The Economy of Brands

The past 25 years have seen the recognition of intangible assets as the main drivers of business and shareholder value. In many businesses brands now account for the majority of shareholder value. This is not only true for the classic consumer goods businesses such as The Coca-Cola Company or Unilever but also for many B2B businesses selling to a professional audience. It is therefore important to understand how the economy of brands works and how it can be exploited to create sustainable value. The purpose of this book is to develop and enhance the understanding of the brand as an economic asset in order to make better business and investment decisions. It looks at the value creation of the brand from all aspects and provides approaches on how to assess and manage the value of brands. The book is written from a practitioners’ perspective and is based on the author’s experience in the practical application of brand value in all relevant areas.

Understanding and measuring the economic value creation of brands requires a clear understanding and definition of what a brand is. The word brand is derived from the old Norse word “brenna” which means to burn. By burning signs onto cattle skin farmers could demonstrate their ownership. Although the initial purpose of branding was to demonstrate the origin of an animal it quickly grew into a means of differentiation. Over time a farmer would establish a certain reputation for the quality of his cattle expressed by the branded mark on the animal.¹ This enabled buyers to quickly assess the quality of the cattle and the price they were willing to pay for it. The information provided by the brand helped to guide the purchase decision. Facilitating choice is probably the most important purpose of branding in commerce. Understanding how the brand guides customer choice is crucial in defining what a brand is and what economic value it creates.

The value of brands materializes in several ways. The most direct and obvious is the sale of products and services to consumers. The combination of the price paid for a product plus the quantity and frequency of purchase creates the sales revenues for a business. This is converted into profits and ultimately shareholder value. The share price of a company is driven by investor’s expectations about the future ability of the business to attract customer revenue and extract profits from these. The value of brands also materializes in mergers and acquisitions, the subsequent balance sheet recognition, licensing, and other financial transactions such as securitizations.

Since brands have become such important business assets there is a need for management to understand and assess their economic value creation. There are three main reasons why management has become interested in the value of brands. The first is to manage and improve the performance of the company selling the branded products and services promoting customer desires to purchase in greater quantities and more frequently. Second, management must know the value of its brands when it is involved in a range of financial transactions including licensing, tax planning, M&A, franchising, financing, and investor communications. Third, the accounting requirements for acquired goodwill and intangible assets, which include brands, need to be met. Most accounting standards require a financial value for an acquired brand in order to capitalize it as an intangible asset on the balance sheet and subject it to annual impairment tests. These demonstrate the need for the financial valuation of the brand so that it can be properly managed and used in financial transactions.

At the time financial markets started recognizing the value of intangible assets and brands marketing academics in the US, in the early-1990s, also attempted to conceptualize the brand as a business asset. The result was the concept of brand equity which capitalized on a financial term to define a marketing concept. The term was made popular by the publications of David Aaker and Kevin Keller. Aaker described brand equity as a “set of assets (and liabilities) linked to a brand’s name and symbol that adds to (or subtracts from) the value provided by a product or service to a firm and/or that firm’s customers.”¹ The main asset categories comprised awareness, loyalty, perceived quality, and other brand specific associations. Despite the use of the term equity, the framework consisted of a combination of market research metrics. Aaker later expanded the framework to include metrics from other models, most notably Y&R’s brand asset evaluator and Interbrand’s brand strength assessment. The resulting measurement framework comprised the following metrics:

The financial community seriously woke up to the importance of intangibles and brands in the 1980s when some large financial transactions were completed on the back of well-established brand portfolios. The leveraged buy out of RJR Nabisco, a US consumer goods business with a diverse portfolio of tobacco and food brands, by KKR, a leading US based leveraged buyout firm, for US$31 billion in 1989 was a landmark transaction based on the steady cash flows of the target company’s brand portfolio. It remained the largest leverage buy-out until November 2006 when the same group joined the US$33 billion buyout of US hospital chain HCA.¹ Also, in the 1980s a number of significant M&A transactions emerged involving companies with strong brands such as Nestlé buying Rowntree for UK£2.8 billion (five times its book value) and Philip Morris acquiring Kraft General Foods for US$12.9 billion (six times its book value) with about 90 percent of the value represented by the company’s brand portfolio.² These transactions did not only show that intangibles such as brands are valuable business assets they also highlighted the increasing value gap between companies’ book and market values. In the 1980s the price to tangible book value of the S&P500 started its long-term ascent.

