Do we have a new Tower of Babel?

Bankers' "acquisition premiums" are "franchise values" to Wall Street.

To accountants and regulators, they are "intangibles" that appear or disappear according to accounting convention.

To Sanford Rose in one of his "Random Thoughts" columns, they are "customer relationships," with no mention of "intangibles." ("Customer relationships" seemingly suggests more respectability than "intangibles.")

All of these terms, which refer to the same underlying business reality, bring to mind the story of the blind men attempting to describe an elephant.

Image Problem

The earliest valuation studies of bank customer relationships actually adopted the term "customer deposit relationships."

As these valuations were mostly to support tax positions, accountants ultimately prevailed with their own "intangibles" terminology.

Relationship valuations thus seemed to represent accounting and tax "gimmickry" - a perception reinforced by Federal Home Loan Bank Board "smoke and mirrors" accounting.

The accounting and tax applications actually are of only secondary importance. Yet bankers regard precisely the same economic phenomena to be of enormous significance in the guise of "customer relationships" and "relationship banking."

We do seem to have some misunderstanding.

A Crucial Observation

Mr. Rose's main point - that the significance of customers and customer relationships lies in their value characteristics - is enormously important.

Much of the value of a banking enterprise is in relationships. Understanding and measuring those values are therefore fundamental to planning and decision-making. Managing those values addresses the "what" and "for whom" dimensions of economic activity, much as business process engineering addresses the "how "dimension.

It is high time we bring relationship values out of the "intangibles" closet.

Costly Indifference

Valuing banking relationships for tax purposes dates back to the 1970s.

The tax authorities require valuation reports, but those reports are normally proprietary and often merely "opinion letters." Bankers often seem unaware even of their existence.

Whatever their purpose, analyses of customer relationship values must rely on the same conceptual foundations. Yet bankers commonly dismiss intangibles valuations as an arcane and irrelevant specialty of tax professionals and a handful of valuation consultants.

Banker indifference detracts from the banking content of these valuations while depriving bankers themselves of an important resource for management decisions.

|Franchise Value'

Valuation consulting also tends to be isolated from investment banking and securities analysis. Generally accepted accounting principles, which exclude most intangibles, constrain most financial analysis.

Investment bankers nevertheless must address the market reality of significant premiums that are common in acquisitions of service enterprises.

"Franchise value" is their recognition that premiums represent earnings beyond those attributable to reported assets and capital. It thus represents what valuation consultants measure more precisely as intangibles.

Basic Considerations

A comprehensive value-based decision framework represents a synthesis of several ideas, including some familiar business fundamentals:

* To attract and retain capital essential to long-term survival, the paramount objective of a corporate enterprise must be to maximize shareholder value

* That objective requires management decision criteria and performance measures that relate directly to shareholder value. Traditional capital budgeting criteria for plant and equipment investment - formulating those decisions in terms of present values of future cash flows - reflect this requirement.

* Any decision affecting future cash flows is an investment decision. Because most management decisions, including those involving customer relationships, are investment decisions, they require application of capital budgeting principles.

* The value of an enterprise always tends toward the net market value of its tangible and intangible assets and liabilities, including customer relationships. Share prices significantly higher than this "true net worth" are a signal to acquire more assets. A converse pattern indicates that new management or asset divestitures would increase shareholder value.

* The net asset value of the enterprise and its dividend value as a going concern must similarly converge. Both represent discounted (present) values of future cash flows. They differ in that the latter includes both the outlays on replacing and perhaps expanding assets and the cash inflows that result from those outlays.

* Concepts and methods for valuing customer relationships have been available for some time. There remains the adoption of familiar statistical techniques to identify the relationships between decision alternatives and relationship value contributions.

* Finally, analyses of customer relationship values require customer information files with levels of sophistication and detail that have become available only in very recent years.

Misleading Yardstick

We are accustomed to enterprise valuations based on ratios of share or acquisition prices to earnings and capital as measured by generally accepted accounting principles.

In services such as banking these measures are particularly misleading, as they record investment in customer relationships as current expense, excluding from recorded assets the capital thus developed.

