Chicago Booth Review Podcast Are Customers More Important than Revenue?

Amir Sufi: And think about it, in terms of the dynamic customer relationships, why is a brand valuable? A brand is valuable because somehow, it elicits a response in you that you're willing to pay extra because somehow the brand either makes you feel good- or you think that it represents some kind of quality. But for whatever reason, it really is about getting you to pay more than marginal cost for that good.

Hal Weitzman: Many of us have so many subscriptions that we've lost track of what they all are. Well, companies also increasingly have subscriptions to services such as software and cloud computing. Add up all those customers, and the value they bring to the providers is a significant source of what they're worth. Have economic models caught up to reflect trend?

Welcome to the Chicago Booth Review Podcast, where we bring you ground-breaking academic research in a clear and straightforward way. I'm Hal Weitzman. Today I'm talking with Chicago Booth's Amir Sufi, who's opened up a new area of research into customer capital and how companies develop it. Customer capital, Sufi says, accounts for a lot of the differences in how companies are valued between industries. It might even have overturned what has been a cardinal rule of business, that revenue is more important than acquiring and maintain customers.

Amir Sufi, welcome to the Chicago Booth Review Podcast.

Amir Sufi: Thank you.

Hal Weitzman: We're delighted to have you here to talk about a whole new line of research for you about customer capital and what firms do with it. What is customer capital?

Amir Sufi: The idea of customer capital is the idea that, if we think about where firm value comes from, we often times think, "Well, firms are bringing employees together, they're bringing physical capital, machines, equipment." What we're trying to point out in this paper is that the customer base that a company builds can actually be quite valuable to that company. We think of the efforts to acquire that customer base, to maintain it as a source of value and we call that value customer capital.

Hal Weitzman: Okay. As a non-economist, that seems obvious, that that would be important.

Amir Sufi: Right.

Hal Weitzman: But is it something that other economists haven't really focused on?

Amir Sufi: I think most people, when they're thinking about efforts to win customers, they just think of it as a variable input cost. I have to spend something to get you as a customer, you buy the good. Maybe you buy the good at a price that's actually equal to more or less my marginal cost, so I don't even really make that much off any given customer.

I think what's new here is really thinking about the customer relationship as a dynamic longterm relationship that, if I get you as a customer, I actually get some profits from you for a long time going forward. I think as the economy has moved more toward the types of business models that are more longterm in nature, this concept of customer capital becomes even more important.

Hal Weitzman: That's interesting. The economy has moved more towards, so customer capital is becoming more important over time?

Amir Sufi: Yeah, that's one of the reasons I got super fascinated with this. For example, we know a subscription-based business model-

Hal Weitzman: Right.

Amir Sufi: ... thinking about your subscription to The New York Times. We often times think in terms of our own self, what our subscriptions, but it also is the case that businesses now have a lot of subscriptions with other businesses. Think a software company that's selling to a legal firm. Those have become more and more common over time. That's just one example.

Branding, loyalty, those are also ways of having longer term customer relationships and those are also becoming more common over time as well.

Hal Weitzman: That's interesting. I'm now thinking about my own subscriptions. I have a subscription to an HVAC company, which I'm always meaning to cancel. That increasing part of the business model is tying us into these longer term relationships, then?

Amir Sufi: Yeah, exactly. That HVAC example is actually a perfect example. I'm guessing you pay a pretty substantial fee based on how much you-

Hal Weitzman: I think it's 20 bucks a month, which is a complete waste.

Amir Sufi: Yeah, you probably don't use it that much.

Hal Weitzman: Yeah.

Amir Sufi: Really, the HVAC company, when they get you as a customer, you are now part of the value of that HVAC company because you are paying that $20 every month and they may not actually be servicing your equipment nearly enough to justify it as much. I'm sorry for your HVAC company, I don't mean to tell them they're ripping you off, but maybe they are. I don't know.

Hal Weitzman: They're very good, but they have locked me in. They've got me by the whatevers.

