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43 просмотров65 страницValuing Subscription Base Business

Sep 15, 2016

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Valuing Subscription Base Business

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43 просмотров65 страницValuing Subscription Base Business

© All Rights Reserved

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Daniel M. McCarthy

Peter S. Fader

Bruce G. S. Hardie 1

May 19, 2016

1 Daniel

the University of Pennsylvania (address: 400 Jon M. Huntsman Hal, 3730 Walnut Street, Philadelphia, PA 19104-6340; email: danielmc@wharton.upenn.edu, web: http://www-stat.

wharton.upenn.edu/danielmc/). Peter S. Fader is the Frances and Pei-Yuan Chia Professor of Marketing at The Wharton School of the University of Pennsylvania (address: 771 Jon M.

Huntsman Hall, 3730 Walnut Street, Philadelphia, PA 19104-6340; phone: (215) 898-1132; email:

faderp@wharton.upenn.edu). Bruce G. S. Hardie is Professor of Marketing, London Business

School (email: bhardie@london.edu; web: www.brucehardie.com). We acknowledge the

financial support of the Baker Retailing Center.

Abstract

Valuing Subscription-based Businesses Using Publicly Disclosed Customer Data

The growth of subscription-based commerce has changed the types of data firms report to external shareholders. More than ever before, companies are discussing/disclosing data such as

churn, customers acquired, customer lifetime value, and more. As such, there is increasing

interest in linking the value of a firms customers to the overall value of the firm. Although

a number of researchers in the fields of marketing and accounting have explored this idea,

previous work did not drive customer-based valuation estimates off of the widely accepted discounted cash flow (DCF) valuation model, nor did the underlying models of customer acquisition and retention fully reflect all of the empirical realities associated with these behaviors.

We develop a framework for valuing subscription-based firms that addresses both of these

issues, incorporating critical factors such as heterogeneity, duration dependence, seasonality,

and macroeconomic variables into a customer-based DCF model. Furthermore, our framework

explicitly acknowledges that publicly disclosed data is overly aggregated, with missingness.

We apply this methodology to data for Dish Network and Sirius XM Holdings, estimating

the value of the firms, analyzing customers unit economics, performing customer segmentation, and developing a new investor metric, the internal rate of return on a customer (IRRC).

Keywords: customer lifetime value; customer equity; valuation; shareholder value;

DCF

Introduction

pay a periodically recurring fee for access to a product or service has grown considerably

in recent years. Previously dominated by newspapers, magazines, and telecommunications

companies, the subscription-based business model has made strong inroads into consumer software (Microsoft 365), food preparation (Blue Apron), health and beauty products (Dollar Shave

Club), and a large array of subscription-based software-as-a-service (SaaS) enterprises in the

B2B space, as businesses look to increase the predictability of their revenue streams. Many

experts have written in depth about this topic (Baxter (2015), Janzer (2015), Warrillow (2015)).

The future looks bright for example, Gartner predicts the global SaaS market may top $51

billion in 2018, more than double the $22.6B it had generated in 2013 (Columbus (2014)).

The increased popularity of subscription-based businesses has brought with it an increase in

the relevance, usage, and disclosure of customer data, including but not limited to churn/attrition,

customer/subscriber acquisition cost (CAC or SAC), average revenue per user (ARPU), and

customer lifetime value (CLV). An SEC text mining analysis performed by the authors shows

that 193 companies within the telecommunications industry alone (companies with SIC codes

4812 and 4813) have disclosed customer data in quarterly and annual filings. ConstantContact, a popular email marketing software firm, mentions CLV as a key growth driver in investor

presentations and even provided an estimate of CLV per user in its 2013 annual report: We currently estimate a customer lifetime-value of approximately $950 per unique customer. Similar

customer data references can be found in the filings of many other companies, including but not

limited to Avaya, Boingo Wireless, Vonage, Zipcar, and Shutterstock.

Customer data is important to investors and is being used by analysts as they make their recommendations. For example, analyst reports for video streaming/online rental business Netflix

from Thomas Weisel Partners, Vintage Research, First Albany Capital and Delafield Hambrecht

all strongly emphasize customer data in general (and the size of the total subscriber base over

time in particular) when justifying their investment recommendations (Stanford (2004)). The

2

price of a stock reflects and incorporates investors beliefs regarding the future cash flows a

company will generate, and for the subscription-based businesses we consider here, the primary source of future cash flows is customers. Customer data allows analysts to create more

grounded, accurate future cash flow forecasts.

