Financial assessment of brand extensions Received (in revised form): 7th February, 2006
HENRIK SJÖDIN is a PhD candidate in marketing at the Stockholm School of Economics. His research deals with brands and business development, with particular attention to brand extension.
Keywords
Abstract
brand extension; financial evaluation; shareholder value analysis
The possibility to assess brand strategies based on their financial consequences is attractive to managers and researchers alike. This conceptual article discusses financial assessment of brand extension proposals within companies. An integrated framework synthesises key questions and arguments in theoretically informed valuation, in order to support managerial decision-making. It highlights the link between brand equity considerations and financial evaluation, to acknowledge the role of brand extension as an investment in business development. The ideal role of financial assessment in the practice and research of brand extension is discussed.
Journal of Brand Management (2007) 14, 223–231. doi:10.1057/palgrave.bm.2550063
INTRODUCTION
Henrik Sjödin Center for Consumer Marketing, Stockholm School of Economics, Box 6501, 113 83 Stockholm, Sweden Tel: + 46 8 736 95 62 E-mail:
[email protected]
Academia, trade press, and businesses are more concerned with examining and substantiating the link between marketing action and business performance than ever.1,2 The calls for marketing accountability and productivity also affect roles and practices within firms. Increasingly, marketing proposals and viewpoints need to be argued through the terminology and criteria used by top management when making general investments decisions.3,4 Recent contributions to the literature have urged marketing proponents to develop their proficiency in analysing and communicating how their initiatives relate to the financial performance of the firm.5,6 Attending to the marketing-finance interface can contribute ‘toward raising marketing’s vitality in the firm and, more important, toward raising the performance of the firm itself ’.7 This paper seeks to address issues involved with assessing the financial consequences for a specific but prevalent element in many marketing strategies: brand extension.
For many companies, brand extension is a crucial part of their marketing strategies, as it can help them sustain and develop their capacity to meet consumer desires. It can help brands stay relevant and create new business. This strategy of associating familiar and appealing brand names with new products is a popular topic of academic research.The literature on brand extension offers numerous insights on how consumers cognitively process and evaluate products that are introduced through this practice. This paper takes a different perspective on brand extensions: financial assessment of brand extension proposals within firms. It draws attention to how organisations can benefit from financial evaluation in developing and analysing such proposals. Specifically, the paper (1) integrates considerations for theoretically informed valuation of brand extensions into a unified framework, and (2) discusses the ideal role of financial assessment in organisational decisionmaking on brand extension. The framework and the discussion should inform
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brand management practice, as well as generate new research opportunities.
BRAND EXTENSIONS Introducing new products is both risky and expensive, particularly so without the help of established brands.The efforts required to build consumer awareness and associations from the ground up can be considerable. For this reason, companies are eager to capitalise on brands that already draw favourable attention from consumers.8–10 Brand extension, or ‘when a firm uses an established brand name to introduce a new product’,11 is one of the most important strategies to this end. Leveraging established brands can facilitate the introduction of new products both in product categories already served by the company and in new product categories. (Sometimes, the situations are distinguished by labelling the first ‘line extension’, while reserving ‘brand extension’ for the second. In this paper, brand extension refers to both.) For example, Procter & Gamble applies its Vicks brand to different varieties of cough drops, as well as to nasal congestion relief products, vitamin C supplements, baby rub, air humidifiers, digital thermometers, and still other products.The L’Oreal brand covers all sorts of skin care, hair care, hair colouring, hair styling and cosmetics products. Brand extension has emerged as a prevalent strategy for business development because of the financial and strategic value of prominent brands: The realization that brands are the true capital of the company has led to this revolution. By capitalizing on a few brands, companies had [sic] to sustain their equity by nurturing them through constant innovations and line or range extensions. Therefore, the question ‘what name do we choose?’ becomes ‘which new product should we put under which already existing brand?’12
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The key role of brands in business development motivates a managerial desire for knowledge on opportunities and risks in brand extension. In some respects, the academic research literature constitutes a respectable source for such knowledge. As literature reviews by Czellar,13 Grime, Diamantopoulos, and Smith,14 and Hem, de Chernatony, and Iversen15 testify, most research has been carried out towards understanding the factors that determine whether consumers form positive or negative attitudes towards products that are introduced through brand extension. The most significant conclusion from this line of work is that consumers accept brand extensions from well-liked brands, provided that the new product has a good ‘fit’ with the brand. Researchers have also sought to determine the consequences that extensions may have for consumer perceptions of the brand. In particular, attention has been devoted to the risk for dilution or damage to the perceptual equity of the brand.16 The brand extension literature provides managers and researchers with many valuable tools for explaining consumer evaluations. However, there is less support for those who wish to assess financial consequences and understand brand extension as an investment in business development.