Amir Sufi: Yeah.

Hal Weitzman: This is an increasingly important part of the structure, the way that companies consider their value. Now, they personally consider their value. So I would say a private equity company comes to buy me, my HVAC company, "Well, we've got Hal Weitzman as one of our customers."

Amir Sufi: Absolutely.

Hal Weitzman: And 100 other people.

Amir Sufi: Yeah, absolutely. That's one of the things we're able to show in the research, because when a public company acquires another company, they actually have to show you what exactly are the sources of value that they're getting. In that, they'll list, "Our customer relationships are valuable." Your part of that value. Hal Weitzman is in that customer relationship bin and they're going to tell you, "Here's how much value we get in terms of those future payments that Hal is going to pay us."

Hal Weitzman: I see.

Amir Sufi: That is a source of value.

Hal Weitzman: It's like buying mortgages.

Amir Sufi: Yeah, exactly. There are actually ideas out there right now to try to think about how to borrow directly against the value of those customer relationships. That's something we talk a little bit about in the paper.

Hal Weitzman: In your new line of research about customer capital, you talk about acquiring or maintaining customers and how that should be treated as an investment and not as a cost or an overhead. My question is are companies currently treating it as an overhead, or are they treating it as an investment?

Amir Sufi: Yeah. If you look at, for example, the way accounting is done, investment is usually something that you don't subtract off of your revenues as a cost. You think of investment as something that is dynamic and is building your value.

Hal Weitzman: That would be things like R&D?

Amir Sufi: Exactly, R&D. Even R&D right now is expensed. You think a little bit more about, for example, buying a computer, or investing in a new plant. That will all not be expensed, it won't be directly subtracted off review when you're calculating, for example, your operating income.

In contrast, your efforts to do sales and marketing, the money you spend on your salesforce, on advertising, that is directly expensed from your revenue. It is counted, more or less, by the accountants as a variable input cost, not as an investment. I think for that reason, a lot of the accountants have said some companies are really being under-valued because it looks as if they have low net income or low operating income because they're spending so much on sales and marketing. Especially for really fast-growing software companies who are spending huge amounts on their salesforce, if you look at the way the accounting's done, you may conclude, "Oh, they're not very profitable." But in fact, those are investments that are going to yield huge amounts of revenue in the future, so they may very well be profitable.

Hal Weitzman: That's so interesting, because if you think of the classic examples, the Amazons. The companies that, in the '90s and naughts, that acquired huge numbers of customers but had no revenue.

Amir Sufi: Exactly.

Hal Weitzman: Facebook.

Amir Sufi: Yeah.

Hal Weitzman: Then it turned out to be a good idea to acquire all those customers. They were investing essentially for the longer term, right?

Amir Sufi: Right, exactly. I think that's one of the points we're trying to make. In fact, those companies that you're mentioning are exactly the kinds of companies that are growing over time and importance. They're the ones that have more dynamic longterm customer relationships, and therefore the industries where you're seeing more and more spending on sales and marketing are the most fast-growing parts of the US economy. That's why I want to do more research on them.

Hal Weitzman: Yeah, it's fascinating. Because of course, the gospel was that you can spend a lot of time and energy acquiring customers, but who cares if you have zillions of customers? What you need to have is revenue. But it sounds like actually, that wasn't the case?

Amir Sufi: Yeah, because the customers today that you're acquiring will eventually lead to a lot of revenue. In fact, in the classic model of how to do this customer capital investment, the firms actually offer you a discount upfront. They offer you the discount upfront because they know once they have you hooked into that relationship, they'll be able to jack up the price in the future and get a lot of revenue.

Hal Weitzman: It sounds a bit like the classic banking thing, where the banks give you no interest, but they assume that most customers just don't switch. To a certain extent, depend on inertia?

