The equity side of customer experience

In this article you’ll find
• why customer experience is also a capital allocation decision
• how ROIC and WACC reveal whether better experience creates shareholder value
• when improving customer experience can increase revenues while destroying economic value

Why should an equity shareholder invest capital to create a better customer experience? Every investment in customer experience represents, in every respect, a capital allocation decision.

Although these decisions are often made by managers, the resources required to improve the customer experience still involve the allocation of corporate capital and, ultimately, those resources belong to shareholders. When a company invests:

• in customer journey fluidity
• in reducing friction
• in service speed
• in staff training
• in the perceptual continuity of the system

it is allocating capital in the hope that customers will:

• increase purchase frequency
• increase the value of purchases
• maintain the relationship for as long as possible over time.

For this reason, from a shareholder’s perspective, customer experience represents a form of capital allocation and, therefore, should be designed to increase the economic value of the business. This may appear obvious, but it should not be taken for granted.

One could argue that if improving the customer experience leads to higher revenues or margins, then the investment is automatically justified. In reality, from an investor’s point of view, the central issue is not simply increasing sales or margins, but increasing the return generated on the capital invested in the retail system.

Customer experience and return on invested capital

A practical example may help clarify the reasoning.
Let us imagine a retail network generating:

• 100M€ in revenues
• 15M€ in EBITDA
• 10M€ in EBIT.

Let us also assume:

• a 30% tax rate
• a financial structure composed of 90% equity and 10% financial debt
• total invested capital equal to 50M€.

For simplicity, we assume that excess cash is zero. At this point we can calculate NOPAT:

From this, we can derive ROIC:

Now let us imagine that the company decides to invest an additional 5M€ to improve the customer experience across the network. For example:

• by introducing new digital services
• by improving product quality
• by improving operational fluidity and continuity throughout the system.

However, there is a very important point to consider. That additional 5M€ may come from:

• new equity
• financial debt
• retained earnings.

Even if the investment is financed through retained earnings, the economic reasoning does not change. Those retained earnings could otherwise have been distributed to shareholders.

For this reason, retained earnings must still be treated as invested capital and therefore evaluated based on the return they are capable of generating over time. Now let us assume that, following the investment:

• revenues increase to 110M€
• EBITDA rises to 17M€
• EBIT rises to 11M€.

Let us also assume that the investment increases depreciation by 1M€. At first glance, the investment appears to have improved the economic performance of the retail network:

• revenues increase
• EBITDA increases
• EBIT also increases.

However, the return on invested capital must be analyzed more carefully. NOPAT now becomes:

While ROIC becomes:

The return on invested capital therefore remains unchanged.
In other words, improving the customer experience generated:

• higher revenues
• higher EBITDA
• higher EBIT

but did not improve the return generated on the shareholder’s invested capital. From an investor’s perspective, this distinction is critical.

A better customer experience does not automatically guarantee a better return on the capital invested within the retail system. Improving customer experience creates value for shareholders only when it also increases the return generated on invested capital over time.

Growth and value destruction

Some may argue that shareholders, after investing an additional 5M€, are still receiving a positive return and that the investment should therefore be considered satisfactory. This reasoning remains valid only as long as the return on invested capital does not begin to deteriorate.

Let us therefore consider a second scenario. Imagine that the same customer experience investment produces more limited improvements:

• revenues rise to 110M€
• EBITDA rises to 16M€
• EBIT rises to 10.5M€.

Once again, at first glance, the investment appears to improve the economic performance of the retail network:

• revenues increase
• EBITDA increases
• EBIT also increases.

However, when analyzing return on invested capital again, NOPAT becomes:

While ROIC becomes:

The return on invested capital has therefore declined by one percentage point. In this case, the investments made to improve the customer experience created value for customers, while simultaneously reducing the economic return generated on invested capital.

In other words, the investment reduced the return on invested capital, compressing the retail system’s ability to create economic value for shareholders. And this is far from a trivial point.

Customer experience, WACC and value creation

To better understand the issue, it may be useful to briefly introduce the concept of WACC (Weighted Average Cost of Capital), namely the weighted average cost of the capital employed by the business.

In simplified terms, WACC represents the minimum return the retail system should generate in order to adequately compensate:

• the capital provided by shareholders
• the capital financed through debt.

Simplifying the reasoning further, WACC can be estimated as follows:

Where:

• Ke represents the cost of equity required by shareholders
• Kd represents the cost of debt
• Equity Weight and Debt Weight represent the relative weight of the different financing sources.

Returning to the previous example, let us assume:

• a cost of equity (Ke) equal to 12%
• a cost of debt (Kd) equal to 5%
• a capital structure composed of 90% equity and 10% financial debt
• a tax rate of 30%.

We can therefore estimate WACC as follows:

This means that, in simplified terms, the retail system should generate returns above 11.15% in order for the investment to continue creating economic value for shareholders.

In the first scenario analyzed:

• ROIC remains at 14%
• the return on invested capital therefore continues to exceed the weighted average cost of capital
• the customer experience investment continues to generate economic value for the business.

In the second scenario instead:

• ROIC falls to 13%
• the return on invested capital declines
• the margin above WACC progressively narrows.

At this point, the issue becomes far more delicate. If additional investments in customer experience were to continue:

• increasing invested capital
• increasing operational complexity
• progressively compressing returns

the risk would be witnessing retail system growth accompanied by a progressive destruction of economic value. The problem would become even more evident if operating returns deteriorated further. For example, with:

• a ROIC equal to 9%
• a WACC equal to 11.15%

the company would effectively be investing capital into activities incapable of adequately compensating the cost of that capital. In economic terms, every additional euro invested in customer experience would therefore be destroying shareholder value, even in the presence of:

• higher revenues
• larger business scale
• a customer experience perceived as better by customers.

There is also one final issue worth considering: what is the point of continuing to invest in a system that destroys value rather than creating it?

Conditions such as those described above can severely undermine the company’s future development and its ability to attract external capital to finance growth, a critical condition for businesses accessing capital markets through public listings.

After all, why should an investor allocate capital to a business that fails to adequately compensate invested capital when alternative systems offering higher returns at similar levels of risk exist elsewhere?

Conclusion

This is precisely where customer experience stops being exclusively about:

• marketing
• branding
• communication
• design
• customer relationships

and instead becomes a genuine capital allocation issue.
From an investor’s perspective, a better customer experience does not automatically represent a better investment. The investment becomes rational only when it:

• improves the economic quality of the customer relationship
• increases the productivity of invested capital
• generates returns above the cost of capital employed
• contributes to increasing the long-term economic value of the business.

For this reason, designing customer experience does not simply mean creating experiences that are more pleasant, sophisticated or memorable. It means designing experiences capable of:

• improving customer economic behavior
• increasing the quality of cash flows generated over time
• strengthening the economic resilience of the retail system
• producing returns that adequately compensate the capital invested to generate them.

In other words, a better customer experience truly creates value only when it simultaneously improves:

• the quality of the experience lived by the customer
• and the economic return generated on the capital allocated within the retail system.