The pioneering work of Gupta et al. (2004) (hereafter, GLS) was the first to explicitly link

firm value to CLV for public companies. However, treatment of the valuation problem by GLS

suffers from two major issues. First is that GLSs CLV calculations are performed assuming

a constant retention rate, which leads to pessimistic customer valuations, often dramatically

so (Fader and Hardie (2010)). The second issue is that GLSs valuation framework does not

incorporate key financial/accounting issues such as firm capital structure and non-operating

assets. Its practical applicability was further diminished by a reliance on external data sources

for key inputs for the few companies that did report customer data.

Many other authors have built upon GLSs seminal work, most notably Schulze et al. (2012,

SSW hereafter), whose work substantially improves upon the aforementioned finance/accounting

valuation aspects (see also Bauer and Hammerschmidt (2005)). However as we will discuss below, subsequent work still assumes a homogeneous retention rate, does not incorporate seasonality and macroeconomic conditions, does not address left censoring and missing data,

assumes quarterly cash flows while the flow of new customers is continuous and the contracts/subscriptions are almost always non-quarterly, and often does not distinguish between

contractual and non-contractual businesses (Fader and Hardie (2009)). Even though many authors have discussed DCF models in CBV papers, no extant models adopt the DCF model into

their financial valuation approach. Instead, they take a purely customer-based valuation (CBV)

approach best described/defined by Skiera and Schulze (2014) (discussed further below), and

they contrast CBV to DCF, treating CBV and DCF as mutually exclusive approaches to corporate valuation.

We show that CBV and DCF are complementary to one another. Our proposed model welds

the two approaches together into one customer-based DCF (CBDCF) model. DCF valuation

3

is the de facto standard valuation model within finance for good reason, and we believe that

allowing CBV models to benefit from the natural conveniences/advantages of DCF models is

an important contribution of our work.

We build a more realistic, accurate, and generally applicable valuation model using only

publicly disclosed customer data, making it suitable for passive external shareholders. If desired, company management could apply the same model with little modification using granular transaction-level data available within the organization. We build a stochastic model for

the acquisition and retention of customers over time, which parsimoniously incorporates factors that are essential to the dynamics of both processes heterogeneous retention propensities,

duration dependence, seasonality, macroeconomic conditions and household formation and

acknowledges the fact that our data is aggregated temporally and across customers (i.e., we

are only provided with quarterly company summaries) with missingness (i.e., all customer data

is not available for all periods). We summarize and compare our framework for analysis and

contributions to previous literature in Table 1 of the literature review in Section 2. We evaluate

the predictive performance of the proposed model by performing rolling 2-year predictions of

future customer metrics over all possible calibration periods. We perform this rolling validation

analysis for our CBDCF model, as well as GLS and SSWs models.

With this general-purpose model in hand, we estimate many managerially/practically important quantities, including the value of the firm, and the value/profitability of a newly acquired

customer (and how this compares to a long-time customer). We also introduce a new investment metric, the internal rate of return on a customer (IRRC), which is a scale-invariant measure

of the marginal profitability of customer acquisition spending. The public company real data

examples we study are Dish Network (Dish), a mature pay-TV company, and Sirius XM, a highgrowth satellite radio service provider. We develop our entire forecasting/valuation approach

for operating assets using only publicly disclosed data from both companies, without any inputs

or assumptions from outside sources.

We hope that this work drives increased adoption of customer-based valuation models, of-

4

fering marketing executives a great step forward to be able to coordinate with (and earn greater

respect from) their finance counterparts and other leaders across the organization.

Literature Review

A central concept underlying customer valuation is customer equity (CE, Blattberg and Deighton

(1996)). An excellent discussion of CE can be found in Kumar and Shah (2015). Customer equity is the net present value of the remaining (or residual) lifetime value (RLV) of all current

customers, also known as current customer equity or CCE (see Pfeifer (2011)), plus the CLV of

all future expected customers.

Wiesel et al. (2008) advocates reporting CE-related metrics within public company filings,

calling CE an integral part of financial reporting. GLS sparked widespread interest in the idea

of valuing companies from the bottom-up through CE. GLS added to its impactful legacy

through a series of subsequent publications (Gupta et al. (2006), Gupta and Zeithaml (2006),

Gupta and Lehmann (2005), Gupta (2009), Gupta and Lehmann (2006), Berger et al. (2006)).

However GLS was more of a proof of concept than an accurate, generally applicable valuation

framework. Its valuation estimates relied upon estimates from experts. Since then, there have

been a number of papers that have extended this valuation framework.