Amir Sufi: Yeah. In fact, in the banking literature, our paper doesn't really focus on the financial industry, but banking scholars have talked about what they call the deposit franchise. Which is somehow, you're willing to put your money into banks and get a very low interest rate relative to market interest rates. My view is that our findings have that exact implication. That they're advertising, they're drawing you in, they're getting you to start using their payment services. As a result, they can then pay you a low interest rate on your deposits and make money from you, because they take your money and they put it in the market interest rate which is higher. That is a form of customer capital. Now you are part of that deposit franchise.

I think another way of thinking about the deposit franchise is as customer capital. Or as depositor capital. You're basically making money off these depositors.

Hal Weitzman: Apart from accounting, it sounds like it does matter whether you consider acquiring customers an overhead or an investment, because if you're about to be bought, it makes a difference to the value of the company. If you were going to be bought, you want it to be considered an investment, not an overhead.

Amir Sufi: Right, absolutely. That's one of the critical results of the paper. Which is if you actually look how the market values the company, the market gets it right. They understand that your efforts at sales and marketing are valuable, and they're leading to valuable customer relationships. If you look at a company like any subscription-based company, a lot of them are software companies really. You'll see that their enterprise value relative to their physical capital, that ratio is super, super high. You might think that's a mystery. Why is the market valuing a company that has such a little amount of physical capital? The answer is intuitive. It's because that company has a ton of relationships with customers that are super valuable.

That's one of the critical ways in which our research tries to prove that sales and marketing should be considered an investment. That companies that do the most sales and marketing generally have high valuation ratios when you look at enterprise value to physical capital.

Hal Weitzman: This customer capital is a lot of the difference in what you identify as intangible capital between companies between industries. Is that what we used to call goodwill? Is that the same thing, intangible capital?

Amir Sufi: Goodwill is generally the assets that you cannot easily separate from the rest of the value of the company. They're so integral to the company that you can't separate them. In general, part of customer capital will show up in goodwill. But one of the things we show in our research is that, when you sell your company, some of that customer capital is considered a separable asset.

A classic example of this would be a brand. There's a very famous transaction in the past for the company J.Crew. Where J.Crew literally assigned a direct value to the brand J.Crew and treated it as a separable asset. It's an interesting point that sometimes it'll be in goodwill because it's all combined, but these assets sometimes are so valuable that they can be separated.

Another classic example is Toys"R"Us, the brand name. That company was liquidated, but the name brand Toys"R"Us still exists and is still valuable. Those are assets that can ultimately be separable.

Hal Weitzman: It's fascinating because sometimes, those companies, you mentioned Toys"R"Us, and Home Depot being another example, they will sometimes hive off, won't they, their intangible assets. Put them in a separate holding company, and then pay themselves for the use of those intangible assets.

Amir Sufi: The rise in intangibles is really where I started getting interested in this whole area, because it just seems like the US economy is more and more headed towards companies that are valued because of their intangible capital. Most of the previous scholarship had really emphasized things like knowledge capital, organizational capital, but we really wanted to put on the forefront really customer communicate is super important. Things like brands, things like longterm customer relationships. These examples of Toys"R"Us on these brand values, it does add this interesting complication that it makes regulation and thinking about where companies assets are a lot more difficult. That's one of the things that's very interesting about intangible capital.

Hal Weitzman: Is brand also part of customer capital?

Amir Sufi: Absolutely, absolutely. Yeah, absolutely. When you're thinking about advertising, and sales and marketing, one of the things you're doing is building your brand value. We do consider that as one of the main aspects of customer capital.

And think about it, in terms of the dynamic customer relationships, why is a brand valuable? A brand is valuable because somehow, it elicits a response in you that you're willing to continue buying a product at higher than marginal cost. You're willing to pay extra because somehow the brand either makes you feel good or you think that it represents some kind of quality. But for whatever reason, it really is about getting you to pay more than marginal cost for that good.

