To better illustrate this point, let’s look at an example.
Competitive Market Dynamics in Theory
In order for us to do so effectively, we must transport ourselves to an alternate universe where we make three small changes to our current economic reality:
- In our imaginary world, the elasticity of demand is zero. In other words, no matter what the price, an equal quantity of goods is demanded by the consuming public.
- Another small change we are going to experience is that demand for any item is infinite.
- Finally, in what may be the biggest leap from reality, customers act completely rationally. If an identical product that was originally offered for $30 is offered by a competitor for $25, customers will immediately and completely switch to the $25 offering – again, given that the product is identical.
As a result of these conditions, it becomes obvious that we can sell an infinite number of any product, provided that we are the lowest cost producer offering the product.
Now, we have firmly established ourselves in this world and have decided to strike out as entrepreneurs. In doing so, we decide to create a T-shirt company where we offer a single white T-shirt. Our T-shirt is of good quality, yet there is nothing proprietary about it. That being said, we sell our T-shirt for $20. Our entire cost of that T-shirt (including production, shipping, salespeople, etc.) is $2. This $2 is the result of a meticulously optimized supply chain, and no one – regardless of their resources, connections, technologies, etc. – can produce at a lower price. Thus, we make $18 profit per T-shirt, and given that demand is infinite, we are quickly en route toward significant riches.
However, when a competitor of ours (we’ll call them “Kim’s Tees”) sees our success, they decide to emulate us. Kim has the same ability to completely maximize their supply chain, and as such, the price to produce the white T-shirt is only $2. Kim’s Tees decides to sell it for $18. They are happy with a $16 profit.
But wait, we decide to counter. We offer our shirt for $15. Kim’s Tees goes to $14, we go to $13, and on and on and on… until eventually one of us winds up offering the shirt for $2.01.
Competitive Market Dynamics in Reality
Now let’s snap back to reality. In the “real world,” two slight changes would occur, although neither of them impacts the point I am trying to make:
- Given that demand is not infinite and there is generally a downward sloping demand curve (more items demanded as price becomes cheaper), there would be a fixed number of white T-shirts purchased at any particular price point (e.g., at a price of $5.00, 1,000 T-shirts will be ordered, but at a price of $4.00, 2,000 shirts will be ordered). The point is not to focus on the steepness of the demand curve, but rather to identify the fact that it exists in the “real world.”
- In the “real world,” economic rents are not the same as profits. Economic rents account for the cost of capital. As such, if the shirt costs $2 to make, but the cost of that capital is an additional $0.20 per shirt (given how risky a shirt-making business is), the price will never fall below $2.20 (or whatever the profit-maximizing point on the supply/demand curve dictates).
If you are sitting there reading this saying to yourself, “this guy Greg is all wrong, there are tons of companies that are able to continually charge a significantly higher price than production on relatively commoditized items,” then you are not wrong.
The most simplistic reason to explain this phenomenon is brand value.
How to Calculate Brand Value?
As such, let’s use a very simplistic definition: Brand value is the value by which an item can be sold above the price that the supply/demand curve dictates.
In terms of measuring brand value, one way would be to identify the margins of individual products and compare them across various brands. If one company is able to extract more profit from the exact same product, we could postulate that the brand is stronger. However, there are many variables that may skew this analysis – and the supply/demand curves may not be exactly the same.
Another way is to look at companies as a whole. If investors are willing to pay more for a dollar of earnings of Company A than Company B – all else being equal – we could argue that the brand of Company A is stronger than that of Company B.
The Importance of the PEG Ratio
Generally, the measure of how much an investor will pay for a dollar of earnings is the Price/Earnings ratio. However, this ratio also incorporates growth expectations about the individual company. As such, we can use the PEG (“Price/Earnings divided by Growth”), which standardizes the expected growth. If the companies are truly offering the same products, we would expect the PEG ratios to be roughly the same (other idiosyncratic factors may impact a stock’s price, which would ultimately impact the PEG, but we would expect them to be roughly the same).
Assessing Brand Valuation in Athletic Apparel and Luxury Goods
To better illustrate this point, let’s look at an assortment of publicly traded athletic brands: Lululemon, Nike, Adidas, Puma, and Under Armour. Given the broad similarities and fungibility of product offerings, we wouldn’t expect significant brand value from any of these companies. Someone may pay up for Nike vs. Puma, but at a certain point, running shoes are running shoes, and the brand can only account for so much value. Furthermore, athletic brands create practical products, so people are buying them for function as much as – if not more than – form.
As we can see, our postulation was broadly correct. There is little variation between the PEG ratios of the five companies, with the outliers (Lululemon and Under Armour) both within 0.4 PEG units of the average.
On the other hand, there are companies that are solely selling a brand. People generally understand that there is a significant markup for their products but are willing to pay given the broader implications (social status, “loyalty,” etc.) associated with the brand. These companies are generally referred to as “luxury brands.” To look at these companies, let’s use Hermes, Salvatore Ferragamo, Burberry, and Prada.
Here, we can see there is much greater variation. In fact, the PEG ratio of Hermes is almost 3x of Prada! While the athletic brands were all within a band of +/- 0.4 PEG units from the average, the luxury brands expand to +/- 1.8 PEG units.