THE RELEVANCE FOR FINANCIAL PERSPECTIVES Recent years have seen financial assessments advanced as a pertinent topic for both marketing scholars and practitioners.17,18 On the scholarly side, researchers have been encouraged to explore and explain how brands and marketing contribute to the long-term cash flow for companies and their share-
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holders.19 As a case in point, consider the research priorities established by the Marketing Science Institute to pro-mote investigations with particularly high potential to be relevant for businesses. The priorities guide funding decisions and are often referred to by academic researchers. One of the top tier priorities for 2004– 2006 is research on ‘assessing the impact of marketing programs on financial metrics’, and another calls for initiatives that provide guidance on ‘managing marketing as a “value-creator” versus an expense’.20 Apparently, the academic interest parallels a business practice where more and more marketers are held accountable for the financial impact of their decisions. Increasingly, marketing decisions must be defensible in the creation of long-term economic value. It has also been argued that the strategic influence of marketing in companies has been circumscribed due to the inability to relate marketing activities to shareholder value: Modern marketing’s reluctance to fully incorporate current financial valuation techniques and, thus, properly quantify its contribution to financial market performance has made it a bystander in many boardrooms. The criteria used by marketing for judging the true financial success of a marketing strategy, or comparing strategic alternatives, remain incomplete and inadequate (cf. Day and Wensley, 1988).21 This, in turn, means it is difficult to accept marketing recommendations on product policy, pricing, promotions, or, indeed, any aspect of the marketing function.22
The emerging picture seems to be that marketing professionals can gain from better knowledge of assessments of financial consequences, particularly shareholder value. Lukas et al.23 list five concrete benefits for marketers who adopt this viewpoint, in claiming that a shareholder value approach:
1. Helps marketing properly define its objectives 2. Provides the language for integrating marketing more effectively with the other functions of the business 3. Allows marketing to demonstrate the importance of its assets 4. Protects marketing budgets from profitmaximization policies 5. Puts marketing in a pivotal role in the strategy formulation process
Thus, brand managers are challenged to put themselves in the shoes of financial analysts in order to develop strategies that survive the intensified scrutiny of top management and company boards. With great potential impact on market-based assets24 such as customer–brand relationships, brand extension is certainly an activity that can deserve such scrutiny. The cash-flow consequences of successful initiatives, such as the extension of the Apple brand into portable music players, or failures, such as the extension of the Levi’s brand into tailored suits, can be considerable. To gain support within the firm and to secure approval from top management, marketing professionals accordingly need to establish the economic soundness of brand extension proposals. Case studies have indicated that financial evaluations become important quite late in the decision-making process.25,26 A good valuation framework should hence be easily appreciated in these final stages. However, it can be a useful tool for analysis, planning, and communication throughout the decision process. Intra-organisational discussions might benefit if brand equity criteria and financial estimates early on can be considered in conjunction rather than as two disconnected sets of estimates.27,28 This should establish brand extensions as strategic investments in business development and promote cross-functional attentiveness to
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their financial repercussions.The following sections deal with how brand extensions can be evaluated to bring together financial and brand equity considerations.
