HeadnoteDoes customer satisfaction

Headnote
Does customer satisfaction really lead to increased firm value? Traditionally, most financial valuation models do not include customer-related metrics such as customer satisfaction in the process. Studies in marketing, on the other hand, have consistently found that customer satisfaction improves the ability to predict future cash flows, long-term financial measures, stock performance, and shareholder value. This research examines the impact that customer satisfaction has on firm value by employing valuation models borrowed directly from the practice of finance. The data used in the analysis is compiled by merging publicly available customer satisfaction data from the ACSI (American Customer Satisfaction Index) with financial data from COMPUSTAT, and Center for Research in Securities Prices between 1996 and 2006. Th e results indicate that a portfolio of stocks consisting of firms with high levels and positive changes in customer satisfaction will outperform lower satisfaction portfolios along with Standard & Poor's 500... Customer satisfaction does matter!
KEYWORDS:
Customer Satisfaction,
Firm Value,
Marketing Metrics
The Role of Customer Satisfaction in Creating Firm Value
The stock market is traditionally seen as the barometer that signals how a company is performing and the promise it holds for the future. But recently U.S. fi rms' earnings have become much less correlated with stock prices. Why has this happened? This phenomenon has been attributed to the failure of analysts to account for intangible assets of a fi rm. While it is easy and relatively simple to estimate the value added of tangible assets such as plant and equipment, intangible assets such as brand names, patents and technological expertise are just more diffi cult to value.
Diffi culty in valuation of intangibles, however is not the sole reason for its exclusion. Why have analysts historically resisted including information about customer satisfaction into fi rm valuation models?
Analysts tend to believe that consumer attitudinal data provides little additional information beyond what is contained in other commonly used data sources to forecast performance. Additionally, a focus on improved customer satisfaction requires a longer-term perspective. Investors, however, tend to be driven by short-term performance. Furthermore, chief executive offi cers (CEOs) are forced to focus on the short-run due to the limited time they have on the job. A recent study of 476 of the world's largest public and private companies found that almost half of all CEOs had held their positions for fewer than three years, with approximately two-thirds holding the position for fewer than fi ve years. CEOs therefore have less time to prove themselves and secure future employment.
Despite this focus on the short-term by managers and investors, there is a growing appreciation that a large part of the market value of fi rms today is attributable to intangible assets. The market-to-book ratio for Fortune 500 companies averages 3.5, suggesting that more than 70 % of the market value of the Fortune 500 fi rms derives from their intangible assets. In fact, the magnitude of intangible assets in today's economy and estimated capitalized value of intangible assets is estimated to be in excess of $6 trillion.
Why is customer satisfaction likely to have a positive impact on a company's value? Well how much does it cost a company when its customers are not happy with the product they just purchased...with the level of service they received...when their questions go unanswered... when their order had to be returned?
The answer is that lowered customer satisfaction ultimately damages the value of a company's most valuable asset: its customers. A great deal of research demonstrates that happy customers tend to be better customers. For example, customer satisfaction has been found to have a positive effect on customer retention, share of spending, increased receptiveness to cross-selling efforts, reduced complaints, and referrals. This in turn translates into increased cash fl ows, reduced cash fl ow variability, and greater buzz about the company.
Data Sources and Approach
To understand the impact of customer satisfaction on fi rm performance, we investigated the relationship between customer satisfaction information and a company's stock performance. We tracked customer satisfaction using a national barometer called the American Customer Satisfaction Index (ACSI), developed by the University of Michigan. This ACSI measures customer satisfaction for 43 industries, and more than 200 companies and federal or local government agencies. These companies are broadly representative of the U.S. economy serving U.S. households. We then appended the monthly stock market returns for each of the publicly traded fi rms in the ACSI sample. The period in this study covers the third quarter of 1996 through the fi rst quarter of 2006 with a total of 151 unique fi rms.