Up until this point, we have used the term PEG units without actually understanding what it means on an underlying basis. Given that the PEG ratio is the amount of money paid for a dollar of earnings – assuming equal growth among the participant set, we can determine the impact of a company’s brand value on its overall value.
In doing so, let’s first assign each company the average PEG ratio for the peer set - in this case, 3.1 (assigned as letter “A”) - and multiply it by the company’s estimated growth (“B”). Doing so will get us a “Standardized P/E” (“C”).
|A||x B||= C|
|Peer Set PEG||Estimated Growth (%)||Standardized P/E|
Using this Standardized P/E (“C”) and multiplying it by each company’s estimated earnings (“D”) will give us an “Implied Share Price” (“E”). Remember, this “Implied Share Price” is calculated as if each of these companies has exactly the same “brand value” - in other words, it is “brand value-neutral.”
|C||x D||= E|
|Standardized P/E||Estimated Earnings||Implied Share Price|
|Prada||62.4||HKD 0.82||HKD 50.89|
Now that we have some sense of the “brand-neutral value” share price, we can compare this value with the actual quoted price in the market by subtracting our implied share price (“E”) from the current market share price (“F”). Doing so gives us the currency value of the premium or discount by which the publicly traded share differs from the “brand-neutral value” (“G”).
|F||- E||= G|
|Current Market Share Price||Implied Share Price||Premium/Discount per Share|
|Prada||HKD 28.45||HKD 50.89||(HKD 22.44)|
Finally, by taking this currency premium or discount (“G”) and multiplying it by the total number of shares outstanding (“H”), we can estimate the theoretical difference of the company’s actual brand as compared to its brand-neutral valuation (“I” - presented in both local currency and US dollars).
|G||x H||= I|
|Premium/Discount per Share||Shares Outstanding (millions)||Theoretical Brand Value (millions)|
|Prada||(HKD 22.44)||2,558.8||(HKD 57,427)||($7,335)|
Now, this is not to say that Prada has a brand valuation of negative $7.3 billion. However, given the difference in brand values vs. the brand-neutral value can infer that were Prada considered an “average brand” as compared to this peer set, the company would experience an increase in market capitalization of $7.3 billion – as we are adjusting for absolute sales numbers and estimated growth. Similarly, we can say that Hermes may have an additional $27.5 billion of value solely due to its brand.
Just as we were able to complete this analysis for our luxury brand peer set, we can also look at the athletic brands. Rather than duplicating the full methodology, please see the results below:
|Theoretical Brand Value (millions)|
As discussed above, we would expect these numbers to be smaller than those of the luxury brands, given the fungibility of athletic products and the greater elasticity of demand for athletic products, relative to luxury products. Even Nike, which notionally has very high brand value, is somewhat misleading given its massive size (Nike has an enterprise value of $154.3 billion). In relation to its enterprise value, the brand only represents ~5.0%.
Refining the Analysis
Obviously, there are significant issues with this analysis, and we are ignoring a number of issues that would impact the value of a company: systemic and idiosyncratic factors in the operational and/or financial elements. For example, a particular stock price could be impacted by technical factors such as a Relative Strength Index, which could identify shares as either overbought or oversold. Likewise, a company may suffer a supply chain disruption, land a big contract, or have some other operational development that impacts its share price. While these occurrences should flow through to the estimated growth and price/earnings ratio of a company, the market may not be fully informationally efficient. While it takes time for information to spread and be interpreted by the market, certain PEG ratio trends may be exacerbated.
That being said, even if we can not exactly quantify the dollar value of a brand, we could use relative PEG ratios over time to analyze the relative strength of brands over time.
When doing this analysis for the previously discussed athletic brands, we can see that Puma has always been at the bottom of the pack, while Lululemon and Nike have maintained relatively strong positions. Under Armour has experienced significant volatility in its PEG ratio (up to 7.8x), such that it exceeded the bounds of the chart at times. Finally, Adidas has steadily improved its perception (based on its relative position to Nike, rather than the general upward trend, which is most likely reflective of rising P/E ratios in the industry overall) and is now considered on par with Lululemon and Nike.
This analysis was a complicated way to approximate a value which manifests itself in many different ways. We haven’t even discussed the circular nature of the hypothesis – if a brand is stronger, it should be reflected in a higher growth rate which would lower its PEG ratio.
That being said, rather than being a definitive answer, hopefully, it will spur further thoughts about the value of a company’s brand.
As some real-life “context” to the athletic brand analysis, in the fall of 2019, a highly publicized lawsuit involving New Balance, Nike, and Liverpool Football Club was concluded. The case shed light on the nuances of how brand valuation is perceived through the raw commercial terms (in this case, retail reach and clout) that aren’t immediately obvious when perusing the financial ratios of a company.
How Does Technology Build Brand Valuation?
As more and more products are being sold direct to consumers, and technology gives firms greater control of their branding, the ability to generate positive brand value is essential for firms of any size.
In a future post, I will discuss ways and thoughts that startups and early-stage businesses can approach building brands, and using that value to raise capital.
Understanding the basics
Brand value is the value by which an item can be sold above the price that the supply/demand curve dictates.
We can use the PEG ratio (price/earnings divided by growth), which standardizes the expected growth, to determine how much investors will pay for a dollar of earnings. If two companies are offering relatively similar products, a difference in the PEG ratio will ultimately highlight differences in brand value.