THEORETICALLY INFORMED VALUATION OF BRAND EXTENSIONS Shareholder value has been advanced as the most conceptually appropriate yardstick for evaluating investment proposals within the firm.29,30 There are a number of specific approaches to measuring shareholder value. These approaches exist in a competitive landscape and particular techniques are open to criticism from opponents.31 However, when viewed from a conceptual level, much of the controversy disappears. From this general perspective, a brand extension (or any other marketing activity) can be said to create shareholder value if it creates a future cash flow.32 This requires the product introduced through brand extension to generate sales in excess of its costs, including the cost of capital. The surplus cash in coming years is discounted to reflect that money today is worth more than money in the future. Lane and Jacobson33 suggest that a brand extension impacts future cash flow as follows:
t =1
A t + R t + BE, t (1 + r) t
) – (∑ C + D + X + B ) 8
8
(∑
t =1
t
t
t
N, t
(1 + r) t
In this model, ‘r is the discount rate, At represents the savings in advertising and other marketing costs required to establish and maintain brand image, Rt represents the increase in revenues generated in the extension market because of the use of the brand name, BE,t represents the gains from brand image enhancement, Ct represents the lost returns from additional product cannibalism of the core product(s), Dt represents the lost earnings in core 226
markets from brand image dilution, Xt represents the lost earnings in all product markets from brand franchise destruction that follows product mishaps, and BN,t represents the lost earnings from not building a new brand image’.34 The model reflects core notions in the cognitively based literature on brand extension.35–37 For instance, value is created not only by direct revenue from the new product, but potentially also by boosting the recognition and favourability of the brand, and the communication efficiencies that would follow. On the other hand, value might be destroyed if consumers buy less of existing products from the brand (ie, cannibalism), or if they become less inclined to rely on the brand because the extension has confused or diluted the meaning of the brand. One problem with the model is that the signs of the effects might sometimes be reversed, which the labels suggested by Lane and Jacobson do not seem to admit.38 For instance, cannibalism is not the only possible outcome of a brand extension, because a product introduction (eg,Apple’s iPod) can bring new consumers who get interested also in existing products (eg, Apple computers), thus increasing rather than decreasing future cash flows.39 Another problem is that the value of a marketing initiative is influenced not only by the level of cash flows, but also by the sustainability, timing, and risk associated with these cash flows.40,41 Lane and Jacobson42 do not discuss these three distinct influences in any depth. The issue of sustainability refers to for how many ‘t’s’ a brand extension can realistically be expected to influence cash flows. This has a direct bearing on fundamental strategic questions of how well the company can serve consumers and ward off competition in the long run. The dynamics of a brand extension can make
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sustainability judgments quite complex. For instance, ‘me-too’ brand extensions aimed at exploiting potentially short-lived trends may not yield very sustainable revenues. On the other hand, unfortunate brand owners may see negative image effects linger. Incorporating such conflicting effects into a sustainability assessment is not trivial. As for timing, shareholder value is increased when cash flows are generated sooner or more rapidly than they otherwise would be. For a brand extension then, an important question is how fast the new product becomes accepted by retailers and consumers. Consequently, the shareholder value should be higher when strong brands are extended into easily accepted territories, than when weaker brands are extended into product categories that customers feel do not fit the brand. Even though advertising and other supporting marketing activities may eventually convince customers even of ‘difficult’ brand extensions, products that need more time to win minds and hearts are less valuable from a shareholder value perspective. Similarly, the timing factor entails that managers may find higher introductory expenses acceptable if they accelerate purchases and word-of-mouth recommendation. Assessing the overall impact on shareholder value requires considerable trade-off and forecasting skills. The third value driver is the risk, or the volatility and vulnerability, associated with the future cash flows.43 As the risk determines the rate used to discount the cash flows, shareholder value is higher when these are predictable and stable. It is important to note that the relevant risk is that of the particular project (ie, brand extension), rather than that of the company as a whole.44 Srivastava et al.45 promote customer satisfaction, loyalty, and retention as keys to risk reduction. Extensions that strengthen existing emotional or
structural ties between consumers and the brand should also be more valuable than more disconnected ventures. In sum, the cash-flow approach to assessing shareholder value effectively directs managerial and scholarly interest to components that contribute to the long-term economic success of a brand extension. The model specified by Lane and Jacobson46 provides a starting point for marketing decisions towards increasing the impact of revenue factors and reducing the impact of cost factors. However, financial assessments are incomplete unless they also consider sustainability, timing, and risk issues, as argued above.