SSW provides thoughtful and accurate treatment of how CE relates to firm value using financial valuation theory in an empirical setting, considering/incorporating financial aspects such as

firm capital structure and non-operating assets. Kumar and Shah (2009) relate CE to public company shareholder value (SHV) through a regression requiring internal, individual-level

transaction data and covariates. However, all companies valued using only publicly disclosed

company data assume that all customers share one common time-invariant per-quarter propensity to churn, and when applicable, model future customer acquisition via a Bass diffusion

model or a simple variant.

A number of more theoretical papers have discussed other considerations without providing

5

explicit valuation estimates for real companies. Pfeifer (2011) shows how one must be careful with the timing of cash flows when estimating retention rates and current-customer equity

(CCE) using publicly disclosed company data, but stopped short of its own estimate of CCE,

let alone a value for the firm as a whole. Pfeifer echoes Bauer and Hammerschmidt (2005),

discussing the merits of a DCF approach like the one we propose but do not pursue the idea

further. Pfeifer and Farris (2004) study the theoretical effect of a homogeneous but duration

dependent retention rate upon customer valuation.

Skiera and Schulze (2014) compare and contrast DCF modeling with CBV modeling. They

offer an excellent discussion and reconciliation of the two valuation methods, but state that DCF

and CBV are fundamentally different, the biggest difference between them being whether the

cash flows are being modeled by time period or by customer. We believe that this conclusion is

more polarizing than it needs to be. Our proposed method marries DCF with CBV. We employ

a DCF model that is driven off of the same customer projections that are made in extant CBV

models a customer-based DCF model. GLS and SSW correctly note that customer-based

valuation methods are useful for valuing high-growth firms; however this does not necessarily

mean that DCF models are not useful in these cases. In our empirical analysis of a highgrowth firm (Sirius XM), we show that our customer-based valuation model performs very

well because, even though it is a DCF approach, it carefully accounts for customer acquisition,

retention, and profitability. We summarize the previous literature and our contributions to it in

Table 1.

It is encouraging to see that these ideas have been gaining attention and respect outside of

marketing. Within the accounting literature, for instance, Bonacchi et al. (2015) provides a

systematic analysis across multiple companies linking CCE as a metric to shareholder value

(further discussion is provided in Hand (2015)). Other work includes Andon et al. (2001),

Bonacchi et al. (2008), Bonacchi and Perego (2012), Boyce (2000), and Gourio and Rudanko

(2014).

With this large and growing base of literature on the importance of (and methods for) cus-

Public

+ Experts

Wiesel, Skiera, and Villanueva (2008)

Public

Kumar and Shah (2009)

Private

Fader and Hardie (2010)

None

Pfeifer (2011)

None

Schulze, Skiera, and Wiesel (2012)

Public

Bonacchi, Kolev, and Lev (2015)

Public

Proposed

Public

Paper

No

No

Yes

No

No

No

Yes

No

No

No

No

No

No

Yes

Missing

Data

No

Heterog

eneity

No

ce

ependen

Duratio

nD

No

No

No

No

No

No

Yes

No

Covaria

tes

No

Yes

No

No

No

No

Yes

No

No

No

No

No

No

No

Yes

No

DCF M

ode

Valuation Elements

mated

No

No

No

No

Yes

Yes

Yes

No

WACC

Esti

Customer Dynamics

No

No

No

No

Yes

No

Yes

No

D

e

b

t

/

O

ther As

sets

Setting

urce

Data So

rs Value

d

Current + Future

Current

Current

Current

Current + Future

Current

Current + Future

Current + Future

Custom

e

7

tomer valuation, combined with ever-improving customer-level data disclosures by public companies, it is important to step back and develop a comprehensive customer-valuation model

which will attract the attention of the C-suite.

We structure the remainder of the paper as follows: in the next section, we describe a model

that enables us to forecast future customer acquisitions and losses which are then incorporated

into a standard DCF valuation framework. We then provide an empirical analysis that explores

how such a model can be fit to real public company data, validating the models goodness of fit

through a rolling validation analysis and comparison to alternative valuation specifications. We

spend the remainder of the paper discussing the sort of inferences that we can draw from the

model, including the profitability of new customers, the importance of customer tenure on the

residual value of the customer, and we develop a new investment performance metric called the

internal rate of return on a customer (IRRC). We conclude with a discussion of the results and

future work.

