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The Investment Value of Brand Franchise Author(s): Jack Treynor Source: Financial Analysts Journal, Vol. 55, No. 2 (Mar. - Apr., 1999), pp. 27-34 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4480152 . Accessed: 27/06/2011 00:56
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Churchill once said that the United States and Britain were two nations separated by a common language. The valuation model has elements recognizable to the marketing strategist-such as franchise.S.analysts can estimatethe investmentvalue efficiencyin defendingit.companiesin thefirst group support theirfranchises by large investments in advertising. This article defines what data analysts and investors need to value a company's investment in its brand franchise and explains how to use the data. not the 27 . Economists. or more. are reluctant to capitalize the expenditures that supportfranchises. however.however. consumers experience the reality-the Law of Two Prices-on the shelves of their friendly retailers every day. introducing new versions of their products. and so on.g. SEC. This article describes an approach analysts can Jack Treynoris president of TreynorCapital Management.. Investors cannot important-brand afford to ignore the value of a brand franchise for a company's future cash flows. When data are verifiable. and equipment. * Data specific to a particular asset should reflect the specifics of the asset-not the interaction of the asset with general economic conditions or someone's opinion about future prosperity. to estimating the investment value of a manufacturer's franchise and the manufacturer's efficiency in defending it. If thefixed marketing costs can be identified. present value. is even more franchise. however. Accountants. "objectivity" ceases to be an issue. * The data should not depend on arbitrary decisions by anybody-not the U. at least in prin*ciple. of thefranchise and the manufacturer's conomists have a lot to say about the value of plant. As a result of the strategic choices companies make. research and development. advertising) "expenses." The traditional approach to estimating value has been to ask what data public companies provide and then to let those data define the valuation methods. by indiscriminately invoking the Law of One Price. with total disregard for the kind of data the model requires.Some manufacturerschoose to limit their output. sell only to customers loyal to their brand (theirfranchise). The neglect by economists of the reality of franchise pricing results in a wholly unnecessary mystique regarding these high prices unnecessary because the marketing and economic aspects of brand franchises are easily linked. of course. The data required for a satisfactory model should have the following characteristics: * The data should be verifiable. But the model can hardly be called "traditional. Opinions cannot be verified. and return on investment. treat all industries as commodity industries. Becausefranchisescan contributeas much. and charge the higher price. in which brand franchise has no value.The Investment Value of Brand Franchise Jack Treynor Brand loyalty manifests itself in consumers'willingness to pay a higher pricefor the brand they prefer. which causes gaps between marketvalue and bookvalue. March/April1999 use. property. Others chooseto chargea lower price ratherthan limit their output. which calls investments in brand franchises (e." The neglect by accountants of the implications brand franchises have for future cash flows results in high price-to-book ratios and high price-to-earnings ratios. but they are silent on an element of investment value that. marketing effort. Accounting principles exacerbate the problem of valuing brand franchises. A simple test for the specificity of the data is whether the data would be the same in a different economic or market climate. and level of rivalry-as well as elements recognizable to the investment analyst-such as cash flow. for some companies.to future cashflows as their plants contribute. Inc. A valuation model cannot be formulated. The data should not be opinions about the future. Investment analysts and marketing strategists are two groups of professionals separated by the language of accounting. if the fixed costs of supporting a brand franchise can be identified.