Additional insights from real options theory Cash flow approaches to valuation suffer from a general limitation, very relevant to brand extension: they assume that the project being valued carries the same risk over its entire life.47 This is hardly a very realistic assumption for brand extensions. Companies often have the opportunity to invest only a modest amount of resources to develop and evaluate new product concepts before they commit heavily. If early indications are unfavourable, the project can be aborted; if things look good, investments can be scaled up. The conditional character of a brand extension situation cannot be handled well by a discounted cash flow approach.48 Instead, assessments should draw more on real options theory to capture the consequences of managerial flexibility more appropriately.49 Laying out the details of this approach is outside the scope of this paper, but its basic benefit is that it acknowledges that managers might defer some investment decisions until the nature of demand and other variables are better known.50–52 At this later point in time,
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managers have the choice—the option— to expand, or to abandon or further defer the project. Dias and Ryals53 give the example of a brand extension that requires an upfront investment in advertising for the parent brand. If the campaign is successful and research shows the extension to be a good idea, the company can then go ahead and make further investments towards the introduction of the new product. If the outlook is less positive, the company may have to settle for the incremental sales gained from advertising the parent brand. As the final decision can be deferred, the downside is limited but the upside can still be pursued. A real options approach captures this situation, which the traditional valuation approach cannot. The greater uncertainty about the future, the more seriously will a simple cash flow approach underestimate the value of flexibility.54 The relevance of real options thinking might be even higher than previously recognised. For instance, Dias and Ryals55 do not bring forward the important potential of brand extension to drive business development in itself. One brand extension can often serve as a bridge to another, sequential, brand extension.56 In other words, a first brand extension can carry an option to invest in a potentially profitable second venture, by serving as a springboard. This option may not have been available without the first investment. Indeed, a documented determinant for the success of a line extension is a history of earlier extensions.57 To the extent that companies are increasingly attracted to this springboard scenario, financial assessments should incorporate this consideration.
Integrating the literature The overarching purpose of this paper is to discuss financial assessments of brand
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extension. To this end, fundamental principles for theoretically informed valuation of extensions have been presented. According to finance theory, the principles underlying shareholder value analysis should inform rational investment decisions.58 Brand extensions, as other business projects, should be assessed based on the net present value of their projected future cash flows. Simple approaches for calculating this value may not suffice, so the application of real options theory may be needed to capture the value of decisionmaking flexibility in an uncertain future. Table 1 builds on these principles and draws together considerations into an integrated framework, previously missing from the brand extension literature (Table 1).
DISCUSSION The integrated framework put forward in this paper makes an original contribution to the literature on brand extension by drawing together relevant work and supplying more detail on financial evaluation than previously offered.Yet, it is still more an outline than an elaborately sophisticated model.While the framework should benefit managers and academics by serving as a checklist, it simultaneously accords emphasis to the difficulty involved in taking the step from a summary of main components to a detailed analysis of specifics in a particular case. No matter how sophisticated a general framework gets, it will still require considerable professional judgment when used to assess the financial consequences of a particular brand extension. Undoubtedly, there are challenges involved with financial evaluation of brand extensions, as has been mentioned several times throughout the paper. For instance, it can be difficult to get reliable input data, especially in early stages of evaluation. In
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Table 1
Questions and responses towards financial assessment of a brand extension