The purely market research and financially focused methods deliver unsatisfactory results for assessing the economic value of brands because they are either weak on the marketing or financial understanding. As a result, new valuation approaches emerged that integrate financial and marketing analyses into one valuation approach. This is referred to as the “economic use” method. This method values the brand as an integral part of a company and focuses on the added value the brand provides to the underlying business. This approach emerged due to a need to go beyond the mechanics of calculating a financial value to understand and manage the value creation of brands. This requires a detailed understanding and valuation of the specific value creation of a brand. There are several consulting firms that have developed their version of the economic use approach including Interbrand, Brand Finance, and Millward Brown.

Out of current brand valuation theory and practice, some consensus on brand valuation emerges. This has been distilled into a tested and recommended brand valuation framework and will be described. The review of the different approaches to brand valuation demonstrates that the approach needs to integrate marketing and financial analyses without sacrificing one to the other. In line with corporate finance theory, as well as capital market and industry practice, the main valuation approach should be a NPV of future expected brand earnings. The valuation approach needs to focus on the specific value creation of the brand to be assessed. The use of comparables including royalties, as well as transactions, should be confined to cross-check analyses and not constitute the main approach. Cost approaches are only appropriate in situations where the brand has not yet been used, or has had no measurable impact on the market. This section develops, out of empirical experience and the review of the currently used methods, a best-practice approach to brand valuation. The recommended valuation approach should comprise five key steps as shown in Figure 7.1.

The debate about the value of brands became the driver for the recognition of intangible assets on balance sheets around the world. In 1988, Rank Hovis McDougall (RHM), a leading British food group listed on the London stock exchange, recorded its non-acquired brands as intangible assets on its balance sheet in a defense against a hostile bid by Australian takeover specialist Goodman Fielder Wattie (GFW). The bid came at a time when value focused investment vehicles exploited the value gap created by the relatively low market values of many companies with strong brands. For example, in 1986 the Hanson Trust had acquired Imperial Group for UK£2.3 billion. It then sold the group’s undervalued food portfolio for UK£2.1 billion and retained a highly cash generative tobacco business which net acquisition costs were just about UK£200 million for a business that generated an operating profit of UK£74 million.¹

The asset value of brands is increasingly used to raise debt financing for a wide range of financial transactions. A key tool for this purpose is securitization. This is a structured financial process that involves the repackaging of cash-flow-producing assets into securities, which are then sold to investors. The securitization of intangible assets such as brands has evolved into an established corporate financing tool used to facilitate M&A, stock buy-backs, and risk transference to investors. As companies recognized that intangibles assets constituted a main portion of their corporate wealth their desire to use them like their tangible assets for financing increased. Chapter 2 established that about two-thirds of business value can be attributed to intangible assets. The total asset value of global intellectual property is estimated to be between US$4 trillion and US$7 trillion. In 2008, intellectual property (IP) licensing revenue worldwide exceeded US$500 billion (compared with an estimated US$18 billion for 1990). For example, IBM alone receives between US$ 1.5 billion and US$2 billion in annual licensing revenue. In addition, due to new worldwide accounting standards on the treatment of intangible assets their visibility has increased significantly.¹

Due to their substantial contribution to shareholder value brands have a significant role in most M&A transactions. In the attempt to maximize the proceeds from such transactions buyers and sellers will look at the value of brand assets to see whether it can benefit their position. Depending on the subject of the transaction this can include an asset specific valuation. There are four key areas in which a brand value assessment can benefit an M&A transaction. First, when a business is mainly driven by a brand then the brand value assessment will provide the core of the business valuation. Second, when only the brand is the subject of a transaction without an underlying business then brand valuation is the only way to assess the transaction value. Third, if the transaction is a merger in which two businesses are expected to be united under one brand then it needs to be assessed which brand would add more value to the combined business. Finally, the acquired brands will need to be valued for inclusion on the balance sheet.