which is what gives the power to brand names. roughly simultaneous transactions in a given good or service will have the same price. When pasteurization was new. Consumers. But it is precisely at this point in the life cycle of the product that consumers are having their first experiences with the product and forming first impressions that will be as lasting as their first impressions of people. Life-Cycle Characteristics Fledgling Industry Product concept evolving rapidly Size of market uncertain Process-centered manufacturing Fluid supplier relationships Quality hard to control Consumer disappointments common Mature Industry Product concept stabilized Market established Product-centeredmanufacturing Stable supplier relationships Quality easy to control Consumer disappointments rare 28 ?Association for Investment Management and Research . Indeed. Quality at this stage is inevitably uneven and almost impossible to control. Each brand. using general-purpose rather than dedicated machine shops. Their preferred brands become the standards by which all other similar products are judged. Marketing is most important in the middle of the cycle. This information asymmetry is typical of the markets for used cars and second-hand watches. has its own group of loyal customers-its brandfranchise. or pro- Exhibit 1. when brand identities have been established in consumers' minds but consumers are still worried about quality: "Almost as good as a Xerox. foundries. The Law of One Price asserts that. In consumables. and heat-treating facilities makes economic sense (what Buffa  called "process-focused" production)." In actual transactions. the parties have their own mental images of what is being transacted. ketchup. When an industry is new. For example. Consumers are not unwilling to buy the others. and dairy brands with their premium prices have largely disappeared. The result is anxiety in the mind of the consumer. the reputation of the dairy (e. the manufacturer knows what raw materials. however. Beatrice. Later. and certainly not the reporting company. In practice. can realize the full value of the scarcity rents on its plant capacity) and. advertising. and what workers were used in the product's manufacture. the very definition of the product is fluid and demand is low." "Not exactly like Hertz. and these two images are rarely the same. Exhibit 1 summarizes the differences between a fledgling and a mature industry. in many markets. manufacturers build production facilities dedicated to the new product (what Buffa called "product-focused production"). the manufacturer who chooses to sell at the lower price is free not to engage in product innovation. which often has its origins in the way the product is manufactured over its life cycle. in the absence of transportation and distribution costs. If they prefer Fords. which competing product is the ideal differs for different consumers. consumers replace their generalized ideal of what a product should be with the highly particularized image of a specific brand. The day consumers do conquer the last of their anxieties is the day the industry becomes a commodity industry. the seller knows more than the buyer. of course. then every way in which a Chevy differs from a Ford makes the Chevy less desirable. what equipment." Marketing experts have known for years that consumers deal with their anxiety about transactions by focusing on the manufacturer's brand. Borden. the manufacturer that chooses the lower price can sell everything that it can economically make at that lower price (in economics. cannot forget the pain of the early disappointments. and as production problems are solved. nobody worries about milk quality. and even more characteristic of markets for consumables-headache remedies. brands can continue to be important long after the industry has solved its quality problems. Hood) was important. Fresh milk is an example. toothpaste. all the consumers can see at the point of purchase is an opaque container. soup. Today. Day in and day out. a manufacturer would price each sale transaction according to whether the buyer was in its franchise or not. Chevy and Ford. They are still anxious. when the role of the product is well Marketingand the Brand Franchise Ideally. In a process not unlike falling in love. The law assumes. corn flakes.g.AnalystsJournal Financial Financial Accounting Standards Board. The source of quality problems is identified. the same people perform the same steps in the manufacturing process. knowledge about solutions circulates throughout the industry. defined and potential demand is clearer. because sales are not restricted to its franchise.. So. Of course. Learning takes place. Branch Franchise Power The key to the value of brand franchises lies in consumer anxiety. however. and so on. that the parties to the transaction have what lawyers call a "meeting of the minds. but this approach is usually impractical. In most cases. but they are willing to pay more for their ideal brands.