Valuator questions and recommended responses
Sample situation increasing cash flows
Sample situation decreasing cash flows
Addressing widespread consumer needs Expanding customer base Promotional efficiencies Better advertising response Image boost enabling higher price premium Better utilization of resources Expanding brand territory Avoiding expensive brand development
Insufficient demand for new product
2. What is the sustainability of future cash flows? — Analyze the competitive situation and the longevity of effects
Addressing basic consumer needs in unique way
Me-too product, responding to short-lived trend
3. What is the timing of future cash flows? — Analyze how quickly and how fast cash flows will accumulate
Consumers require time to accept extension
Extension is quickly understood and accepted
4. What is the risk associated with future cash flows? — Analyze the vulnerability and volatility of cash flows for the project
Ties with existing customers are strengthened
Extension is geared at new segments
5. Can some decisions/investments be deferred? — Analyze the value of flexibility, using a real options approach
Breakthroughs in company capabilities Future extensions made possible
N/A
1. What are the components that increase or decrease future cash flows? — Analyze all direct and indirect changes in cash flow, including: — Net revenues from new product — Changes in demand for existing products — Changes in marketing costs — Changes in pricing — Changes in production/operations costs — Changes in ability to launch future brand extensions — (Alternative impact of building a new brand
fact, the difficulty to cover and predict all the contingencies of feedback effects, cannibalism, and more, means that the perfect assessment of shareholder value will remain an ideal. However, there are a number of reasons why a financial evaluation framework can benefit brand extension decision processes, despite challenges. Connecting brand equity and financial considerations establishes important common ground between internal stakeholders. Several authors argue that a main benefit of shareholder value analysis is that it can equip marketers with vocabulary and arguments appropriate for discussions with top management and company boards.59,60
Cannibalism Heavy support required for new product Increased exposure for adverse publicity spillover Undermining premium positioning Increased logistic complexity Increased skepticism due to failure Missed opportunity to build new franchise)
It may give marketing proponents more clout in decision processes and it certainly forces them to be clear about how new initiatives contribute to business performance. More fundamentally, it invites a broad view on brand extensions, where branding implications are assessed alongside the fundamental attractiveness of the investment in terms of traditional issues of costs and competitiveness. This approach reveals the strategic nature of brand extensions and highlights their potential influence on the financial health of companies. Accordingly, it is one response to calls for ‘reinsertion of brand extension into the context of corporate strategy’.61
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All this should require reasonable working models that support practical decisionmaking,rather than all-inclusive but unwieldy or impenetrable constructions. Towards this end, a key benefit is that the evaluation framework facilitates project analysis.62 In other words, it can help expose unknowns and identify variables and interactions that determine the wisdom of a project, overall as an economic investment. Perfect data will seldom be readily available, but estimates can be adequate. Uncertainty can be addressed by building scenarios, allowing both optimistic and pessimistic estimates. If it is impossible to generate meaningful input, this should perhaps be seen as a signal in itself— of highly uncertain prospects for the suggested brand extension. Sometimes, marketers fear that formal evaluation procedures hinder innovation.63,64 Creative and original initiatives might spring easier from gut feeling than painstaking forecasts. Indeed, careless use of shareholder value analysis could favour incremental, seemingly safe, but uninspiring extensions, if it is easier to obtain supporting data for them. Sensible application implies taking financial assessments for what they should be in this context: opportunities to explore the odds of success and ways to stack them in your favour. Neither the necessity of vision nor the value of good judgment will disappear. The critical issues seem to be whether the limitations of shareholder value analysis are understood and whether the analysis is used as one of several inputs to brand extension decisions. The underlying judgments that determine the numbers that are fed into the model should keep centre stage: Value ultimately is created by actions that enhance and sustain the competitive advantage of the business in the markets it elects to serve. No method of resource allocation can be allowed to distract managers from this reality.65