We examine both the absolute level in customer satisfaction and the changes in customer satisfaction over time by forming portfolios of companies based on a company's customer satisfaction performance over time. Specifi cally, we devised a classifi cation scheme for portfolios where each fi rm is allocated into one of the four groups depicted in Figure 1 (Refer to Figure 1).
As new data is released from the ACSI each quarter, fi rms are then reclassifi ed based upon the new information. This resulted in 117 monthly value weighted portfolio returns from December 1996 to August 2006. This large, robust data set offered us the opportunity to investigate the impact that customer satisfaction has on shareholder wealth by examining the monthly series of the four portfolio returns.
Performance Differences Based on Customer Satisfaction
How much is $100 that is invested in a high customer satisfaction portfolio likely to bring in 10 years? A lot! An investment of $100 in Portfolio High at the beginning of December 1996 more than triples to $312 by August 2006. If we compare this to the S&P 500 index, our $100 only grows to $205. And low satisfaction results in a dismal market performance. An investment of $100 in Portfolio Low decreases to $98 by the end of the 10 year investment horizon (See Figure 2).
Does this mean that stocks of fi rms with high customer satisfaction perform better than expected? An analyst might question the results as a function of risk. This is because high risk is associated with higher returns, without necessarily implying abnormal returns.
To address whether customer satisfaction truly creates shareholder value, we turn our focus on excess (or abnormal) returns. This allows us to understand whether the returns generated are indeed due to higher returns rather than accepting high-risk investment strategies. To this end we used three popular valuation models frequently used in fi nance: the Captial Asset Pricing Model (CAPM), the Fama French 3 Factor Model, and the Fama French (Carhart) 4 Factor Model.
CAPM is a very popular (albeit controversial) model in investment markets and project evaluations. It is widely believed that CAPM does not work well, especially in certain situations such as when using cross sectional data. It does, however, tend to have a more positive reputation in models where time series data are used. CAPM predicts a positive linear relation between an asset's expected rate of return and its covariance risk with the market.
More recently the Fama French 3 Factor Model has gained increased popularity. It is a model that is empirically driven (although it is sometimes criticized for being non-theoretical). It is very popular in fi nancial valuation. Fama and French argue that a three-factor model which incorporates size, value, and the market factors can explain almost all pricing anomalies.
The fi nal model used to estimate abnormal portfolio returns is the Fama French (Carhart) 4 Factor Model. In addition to the variables in the Fama French 3 Factor Model, a momentum variable is included as an additional risk factor. This risk factor accounts for the popularity of the stock in the market.
Running these models on the data indicate striking results in terms of the impact of high levels and positive changes in customer satisfaction over time. If one is to invest in Portfolio High, it would bring a clear positive excess return of 0.78 % per month above and beyond the risk factors!
Furthermore, the maximum gains would be achieved by following an investment strategy where one would build a zero net-investment portfolio. This would imply buying stocks in Portfolio High and short selling those in Portfolio Low (High-Low). Based on this investment strategy it is possible to make an average monthly excess return of 0.92 %.
As Figure 3 indicates, monthly abnormal returns for the various portfolios are quite varied with the highest gain from Portfolio High and negative returns from Portfolio Low. The other portfolios are somewhere in between. The results are clearly quite consistent across the 3 different fi nancial models used. When we examine the zero net investment portfolio based on the Fama French (Carhart) 4 Factor Model for example, the results indicates an abnormal return (risk-adjusted) of 0.88 % per month. This is a sizeable gain which adds up to a signifi cant 10.56 % per year even after controlling for risk! The only risk factor that is signifi cant in this portfolio is a momentum effect present in stock returns. Portfolio High tends to have in-favor stocks whereas Portfolio low tends to have stocks that are mostly out-of-favor with investors.
In summary, these results provide strong evidence that high and increasing customer satisfaction leads to abnormally high stock returns, indicating that the stock market is slow to recognize the full extent of the intangible value created (Refer to Figure 3).
What did experts in the area of fi nance have to say? Personal