and assert that &is constantacrosstime. they are not affecting total supply or total demand. with particularattentionto fixed costs. can vary acrosstime.and equipment.pricing that investment is a challenge. and ease of entry. If a franchiseis measured by its gross manufacturer's z cash "flow-back.and the impact of brand franchise on monopoly power. (5) * * the economics of brand franchisewhen fixed costs are important.So. Butanalystscan estimatethe costs. at annual rates).TheInvestment Valueof Brand Franchise that chooses the higher motion. a manufacturermust take customers away from its competitorsas fast as they are takingaway customersfromthe manufacturer. unlike ac.with largevalues of (Xv!/ I z. So. The Estimation Problem. (1) where oc and a are coefficients that express the sensitivity of change in franchise to. even if it is the same for all competitors at a point in time. a competitorcan romanceaway twice as many potential customers if it spends twice as much and vice versa. the two independent variables are highly correlated. considera single-variable regression Az/z on of 29 .wateris constantlyflowing in and flowing out. like v. This discussion of how to value a brand franchiseconsiders three issues that brand franchiseraises for investors: * the estimationproblemin the case where fixed costs are either known or small enough to ignore. nothing to do with price theory.satisfy the equation Az = av. Considerregressionestimates of the undeterIn mined coefficients a and o&: the cross-section.-related losses) is in a certain sense relative to the other competitors. unknowncoefficientoc not necesThe is sarilyconstantacrosstime for the same competitor. net of any fixed marketingcosts in the industry.PIz. So. when firms do not report their fixed costs separately for manufacturingand for marketing).Az.Then. Customers are fickle. the same for all competitors.Thecompetitors' swimmingholes in a river. To maintain its franchise. and promotion. advertising..then one-period changes in gross flow-back.X. The manufacturer price is restrictingits branded output. (4) Obviously.we can write Yav = &Xv. When consumers choose to buy at the lower price. large v's are likely to be associated with large z's and. without any loss of generality.1When the size of that element is not known (i. To begin estimating the costs of supporting a brand franchise.Therefore.e. gains and losses in franchiseshare sum to zero. (2) is so.then 0 = . irrespective has. that is.but it is actuallyin confranchisesharesarelike stantflux. Let that averagebe6c. marketingeffortand initial franchisesize. We can minimize this problem by recastingthe regressionin the form =z=c a([a J (7) Now. of how much capacitythe manufacturer to the this market. assume that. manufacsize of its franchise turerdoes whateverit can to increaseits franchiseproduct innovation.cLv.Becausethe choice merely shifts consumers from one brand to another or to unbranded competitive products. The costs of marketingoften include a significant fixed element. The basic model then becomes Az = ov -&iz z (6) An industry may appear to have stable and unchangingfranchiseshares. an appropriately weighted average of the individual efficiencies should be constant across time-even if individual efficiencies or associated weights are changing. theirchoiceis not affectingthe scarcity of productioncapacityor the scarcityrents on that capacity. But the efficiency with which competitors transformdollars of marketingeffort into change in franchise (gross of the . then. the task of analyzing the value of a franchisehas little in common with the task of analyzing the value of plant. sunk costs. if we assume that I..So. althoughthe overalllevel of each hole may change little. At every point in time. XAz = 0.z. Standard errors of estimate will be correspondingly large. is observable." (franchiseshare multiplied by brand premium) and its marketing effort net of fixed marketingcosts is defined as v (bothvariables March/April1999 where the expression in parentheses. property. it has nothing to do with scarcityor marketequilibrium-hence. respectively. (3) with the result that =' I oav . marketing Themanufacturer the higher-priced uses effort to increase (or defend) its share of the franchise in its industry. therefore.
all competitors have the same fixed costs. indeed. they are "timing"the industry.) The other variables in the formula are verifiable. l(u-F) = z (12a) and 30 In this result. In industrieswhere fixed advertising and development costs are important.z.z. When investors forecastthis number..(15) and u*= (z+F. a forecast that depends on events outside the industry.F) . and they arenot influencedby anybody'sforecasts or anybody's arbitrary rules: Az2 a(z)-a E (14) Maintenancelevel v* of v is defined by 0 =aV)& so z .We can make this useful distinction.substitutingu*for u in the expressionfor franchisechange produces c1(u*-F) .fixed costs are not explicit.. The maintenance value of u (the value at which franchisegains just offset franchise losses) canbe termedu*. A small gain in franchise share achieved with high efficiency may represent a better job of marketing management than a large gain achieved with an exorbitanteffort.change in franchiseis Az = a(u . however. The present value of a franchise share z ?Association for InvestmentManagementand Research .2We can measurecompetitors' total marketingeffortsby the cash outflow u and theirtotal fixed marketingcosts (assumingthe costs can be measured) by F (all variable annual rates).e.(Thecurrent value of .or = Z-u z (16) Then. On the other hand.When we introducedfixed costs. the variable-costportion of a company's marketingeffortis u . we have XAz = = c(u0.One variable in the formula for measuring franchise value should probablybe treatedas a forecastratherthan as a verifiable fact-and. between level of marketing effort and efficiency.net flow-backis ] (10) Z-v* = z 1-() | (17) = Z(1-)-F.which usually depend on prosperity beyond the industry. both across competitorsand across time. Net flow-back from the investment is gross flow-backminus the maintenancelevel of effort. (9) L v*=Z(). We use the resulting estimateof octo computevalues of cc for each data point (i. The way to avoid such timing is to use the forecastthatbest explains the currentmarketprices of companiesin the industry. They are specific to the firm and its industry. Forthe industry as a whole.Financial AnalystsJournal variableviz is lviz: The suppressedexplanatory plausibly uncorrelatedwith v . assume a = a for different competitors. at We can use this result to distinguish. That variable is -z the industry's total franchise. The (12b) Substituting in the expression for net flow-back produces Z= Z 1_ iz F) (13) fixed costs of product development and advertising representthe competitor'sadmission ticket to the variable-costgame. measuredin gross cash flow.z = 0. Equations13-19 assume away differencesin marketing efficiency-that is. only when fixed costs are little known or unimportant. on average.for each competitor eachpoint in time). we defined v as equal to u F and v*as equal to u" F if. u*-F =f Recallthat our first criterionfor a satisfactory model was that the databe verifiable. competitor by competitorand period by period.z is observable but probablynot relevant. aXF-I3Xz (11) hence. (8) The value of z to investors is reduced by the marketing effort required to maintain the company's market share. The Economic Impact of Fixed Costs.. It depends on overall industrysales.F. Then.