Brand royalties or licenses have become an important source of brand value creation. The size of the global licensing market was estimated to amount to about US$187 billion in 2008.¹ Brand licensing is one of the fastest growing sectors in the licensing industry. Licensing is a contractual agreement in which the owner of a trademark grants permission to a third party for the economic use of the brand. In exchange for granting the rights of a brand to a licensee, the licensor obtains financial remuneration — known as the royalty. On average, royalty payments are between approximately 5 and 15 percent of the wholesale price of each sold product depending on the industry. Luxury and strong consumer brands can command a royalty fee at the higher end. Brands are licensed in categories and markets including: consumer goods; luxury goods; retailing; telecommunications; and many B2B categories.

The value creation of brands lies in their impact on customer purchase decisions. The manifestation of brand value is the economic value that can be derived from current and future purchases of the brand’s products and services. In order to maximize the value generation of a brand it is important to understand the flow from the brand to its impact on customers’ purchase decisions. This flow can be described in a brand value chain. There have been several concepts that have tried to describe and explain the relationship between brand, marketing actions, and financial outcomes. One of the most well-known academic approaches comes from Kevin L. Keller, a professor at Tuck Business School who identified a value chain consisting of four elements: marketing program investments; customer mindset; brand performance; and shareholder value.¹ While Keller’s four building blocks describe the main marketing investments and metrics their interplay remains at a very top-level view. Another value chain concept is the “purchase funnel” and its derivatives which has been made famous by McKinsey but is also used by other consultancies in different variations.² Based on market research studies it starts with the total possible market for the brand and then analyses how many potential customers are lost at each stage of the funnel until the actual customers that buy the brand remain. Over the last couple of years the purchase funnel has been criticized for its strict linear nature. Nevertheless, it is still a widely used tool.

With brands being such important business assets that account for substantial corporate value the question of managing and measuring the investments a company makes into a brand arises. Marketing expenditures for most companies have grown exponentially over the past decade. In several industries, especially consumer goods, marketing represents more than half of total costs of goods sold (COGS). Brands as intangible assets account for between 30 percent and 80 percent of shareholder value. In most companies brands are the single most valuable asset. It is therefore not surprising that the pressure from senior management and the financial community has grown to make marketing and brand investment accountable and align their use of funds to the value-based management agenda. The days when companies accepted the view expressed by Lever Brothers founder Lord Leverhulme (among others) who reputedly said: “I know half my advertising budget is wasted. But I am not sure which half” have passed.¹ In the post-Sarbanes-Oxley world of accountability and the need to boost corporate earnings following the 2008/9 recession, management require quantifiable proof that the resources being spent on marketing can be justified to shareholders. As brand-building requires substantial investments of both time and money companies are looking for a Return on Investment (ROI) framework that optimizes resources in order to achieve maximum value creation for shareholders.

Brands are key corporate assets accounting for a significant portion of shareholder value. In 1987, the price to tangible book value of the Standard & Poor’s 500 Stock Index (S&P 500) exceeded 2 indicating that intangible assets were starting to become more valuable than the asset base reported on companies’ books. This ratio peaked at around 7 during the dotcom frenzy and stabilized after the 2008/9 market crash at 2.7 as of the end of the first half of 2009. The average price to tangible book value of the S&P 500 between 1985 and 2009 is 3.9 indicating that about 74 percent of the average long-term stock market value of all companies (including utilities, real estate, commodity and manufacturing businesses) included in the S&P 500 is generated by intangible assets such as brands, customer base, patents, organizational frameworks, and channel relationships. This is remarkable as the share price represents the NPV of all of the companies’ future expected cash flows.

The various aspects of brand value creation demonstrate that both the business and finance communities acknowledge the economic value of branding. The brand generates and secures a loyal customer base with the related cash flow. The brand enables companies to enter new markets and shift their business focus to adapt to changing market conditions. The brand is one of the few business assets that if properly managed and invested in, can appreciate in value on an on-going basis. The brand is one of the most sustainable assets and can outlive the average corporation. Of the leading global 100 brands about 70 percent have existed for longer than 50 years with most of the younger brands emerging in new categories such as IT and the Internet. It also shows that brands can maintain a leadership position over a sustained period as evidenced by brands such as Coca-Cola, IBM, Gillette, Louis Vuitton, and Goldman Sachs. Brands help companies to outperform rivals on the stock market. Companies with strong brands generate higher returns at a lower risk compared to competitors and market indices.