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RESEARCH OPPORTUNITIES The existing literature on brand extension development processes is still limited.66–69 Accordingly, there are ample opportunities for further work on the relationships between decision criteria, including financial assessments, and business performance. Furthermore, the impact of brand extensions on actual cash flows or company values is not fully charted by research. For instance, whether investors value the same properties that academic studies have found to be important for consumer evaluations largely remains an open question. Pioneering research by Lane and Jacobson70 illustrates one approach towards this end, as they considered stock market reactions to brand extension announcements.Work along these lines can address our limited understanding of the mechanisms behind investor reactions to marketing initiatives in general.71 References (1) Rust, R. T., Ambler, T., Carpenter, G. S., Kumar, V. and Srivastava, R. K. (2004) ‘Measuring marketing productivity: Current knowledge and future directions’, Journal of Marketing,Vol. 68, No. 4, pp. 76–89. (2) Uncles, M. (2005) ‘Marketing metrics: A can of worms or the path to enlightenment?’ Journal of Brand Management, Vol. 12, No. 6, pp. 412–418. (3) Day, G. and Fahey, L. (1988) ‘Valuing market strategies’, Journal of Marketing,Vol. 52, No. 3, pp. 45–57. (4) Lukas, B. A., Whitwell, G. J. and Doyle, P. (2005) ‘How can a shareholder value approach improve marketing’s strategic influence?’ Journal of Business Research, Vol. 58, No. 4, pp. 414–422. (5) Lukas, et al., ref. 4 above. (6) Uncles, ref. 2 above. (7) Rust, et al., ref 1 above, p. 76. (8) Aaker, D. A. and Keller, K. L. (1990) ‘Consumer evaluations of brand extensions’, Journal of Marketing, Vol. 54, No. 1, pp. 27–41. (9) Blichfeldt, B. S. (2005) ‘On the development of brand and line extensions’, Journal of Brand Management, Vol. 12, No. 3, pp. 177–190. (10) Kapferer, J. -N. (2004) ‘The New Strategic Brand Management’, 3rd edn, Kogan Page, London, UK. (11) Keller, K. L. (2003) ‘Strategic Brand Management’, 2nd edn, Prentice Hall, Upper Saddle River, NJ, p. 577. (12) Kapferer, ref. 10 above, p. 313. (13) Czellar, S. (2003) ‘Consumer attitude toward brand extensions: an integrative model and
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Grime, et al., ref. 14 above. Hem, et al., ref. 15 above. cf.Lane and Jacobson, ref. 33 above. Swaminathan, V., Fox, R. J. and Reddy, S. K. (2001) ‘The impact of brand extension introduction on choice’, Journal of Marketing, Vol. 65, No. 4, pp. 1–15. Day, G. and Fahey, L. (1988) ‘Valuing market strategies’, Journal of Marketing, Vol. 52, No. 3, pp. 45–57. Srivastava, et al., ref. 24 above. Lane and Jacobson, ref. 33 above. Srivastava, et al., ref. 24 above. Brealey, R. A. and Myers, S. C. (1991) ‘Principles of Corporate Finance’, International Edition, McGraw-Hill, New York. Srivastava, et al., ref 24 above. Lane and Jacobson, ref. 33 above. Brealey and Myers, ref. 44 above. Day and Fahey, ref. 3 above. Dias and Ryals, ref. 17 above. Brealey and Myers, ref. 44 above. Dias and Ryals, ref. 17 above. Luehrman, T. A. (1998) ‘Investment opportunities as real options: Getting started on the numbers’, Harvard Business Review, Vol. 76, No. 4, pp. 51–67. Dias and Ryals, ref. 17 above. Ibid. Ibid. Keller, K. L. and Aaker, D. A. (1992) ‘The effects of sequential introduction of brand extensions’, Journal of Marketing Research, Vol. 29, No. 1, pp. 35–50. Reddy, S. K., Holak, S. L. and Bhat, S. (1994) ‘To extend or not to extend: Success determinants of line extensions’, Journal of Marketing Research, Vol. 31, No. 2, pp. 241–260. Brealey and Myers, ref. 44 above. Lukas, et al., ref. 4 above. Srivastava, et al., ref. 24 above. Kapferer, ref. 10 above, p. 235. cf.Brealey and Myers, N, ref. 44 above. cf.Ambler and Styles, ref. 25 above. cf.Dall’Olmo Riley, et al., ref 26 above. Day and Fahey, ref. 3 above, p. 55. Ambler and Styles, ref. 25 above. Blichfeldt, ref. 9 above. Nijssen, E. J. and Agustin, C. (2005) ‘Brand extensions: A manager’s perspective’, Journal of Brand Management, Vol. 13, No. 1, pp. 33–49. Dall’Olmo Riley, et al., ref 26 above. Lane and Jacobson, ref. 33 above. Karrah, J. A. (2004) ‘Does advertising influence investors? Evidence and Research Propositions’, Journal of Current Issues & Research in Advertising, Vol. 26, No. 2, pp. 1–10.
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