention curve was there. More than any other data point that I had seen in the media, it was really insights from that retention curve that were being mentioned the most.

Fader: It’s not just calling attention to retention. People understand that that’s important already. But as Dan was saying, it’s the distinction between the numbers — you can’t talk about what the company’s retention rate is, but how it varies across the customers. How many of them are flighty and will leave quickly, versus how many are loyal and locked in? It turns out there are some very nice, systematic patterns to understand the mix of those two kinds of customers. We could ferret that out from the data pretty early on. That’s going to be a very good leading indicator, not just of retention and churn patterns but overall valuation.

Again, that was the heart and soul of that Blue Apron analysis and continues to be for everything that we do. Part of it isn’t only saying, “Hey, investors and senior executives, you need to look at these metrics.” We also need to look at them carefully, even if it means that we have to start bringing other words into the vocabulary, like it’s the “variation” or the “heterogeneity” in the retention rates. There’s a lot of money riding on that.

I have a 10-year-old paper on this issue, “The Perils of Ignoring Heterogeneity on Customer Retention.” It was an academic piece widely ignored by anyone with a real job. But now people are starting to go back and look at some of those papers and those methods and their implications. And they’re saying, “You know what? There is some good stuff in this marketing literature that we on Wall Street ought to be paying attention to.”

Knowledge@Wharton: Why has taken so long to realize that?

Fader: Silos. The metrics, the mindsets that exist in finance and marketing tend to be quite different. There tends to be some, I don’t want to say disrespect, but mistrust across the two. It’s still true today that a lot of the marketing people are talking about metrics that finance people are kind of skeptical about, that they don’t trust very much.

If we can come up with a set of metrics that both parties should agree on — I think we’ve been doing a pretty good job of that — it’s not going to be a compromise. It’s going to elevate things for both of them.

Knowledge@Wharton: Is there hope of breaking down the wall between those two sectors of business?

McCarthy: That’s exactly what we’re trying to do. Hopefully, the progress that we’ve made so far as marketing professors in financial news media is a step in the right direction. I think there are two things that would need to happen, and I think we’re seeing more and more of it on both sides. On the marketing side, we need to do a better job of speaking in terms that finance people and accounting people will respect. Just talking their language of valuation. I think that, hopefully, we in marketing can appreciate they’ve pretty much solved that problem. We don’t need to recreate that with some other method that may be a little bit imperfect in their eyes.

On the finance side, I think it’s going to be on them to adopt acquisition, retention, ordering and spend as the way that they’re going to drive the revenue line. I think it’s a two-way street, but I think we’re seeing good progress so far.

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