Corresponding distortions in value conclusions drawn from those measures are unavoidable. They are merely crude approximations, necessitated by deficient measurement standards.

The consequent short-term distortions to share prices are a poor basis for longer-term investment and management decisions.

Nevertheless, earnings eventually converge with cash flows and dividend capacity, and thus with the underlying net asset values.

Basing decisions on relationship value concepts and value contribution analysis is only an incipient trend at the present time. its compelling logic nevertheless suggests growing momentum as competition intensifies.

Without a value-contribution approach to customer relationships, "relationship banking" is mostly a slogan with little substance.

Abandonment of conventional reliance on profit criteria and corresponding performance measures is an essential first step.

Whatever the attributes of generally accepted accounting principles that recommended their use for public financial reporting, they are misleading and potentially pernicious for internal use.

Commenting on the insidious effects, Mr. Rose observed that while 40% to 60% of bank customers are typically unprofitable on the basis of generally accepted accounting principles and that 70% may represent negative value on a present-value basis.

Thus, seemingly "profitable" customers and services may be eroding shareholder value.

The focus on customers is important. Even value-contribution analysis falls short if applied only to services.

Looking More Deeply

The reality is actually more complicated than this observation suggests:

* Many "unprofitable" customers actually contribute value to the enterprise. Initial losses may simply be part of the investment in developing valuable customer relationships. This pattern is common for credit cards and trust services, for example.

Moreover, because of uncertainties, some relationships with negative value contributions are unavoidable byproducts of developing relationship values.

* Many "profitable" customers represent negative value contributions. Loan customers, and particularly those that fail to develop significant balances, are often in this category. The volume of business generated may simply be insufficient to recover prior investment in developing it.

A further complication is that many individual customer relationships require services that contribute value, such as deposits, as well as services that often do not.

Many loans, for example, contribute value to the enterprise only indirectly - by attracting and retaining customers for other services, which contribute value directly.

Yet those same types of loans, perhaps priced differently, may be direct value contributors for other customers.

For the most part banks have scarcely scratched the surface of adapting prices, service offerings, and promotional practices to different customer characteristics.

A "value engineering" decision framework thus involves market research and analysis directed to developing more focused approaches to the marketplace.

More effective and creative use of available customer information makes it possible to increase the value of current customer relationships, both by selling more value-contributing services and by increasing the duration of relationships. It also provides guidance in developing programs to attract new customers.

Moreover, for identical reasons, the value criteria that should guide product, pricing, and marketing decisions should also be the bases for assessing entries into new markets - whether de novo or by acquisition - and for assessing and restructuring current programs and activities.

In the Meantime

Few banking organizations are likely even to consider wholesale adoption of a value-based decision framework, irrespective of the perverse consequences of the alternatives.

With the recent recovery in bank earnings, there may be little apparent urgency for any substantial change.

Therefore, if only for illustration, here are a few more modest applications of value principles:

In mergers, acquisitions, and divestitures. The premium values exchanged in bank mergers and acquisitions consist predominantly of customer relationships. Nevertheless, acquisition analyses and purchase investigations ("due diligence") rarely consider these values directly. A low-quality depositor base may cause more problems in the long run than deficiencies in a loan portfolio.

Disclosing intangible asset values in annual reports. Whatever the skepticism about the usefulness of information reportable under financial accounting standard 107, an important early step in rationalizing decisions is to develop an understanding of the value characteristics of customer relationships.

In Performance assessment of business units and branches. The values suggested by earnings and cash flows should be commensurate with the values of the underlying assets, including particularly the customer relationships. Those values should also be consistent with the value potential of the marketplace.

In identification of customer values. A first step in reformulating product, pricing, and other marketing decisions and strategies is to distinguish between customers who contribute value to the enterprise and those who do not, thus identifying their respective characteristics.

A modest second step is to re-price services or alter service offerings so as to induce customers in the latter group to contribute value or to terminate their relationships.

Banks, like other corporate enterprises, face an investment community that is increasingly cynical about reported financial Performance, commitments to building shareholder values, and management ability to follow through on those commitments.

American enterprise must reverse this if it is to realign itself with modern technologies and international market realities. New information technologies already are undermining much of the traditional business of banking.

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