December 21, 2007

Brands and Competitive Advantages

Brand names are often linked to the existence of strong competitive advantage in business and in turn command premium valuation. Companies spend billions of dollars to create, promote and sell their brands to consumers. Developing a great brand can be a long and substantial process to gain customers trust and mind share. A company with a recognizable brand can gain significant economic benefits. Products with brand names can outsell their cheaper generic competitors. For example, Coca-cola's market share is far superior to any generic or store bough soda. In fact, Coca-cola is the most valuable brand in the world with a value of $63.4 Billion according to recent BusinessWeek research. Another example, is Advil, which outsells the generic and much cheaper Ibuprofen bottles.

In this post I want to examine the role of brands plays in valuing a business. Does a brand name lead always to competitive advantage? Do brands deserve a premium valuation? Brand names indeed may lead to competitive advantage, but not always. One need to evaluate the industry, pricing points, competing products and consumer usage to determine the brand value in creating sustainable competitive advantage.

There are several cases where brands do not translate into competitive advantages. Here are some cases:

  • Highly competitive industries: You can always bet that industries with too many alternatives of equal quality and product specification, brands do not translate into competitive advantages. Rarely that any company in similar industries has created sustainable advantages over its competitors. Here you can probably think of car brands. One of the most successful and quality cars is the Mercedes Benz, but the brand of Benz did not translate into leading market share or added value to investors as many luxury car makers followed into this segment and took customers away from Benz.
  • Commodity industries: Any firm that invests in branding in a commodity industry will destroy value. No one really cares what brand of plumbing, wires, screws...etc they are buying. You just buy the cheapest one.
  • Typically capital goods items where they are purchased infrequently and require large investment do not have brands with sustainable competitive advantages. Long lasting goods are purchased less frequently, often cost a lot, and you are therefore more likely to take the time to carefully consider your options before purchasing.

When do brands lead to Competitive Advantage?

Branding by itself is not sufficient to create a competitive advantage for a business. A new entrant to the industry with sufficient resources can create an equally competitive brand in terms of quality and reputation. In order for a brand to create sustainable competitive advantage, it has to be coupled with captive consumer behaviour that locks them into buying the same brand over and over. A business needs to be able to convert a product brand into something the customer connect with at many levels by coupling it with one of the following:

  • User Habit: think of a smoker and his preference for Marlboro cigarettes or a Coca-Cola drinker who got accustomed to the taste, Buffett can attest to that as he drink 5 cokes a day. It is very hard or nearly impossible to change consumer habits and behaviour. Products associated with habitual purchases create some of the strongest competitive advantage for a business that exists.
  • Switching costs: customer will be captive to a brand if it has high switching costs associated with changing brands, particularly for low cost and frequently purchased products.
  • Search costs: customer is tied to a specific brand if his search costs for an alternative is too high. Car insurance is a great example. Have you tried to compare quotes between providers? It takes too long and you come up with different policies that you can't you stick with the provider or the brand that you have. Also, brands that are frequently purchased are more likely to lead to strong competitive advantage. A consumer is more likely to be brand loyal with low cost items, since the cost and the effort to research alternatives outweigh the purchase itself, so you stick with what you know.

How to value brands?

I always place a valuation on brands for companies that demonstrate some of the characteristics listed above. Brands in these cases are as or more valuable than fixed assets. There are no rules how to value brands and it is almost a judgment call to the strength of the brands. BusinessWeek does an annual survey for the best 100 global brands that can be a starting place if the company is listed there. If it is not, I usually take the sum of the last 5-7 years of marketing and advertising expenditure and capitalize it on a declining balance, i.e. reduce earlier years expenses by a percentage factor. The sum is added to my valuation on per share basis. This figure will replace whatever goodwill written into the balance sheet as it is more accurate and relevant than book value of merger and acquisition premiums.

Sources: "Competition Demystified" by Bruce Greenwald, Brands-vs-franchise by, "best Global Brands" by Businessweek


augustabound said...

"I usually take the sum of the last 5-7 years of marketing and advertising expenditure and capitalize it on a declining balance, i.e. reduce earlier years expenses by a percentage factor."

What's the factor you use? Is it a simple inflation multiple like 3%?

Thanks and have a great '08!

Sami said...

Hi augustabound,

yes generally I take inflatin rate as a minimum to reduce the figure, I may up it a bit if there is some technological innovation involved as the rate of change in technology is great.

I should have mention that in the post.

Have a great new year!!


augustabound said...

Thanks for the clarification.
I enjoy your blog, keep up the ideas in '08. May the gains be on your side.

Sami said...

Thanks for reading and for the nice comment.

Hope you have a great 2008.