Hal Weitzman: If you're enjoying this podcast, there's another University of Chicago Podcast Network show that you should check out. It's called Not Another Politics Podcast. Not Another Politics Podcast provides a fresh perspective on the biggest political stories, not through opinions and anecdotes, but through rigorous scholarship, massive datasets, and a deep knowledge of theory. If you want to understand the political science behind the political headlines, then listen to Not Another Politics Podcast, part of the University of Chicago Podcast Network.

Amir Sufi, in the first half we talked about customer capital and that it's part of the value of a company. But of course, you're an economist, so you're into measuring things. How do you measure customer capital?

Amir Sufi: The first way is-

Hal Weitzman: Or investment in customer capital?

Amir Sufi: The first way is the most obvious, just look at the income statement. It turns out that a lot of companies actually break out their broader expenses and have a line item that is sales and marketing expense. We were able to be clever about finding the right data providers that actually break it out. That was a real big jump forward in the project.

The other thing-

Hal Weitzman: Sales and marketing, by definition, is part of customer capital because it's acquiring customers?

Amir Sufi: Absolutely. Well, it's the investment in customer capital. It's the way in which you actually obtain the customers, and therefore leads to the value.

The second thing we did was really leverage these new large language models, AI people are calling them. We used Gemini, Google's Gemini, because firms actually describe in a lot of detail in their SEC filings, their 10Ks, the efforts they're putting forward in sales and marketing. This was a great way for us to really learn what these large languages models can do, what AI can do, and it's remarkably efficient at processing that text. If a company talks about their sales and marketing, says it's about building brand value, it's about getting new customers, it's about employment a salesforce, we can detect all of that using AI. We do it for the full sample, which is 55,000 firm year observations. We could never do it with people. We could, but it would take forever. These AI techniques make it easier.

Hal Weitzman: Okay, excellent. Now you've got these great findings. What are they? What new things did you find out about investment in customer capital?

Amir Sufi: Yeah, the first main thing is this just real striking variation across industries. Some industries, think mining, think upstream manufacturing, they spend almost nothing on sales and marketing, on investing in customer capital. Whereas software, business services, anything in the high-tech area seems to spend a lot. In fact, high-tech manufacturing goods, think about computer and peripheral equipment manufacturers, or medical equipment manufacturers, they spend huge amounts on sales and marketing.

One of the cool things about using the AI with the text is we can figure out why. There, for example, for medical manufacturers, they say things like, "Look, these are really technical products. We have to meet with the customer, we have to explain the product, we have to make sure it works with the customer." You can really see the guts of why this works and why this creates valuable capital.

Hal Weitzman: You find in your research that investment in customer capital is huge. By some measures, spending on sales and marketing exceeds spending on research and development and capital spending. Was that a surprise?

Amir Sufi: That was a surprise that it was as large. I thought it would be higher than R&D. I didn't realize it would be almost as large as general capital expenditures on physical equipment.

I kind of turns a lot of our notions of what firms are doing on its head. We think of a firm opening up a plant, spending money on equipment in the plant, spending money on computers, hiring workers. It turns out, when you look at the amounts they're spending on sales and marketing, they are comparable to the amount they're spending on capital expenditures on physical equipment. When we think about what firms are doing to invest, we really should have sales and marketing, investing in customer capital, way up high on the list.

Hal Weitzman: Okay. You've found a lot of variation though, in whose, that you said. Some of the companies are spending not very much, so you talked a little bit about that. It makes sense that mining companies wouldn't.

Amir Sufi: Yeah, they don't really need to.

Hal Weitzman: I don't know a lot about that industry, but I'm guessing that it's less important than selling sneakers, or whatever. Does that intuition play out across all industries?

Amir Sufi: Yeah. In a lot of ways, what I thought was interesting is that, when I was talking to some of my PhD students about the project, I was saying a lot of the ways we think about firms are stuck in the 1920s, thinking about Henry Ford. Building plants and putting workers together in the right way. That probably still well describes some industries, like mining, and oil and gas exploration, and maybe some upstream manufacturing firms like coal manufacturing or plastics. But it doesn't really describe most of the economy, in terms of we interact with it.