3

3.1

Model Development

Valuation 101

According to standard corporate valuation theory (Damodaran (2012), Greenwald et al. (2004),

Holthausen and Zmijewski (2013), Koller et al. (2010)), SHV is equal to the value of the operating assets (OA) plus the non-operating assets (NOA), minus the net debt (ND) of the firm (all

figures below assume a quarterly clock, consistent with firms external reporting period for

the financial data below):

SHVq = OAq + NOAq NDq ,

(1)

where q = 1 represents the first quarter of the companys commercial operations. Equation 1

reiterates SSW Equation 1. The primary elements of Equation 1 will be defined below, with

elements either of secondary importance to company valuation or directly available through

8

public sources elaborated upon in Web Appendix B, where we will also provide a detailed

summary of where these data elements may be obtained. The value of a firms operating assets

(OA) is equal to the sum of all future expected free cash flows (E(FCF)s) the firm will generate,

discounted at the weighted average cost of capital (WACC, assuming quarterly compounding):

X

E(FCF)q+q0

.

OAq =

q0

(1

+

WACC)

0

q =0

(2)

As noted in SSW, WACC is the appropriate firm-specifiic discount rate to apply to future free

cash flows.

We elaborate upon the expected free cash flows (E(FCF)) in the numerator of Equation 2

while WACC is discussed further in Web Appendix B. E(FCF) is equal to the net operating profit

after taxes (NOPAT) minus the difference between capital expenditures (CAPEX) and depreciation and amortization (D&A), minus the change in non-financial working capital (NFWC):

(3)

The most important ingredient of E(FCF) is NOPAT, which is a measure of the underlying

profitability of the operating assets of the firm. NOPAT is equal to revenues (REV) after variable

costs (VC%), minus fixed operating costs (FC), after taxes:

(4)

where TR is the corporate tax rate for the firm. The other elements of Equation 3 make adjustments for balance sheet-related cash flow effects are generally of secondary importance to the

value of the firm.

The methodology summarized above is a discounted cash flow (DCF) model, which is the

de-facto industry standard way in which operating assets are valued within the financial community. While we are not the first to discuss DCF modeling (in particular, see Schulze and

9

Skiera in Skiera and Schulze (2014)), we are the first to build a CBV model on top of a DCF

model. We show how to do so in the next section.

3.1.1

Customer data very naturally enters the DCF framework presented in Section 3.1, primarily

by providing further structure to REV within Equation 4. For subscription-based businesses,

revenue in a given time period must be equal to the average number of active users during the

period multiplied by the average revenue per user during the period. We operationalize our

revenue model by specifying sub-models for both processes the number of active users at the

end of each period (END), and average revenue per user (ARPU).

Subscription-based firms disclose the number of active users at the end of each quarter. Let

ENDq be the number of active users q quarters after the company begins commercial operations. Then ENDq is, by construction, equal to the cumulative historical number of customer

acquisitions (ADD), less the cumulative historical number of customer losses (LOSS), during

each prior quarter:

ENDq =

q

X

ADDi LOSSi ,

(5)

i=1

Therefore, our customer-based DCF entails constructing models for LOSS, ADD, and ARPU

using only publicly available data from which we can generate forecasts of REV. As we will

discuss at more length, valid modeling and projection of END require proper specification of

the acquisition of new customers, and the retention of customers once they have been acquired.

With more accurate revenue projections, the valuation estimates which result when we complete our DCF analysis must be improved as well. This is important, because coming up with

an appropriate model for future revenues is usually the most important and most challenging

valuation task analysts must perform. Before we can come up with these more accurate revenue

forecasts, however, we must first understand the data we need and how it compares to the data

which firms actually provide. We explore this in the next section.

3.2

10

In this section, we illustrate the data structure that firms with a subscription/contractual business

model should be reporting internally to account for their customer bases, and how it maps to

the data firms are increasingly providing publicly.

Let us assume the internal reporting occurs on a monthly cycle, and for ease of notation,

that the quarters always align with the months (i.e., that the first month of each quarter is

either January, April, July or October), and let C(m, m0 ) be the number of customers acquired in month m who are still active in month m0 , where m0 m. Then C(m, m) is the

number of customers acquired in month m. This gives us the upper-triangular matrix shown

in Figure 1. Each row is called a cohort, the group of customers born at the same time.