if they are large. A will win the war. Because F.theirideal is an industry that pushes output up to the point 31 (20a) March/April1999 . In a marketingwar. When rivalry escalates. with low-ratiocompetitorsfollowing willy-nilly. the rule is: Never acquire a company with franchisez such that z < Xz/(n2). acquiringcompetingcompanies. and goes up with the number of competitors. Marketing wars are basicallywars of attritionintended to exhaust competitors'borrowingpower.) Calculating a Sz)= Sz n2 (24) An -n shows thatwhen a companyis acquired(i.3 A marketing war ends when a competitor either exhausts its borrowing power or. the level of rivalryis so high that net flow-back becomes negative. z. Largeestablished firmsbenefitby encouragingnew firms. The bigger the franchiseshare.) The Two Meaningsof "Competition" Wheneconomiststalkaboutcompetition. and L are all positive. rather.but because it lowers the thresholdfor acquisition targets.Xu. J+z (20b) with respectto n produces Differentiating au* (19) Fz (u . Butthereis no point enteringan industryif you aren't sufficiently well capitalized to defend your entry.they can be more aggressive in marketingpeace. a company must have a higher ratio of borrowingpower to franchisethan its competitors have.the incrementalrate of returnis a(z-u*) a(z -zu*) az au az au = = Frl-.TheInvestment Valueof Brand Franchise discounted at marketrate p is _ Z ]_ - PF (18) can be used as the measureof ease for entrantsthat expect to compete for franchises.F)- An J:z (21) L z The rateof returngoes up with the gross flow-back from the industry's franchise. on the other hand.but its n falls by 1. Becausethe purpose of a marketingwar is to force a competitor to abandon its franchise. So. Brand Franchise and Monopoly Power. its rate of loss) is bigger. (23) So. if CompetitorA has the same size franchiseas CompetitorB (and the same marketingefficiency) but more untapped borrowing power. maintenancecost (see Equation9). (Considerthe extremecase of Company Q acquiring a company of negligible size:CompanyQ's z does not increase. seeing that its causeis hopeless. For example. the industry average increases by Iz/n2.We concludethatwhat established competitors should fear is not entry but.the bigger the rate of loss. If.. abandonsdefense of its franchise.by increasing the frequencyof new-product introductions?Differentiatingthe maintenancecost expression with respect to F produces au* = 1-- . Lawyers often assume thathigher fixed costs will make entry more difficult. A and B have equal untapped borrowingpower but A's franchise(hence.evidently pays. So. entry of a competitor always lowers maintenance cost for existing competitors.e. Companies do not have to compete for franchisein order to enter an industry.not merely because entry reduces their maintenance costs. borrowing power depends on the value of the plant (less liabilities). U= Z X (U-F) +F.And because marketing wars benefit those competitors. To win such a war.when n falls by 1). then B will win the war. no rationallender will rely on franchisevalue as the security for a loan.high-ratiocompetitorslead the way.(Smallcompanieswho would prefer to be priced as potential takeovertargetswill also favor entry.We can rewrite this expressionas u* Foran establishedcompetitor. but when they enterthe battlefor brandfranchise.goes down with the level of rivalry. Does it pay established competitorsto increase the industry's fixed marketingcosts-for example. (22) A new competitor'smaintenancelevel of u will fall with increasingF if its franchisesatisfies n= Average z. a marketingwar shifts franchiseshare toward the competitor with the highest ratio of borrowing power to franchise. Eitherway. B will run out of steam sooner than A.So.they incur the maintenance-level costs of their marketing efforts.entry of financiallystrong competitors.
however. an industry is divided up among a few large firms.steel companies. How does the high-productioncost type survive in such an industry? By not competing for franchise share. "Low" and "high" as they apply to cost. In industries where such franchises are valuable. it takes a lot of low-cost capacityto defend a big franchise. Implications for Antitrust Whenhigh fixed costs in an industryareassociated with marketing rather than production. The owner of the industry's marginal capacity. is why the valuable franchises end up in the hands of low-cost producers. If the industry has important fixed costs that are the same for small companies as for large companies small-scale attempts at entry will fail. The manufacturer will push output closer to the point at which the unit cost of producing on the marginal capacity equals the price-that is. as a result of business combinations or barriers preventing new entrants from starting small.In such industries. including the competitor types.withhold some of theirproduction?If a competitorproduces less than its own franchise demands. they have a big stakein industrypricing. of course. Instead.4 If marketing expenditures entail significant fixed costs-space in national media. If this manufacturer is small-if it has limited capacity-the price penalty will be less important to it than if it is big. it usually pays an industry not to produce up to the perfectly competitive level. They use it to refer to the battle for brand franchise.industriesin which the companies that own the marginal capacityhave little incentive not to use it. in an industrywith high fixed marketingcosts." one company's franchise gain is another's loss. Some industrieshave fixed costs of production. When competitortypes are large.Tryingto extrapolatethat experience to the kind of modern industries discussed here may lead to confusion between the two meanings of "competition"with consequences that are disappointing or even perverse. a low second-hand value. however.) When the level of rivalry is high enough. they decide whether or not to use it.(Because marginal producers will increase their output when a low-cost competitor reduces its output.the competitionbenefitsat the expense of the competitor.) Entryinto the battle for franchiseis obviously daunting. So. entry requires only some plant with a high unit variable cost of producing and. The word "competition" has a different meaning for marketing strategists than its meaning for economists or accountants. the net reduction in industry output a competitor can achieveis never more thanhalf its gross reduction. which weakens the competitor's ability to defend its franchise. But for a producer type. Unless demand is perfectly price elastic. behaving more like the economist's ideal. hence. development of new products good enough to justify the ads-it 32 does not pay a company to have a franchiseunless it is a big franchise. producertypes tend to be small comparedwith competitortypes.So. ?Association for Investment Management and Research .low productioncosts and big franchises tend to go together. And if the industry requires low-cost capacity to defend a franchise. however. it takes more money than the brand itself can generate. and Rosenbergfor pointingout a logicalflawin theoriginal draft of thisarticle. and oil companies-that preoccupied trust busters in the 1890s. generic. even though the decision affects selling prices for all the companies in the industry. (As in "competitive sports.Will they.which discouragesentryinto the battlefor franchise and produces industries in which the low-cost companies are large and the high-cost companiesare small-which is to say. competitors turn to their other financial resources-scarcity rents on their plant capacity. companies often spend hundreds of millions of dollars a year in the battle. At that point. But the only plant capacity with high scarcity rents is capacity with a low variable unit cost of producing. nevertheless. is concerned only with the price penalty on its own output.) A big marketingeffort is needed to defend a big franchise. I wouldliketo thank Thomas Philips Barr K. So. The producer type is critical to the industry's willingness to use its high-cost capacity.Whencompetitorsare low cost.but even those costs are usually small comparedwith the fixed costs of marketing.(Introductionsof new brands into such an industrymay be few and farbetween. they put pressureon competitortypes to become as largeas possible. creative spots for ads good enough to justify the space. Because producer types own that capacity.FinancialAnalysts Journal where marginal cost equals price. are relative. increments in output will lower equilibrium price-penalizing all output and causing marginal revenue to be less than price. High fixed costs may have discouraged entry and competitive pricing in the commodity industries-the railroads. however. So. the economist worries when. which. such industries have two types of companies-competitors who battle for franchise share and producers who do not-and two kinds of entry. their output is distributed as off-brand. or house brand products. they have a big stakein output.