Most of the economy are firms that don't really have a lot of physical capital, but they're hugely emphasizing the importance of getting customers, and winning those customers, and keeping those customers. Those are the industries I think that are the fastest growing parts of the economy.

Hal Weitzman: But do they tend to be more like the B2Cs that are doing it?

Amir Sufi: No, B2B actually. Software ...

Hal Weitzman: Right.

Amir Sufi: There's this whole industry, I don't know if your listeners know this term SaaS industry.

Hal Weitzman: Sure.

Amir Sufi: Software-as-a-service.

Hal Weitzman: Software-as-a-service, right.

Amir Sufi: Right. SaaS companies spend huge amounts on sales and marketing. Business services, so think about H&R Block. How many H&R Block advertisements do we see around this time of year, or Turbotax, to try to get people to sign up for their tax services?

These companies don't have almost physical capital. They have computer equipment, they may have renting some places to have workers. But it's really this customer capital that ends up being most important there.

Hal Weitzman: Now your research is descriptive, you're describing what companies are actually doing. But is there some kind of recommendation there? Should companies be thinking about investing more in customer capital?

Amir Sufi: Well, I think there's a broader question about how useful is any of this from the broad perspective, and that's something that we don't really tackle in this paper. But I think of polar examples.

One example. In fact, some scholars at Booth and other places have been working on the idea that people sign you up for subscriptions and then you forget to cancel, and then you end up paying more than you really want to pay. We don't think of that so socially valuable, about companies just trying to get you to pay for things you don't really need. But on the flip side, the medical technology example I gave where a company's really spending to try to tailor the product to your preferences, to really make the product the best for you, that seems pretty socially valuable and something that we want companies to do.

It's not something that we tackle in this paper, but it's something I want to look forward to working on in the next one.

Hal Weitzman: One does get a general sense that customization is becoming more and more available in all sorts of products, like you say.

Amir Sufi: I think that's partially socially valuable in that if it is customized, you probably do like it better. But at some point, if you're buying toothpaste and there's 100 types of toothpaste, you have the raspberry, at some point, it does seem a little bit silly. Do we really need 100 types of flavored toothpaste?

It's a hard question to know whether this is just about winning new customers, and catching them, and getting them to pay way above marginal cost. Or is it really making the customer better and making the customer happier in what they're buying?

Hal Weitzman: And more connected to the company, it sounds like.

Amir Sufi: Yeah, exactly. That could go either way. Even the subscription-based model, I give you a subscription, but maybe I then have a closer relationship with you and you trust me more that I'll show up when your HVAC system breaks down, they'll actually be there for you.

Hal Weitzman: Coming back to my example. Or, I suppose, just by default, they're the first people you call because you're paying them anyway.

Amir Sufi: Exactly. This is the thing that I want to tease out in the next round of research.

Hal Weitzman: Okay, yeah. Tell us about that. What are you thinking about next with this?

Amir Sufi: Yeah. Next, I think we're going to first try to think about more detail in terms of whether customers are made better off from these relationships. I mentioned we have some scholars at Booth, other scholars at Stanford, have been looking at this idea of subscriptions and seeing that people over-pay for subscriptions. Sometimes you only see people drop their subscriptions when their credit card expires, for example, which is pretty good evidence that they didn't really want the subscription, they just forgot they had it. Trying to push that and see if that's really what driving the patterns in this paper is something we'll probably do in the next version.

Hal Weitzman: Okay. Well, we'll look forward to talking to you more about customer capital. For the moment, Amir Sufi, thank you very much for coming on-

Amir Sufi: Great, thanks.

Hal Weitzman: ... the Chicago Booth Review Podcast.

Amir Sufi: Thanks for the time. I appreciate it.

Hal Weitzman: That's it for this episode of the Chicago Booth Review Podcast, part of the University of Chicago Podcast Network. For more research, analysis, and insights, visit our website at chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research.

This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe and please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening.