ADVERTISEMENT

In Pricing, What Is the Goal?

January 2020 Pricing

In pricing, what is the goal?  Is it to increase profits, revenue, or some other newfound metric?  It seems profit optimization is the obvious answer. After all, they teach that in freshman economics.  Yet, experience repeatedly demonstrates that improving profits is not necessarily the goal.  Why is that?

Let’s look at corporate financial valuations and their implications for business strategy, CEO focus and the nature of pricing decisions.

The goal of pricing is not always focused on profit optimization

Profit Valuation

While it may seem obvious for businesses to be valued according to their expected return-on-investment (ROI), the are clear challenges in calculating the ROI of future firm earnings.  One might be tempted to use current profitability, or profitability over some time period in the past, and project that into the future to calculate the discounted cash flow.  Indeed, this is the motive behind examining the widely touted Price-to-Earnings (P/E) ratio that clearly identifies the value of the business (price of acquiring a single stock share) to the current earning of the company (profits).

Unfortunately, it is not that simple.  If it were, all companies would have the same P/E ratio and investors would eschew firms with a high price relative to earnings and invest in firms with a low price relative to earnings.

Managers (CEOs in particular) are charged with taking initiative to improve their future earnings.  This generally requires making investments today in various areas (research and development, property and equipment, and even employee and organizational capability) that consume profits today in the expectation they will earn profits tomorrow.  As such, a company may have a high P/E ratio precisely because it is making many investments today and a different company may have a low P/E ratio because it is making few investments and expects little future growth.

This implies that current period profits are not always the goal.  Therefore, while CEOs and other executives generally seek to maximize profits on every offering, we must accept that is not always the goal.  Some offerings may be designed to capture market share to entice customers towards a more profitable offering.  And some CEOs will prioritize other metrics over profits.

Revenue Valuation

In many business sectors, businesses are valued as a simple multiple of revenue. For instance, a 2017 Equiteq study of mergers and acquisitions across a variety of business consulting firms suggests the value of many private consulting firms can be well estimated as a simple multiple of revenue.

Pricing chart: valuing a company based on revenue

Valuing a company purely on revenue, not earnings, might seem odd, but it is rational at times.

Reflect on the structure of small consulting firms.  Most small consulting firms are owned and operated by the major consultant of that firm.  The owner/operator can somewhat arbitrarily choose to take the same pay in the form of salary and bonuses, thereby reducing earnings on the Statement of Profit & Loss, or as a distribution, thereby increasing earnings on the Statement of Profit & Loss.  The actual value of the company should be the same, but the way those earnings are paid the to the owner/operator impacts the Statement of Profit & Loss.  If a simple choice of how the owner/operator pays him/herself impacts the stated profits, then profits are not an objective metric of company performance.

As another example, reflect on the history of Amazon. Though it went public in 1997 with a value of $438 million, it made no profits until 2002 and only modest profits around 2005 to 2010.  Amazon, like many of its industry followers (such as Uber, DoorDash, and Zoom) focused on revenue growth over profits long after their inception.  This strategy paid handsomely for Jeff Bezos, the founding CEO.

Users or Alternative Valuations

At times, revenue isn’t even the metric of focus.  Since Facebook and Google’s demonstrated success in using user metrics to guide strategy and capture investor cash, the number of alternative metrics touted to be a signal of value has multiplied.

It is hard to explain the valuation trajectory of WeWork under Adam Neumann or even GE under Jeffrey Immelt without resorting to alternative metrics.  While the alternative metrics in these two cases eventually failed to predict future profits, they were convincing to enough investors to make those two CEOs very wealthy.

The use of alternative metrics for determining corporate valuation is not always silly.  We have long known economies of scale, scope, and experience can deliver high profits but take time to develop.  Similarly, network effects and customer lock-in can deliver strong profits but take time to create.

Businesses are constantly looking for new forms of economies that can be exploited in the future.  As such, CEOs will create and tout new metrics that they believe will create value in the future.

Elizabeth Holmes of Theranos didn’t invent the phrase “fake it till you make it.” And while a Texan and Midwesterner like me finds this sentiment repugnant to the practice of humility, I also know it works at times.  Thomas Edison practiced this approach for four year in telling lies and half-truths regarding his progress on solving the incandescent light bulb problem, but he did eventually solve the problem and was well rewarded for his efforts.

If investors will fund businesses based on alternative metrics, then CEOs and executives will define their strategy around maximizing those alternative metrics, and pricing itself will focus on optimizing the achievement of those metrics. Neither profits nor revenue are the goal of price optimization in these cases.

Corporate Valuation -> CEO Strategy -> Corporate Metrics -> Pricing Goals

Corporate valuations may or may not be driven by earning immediate profits. Therefore, CEOs and other executives may not always focus on profits. They may focus on revenue or even some other alternative metric.  Pricing should be aligned with the strategy of the company and the goals of the CEO.  As such, prices cannot be chosen by profit optimization alone. Sometimes, there are other goals that are more important.

Perhaps it can be best simply stated as: Corporate Valuation Practices drive CEO strategy decisions which drive key metrics to optimize which, in turn, should drive the goals behind pricing decisions.

If this logic holds, we cannot expect prices and pricing decisions to be optimized for profits all the time.  Sometimes, there are other goals.



About the author

Tim J. Smith, PhD is the Managing Principal of Wiglaf Pricing, and an Adjunct Professor at DePaul University of Marketing and Economics. His most recent book is Pricing Strategy: Setting Price Levels, Managing Price Discounts, & Establishing Price Structures.

Tim J. Smith, PhD
More by Tim J. Smith, PhD