Keep in mind that lawyers make an important distinction between fixed costs and sunk costs (see Appendix A). So. as well as marketing) is the purpose for which the competitor incurs the costs. March/April1999 33 . should we conclude that product development is a cost of production rather than marketing? No because what matters (in analyzing production. Does the competitor develop its new products (or product improvements) in a comer of the factory? Do the key professionals wear laboratory smocks rather than the power suits favored by the company's salesforce? If so. For long-range planning or investment analysis. as well as production. 2. But this choice is not rigidly dictated by the size of its franchise or the scale of its marketing effort. it merely transfers franchise from one competitor to another. the original investor is merely the first of what may ultimately be several owners.TheInvestment Valueof Brand Franchise Appendix A: Sunk Costs versus Fixed Costs Antitrust lawyers have recently discovered the concept of sunk costs. you can sell the investment and recover the cost. for example. we find that product development. investment in capital goods-in productive capacity-is rarely a sunk cost. Typically. like advertising. or an acquiring firm replaces it with its own brand. we know what the purpose of product development is. investment in a brand franchise is almost always a sunk cost: * It has no social value. most capital goods are not as liquid as securities. 3. The sunk cost has value only to the original investor. a useful generalization is possible: Other things being equal. per unit of capacity. and the fixed costs are independent of the scale of the marketingprogram-specifically. Classic examples of fixed marketing costs are the creative costs of an advertising campaign-costs that must be incurred before a single TV spot or page in Newsweek has run. One kind of investment has social value. although you have no guarantee that you can recover the cost (so. it is the costs of marketing. They raise the same kind of uncertainties in a potential buyer's mind that a used car raises. rather than the costs of production.. And when industry demand expectations change. The cost of product development is a marketing cost. the lower the rent on the plant. If you make an investment in a liquid security and change your mind.e. representative or long-term averages of fixed marketing costs are appropriate. On the one hand. * If the owner abandons the brand. A car maker can choose to economize on its manufacturing fixed costs-rearranging the chrome. If the buyer's expectations are sufficiently rosy. you do have a chance to recover it. When we distinguish between competitors. is a cost producers choose not to incur. the higher the unit variable cost of producing in the plant. these fixed costs must be incurred in order for the "variable" costs of marketing to have any value. Sunk costs are gone with no possibility of recovery. is important-in which competitor types as well as producer types are important. or scarcity. competitors' borrowing power does not change proportionately. The value of the plant derives from its economic. Still. that pose the problem. all prior investment in that brand becomes worthless. the competitors with low-cost plants cope more effectively with both marketing wars and marketing peace. So. rather than actually reducing.who do not. Examples are * leasehold improvements. Notes 1. when a competitor introduces a genuinely new model. * investment in a discarded brand. (To be sure. By this test. and so on. and producers. on uncertainty about which plant will be marginal). This rent is the difference between the unit variable cost of producing in that plant and (in a competitive industry) marginal cost-the unit cost of producing in the marginal plant. And the car maker is deferring. On the other hand.) By the same test. A sunk cost is an investment that is certain to be worthless if you change your mind. the absoluterisk is the same for all plants irrespective of the absolute rent. who care about the size of their brand franchise. of sales volume. The lawyers' discovery attests to their recognition of industries in which marketing. These considerations suggest that if sunk costs pose a special problem for new entrants. Development costs must be incurred before the sales force can sell the product. Costs of developing a new product may also be considered part of marketing costs. the investment is risky). 4. the plant still has potential value to other buyers. In particular. Instead. and * abandoned new-product development programs. before advertising can promote it. if the original buyer fails. rent. the size of the sales force. * creative costs of a discarded advertising program. the size of the media buy. and so on. the risk regarding the future rent depends only on the unit cost for the industry's marginal plant (i. its costs. Sunk costs differ from simply making risky investments.
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