C(m, m0 )/C(m, m) gives us the empirical survival curve for cohort m as it represents the

proportion of the customers acquired in month m who are still active in month m0 (hence,

C(m, m0 ) C(m, m0 + m) m = 1, 2, . . .). The total number of customers the firm

has in month m, C(., m), is the number of customers acquired in month one who are still customers, plus the number of customers acquired in month two who are still customers, ..., plus

the number of customers acquired in month m:

(6)

While this matrix will be reported internally in more enlightened firms, firms do not release

this data to the public. When firms disclose customer data at all, they report quarterly summaries

the number of customers active at the end of each quarter (ENDq in Equation 5), and the

number of customers added and lost each quarter (ADDq and LOSSq in Equation 5). Publicly

disclosed customer data thus suffers from aggregation, because we observe quarterly summaries

when customers make acquisition and retention decisions at a higher temporal frequency.

We first explore how this upper triangular matrix maps to the reported numbers and then look

at how we can attempt to reconstruct and project it into the future from the publicly reported

11

data. Assume that external reports are provided quarterly. It follows from Equation 5 that

quarter customer additions and total ending customers are equal to

ENDq = C(., 3q).

and

(7)

(8)

We illustrate this mapping visually in Figure 1. Let L(m) denote the number of customers lost

in month m. Then

LOSSq = L(3q 2) + L(3q 1) + L(3q).

and

(9)

(10)

summary data is not available back to the start of commercial operations. For example, while

Sirius XM began commercial operations in Q4 2001, it started disclosing paying customer data

12

in Q3 2008. Similarly, while Netflix began commercial operations in calendar Q4 1999, they

started disclosing customer data in Q2 2001. Amazon, Ameritrade, Capital One, eBay and

E*Trade began commercial operations in 1994, 1971, 1993, 1995, and 1982, respectively, well

before GLS began modeling their respective customer data in 1996-1997. To properly handle

missing data, we must backcast the initial datapoints in addition to the in-filling we must

do to impute the monthly cohort-level numbers in the upper triangular matrix shown in Figure

1 from the quarterly summary figures which are disclosed publicly.

Our overarching modeling objective, then, is to take the aggregated, left-censored customer

addition and loss data that firms have made available, and use it to forecast into the indefinite

future the upper triangular matrix shown in Figure 1. This requires us to have well-specified

models of both customer acquisition and retention. Furtheremore, this matrix simply provides

us with the number of customers active at the end of every period, and not their spend. Therefore, we also need to develop a model for ARPU. We specify and estimate models for customer

retention, customer acqusition, and ARPU over the next four sections.

3.3

Retention Process

As noted above, C(m, m0 )/C(m, m) for m0 m gives us the empirical survival curve for

cohort m. Letting SR (m0 m|m) denote the probability that a customer acquired in month m

survives beyond month m0 ,

(11)

Therefore, given knowledge of C(m, m), modeling and predicting C(m, m0 ) is a well-studied

problem. Our objective is to specify an accurate yet parsimonious survival model for the duration of customers tenure with the firm.

We want to capture the effects of heterogeneity and duration dependence, and incorporate

time-varying covariates for seasonality and macroeconomic conditions. As we will see later,

13

each of these factors has a significant effect upon the propensity to churn. Therefore we use a

Weibull baseline with covariates incorporated using proportional hazards, with cross-sectional

heterogeneity in the baseline propensity characterized by a gamma distribution. This is a wellaccepted model for duration data and has been proven to be quite effective and robust in numerous previous studies (Morrison and Schmittlein (1980), Moe and Fader (2002), Fader and

Hardie (2009), Schweidel et al. (2008b)).

Let SR (m0 m|m, , cR , X(m0 ), R ) denote the probability that a customer acquired in

month m will survive for at least m0 m more months (i.e., he/she survives beyond month

m0 ), given his/her individual-specific baseline propensity to churn (R ), homogeneous retention shape parameter (cR ), time-varying retention covariates up to and including month m0

(XR (m0 ) = [xR (1), xR (2), . . . , xR (m0 )]), and coefficients for retention covariates ( R ). Then

SR (m0 m|m, R , cR , X(m0 ), R ) = exp(R BR (m, m0 m)), where

(12)

0

m

X

T

BR (m, m0 m) =

[(i m)cR (i m 1)cR ]eR xR (i) . (13)

i=m+1

Following Schweidel et al. (2008b) and Jamal and Bucklin (2006), we expect cR > 1 if it is

significantly different from 1. When cR = 1, it reduces to an exponential baseline.

Assuming R is gamma(rR , R )-distributed across the population, the unconditional probability that a customer acquired in month m survives past month m0 is

0

rR

R

=

(14)

R + BR (m, m0 m)

SR (m m|m, cR , X(m ), R , rR , R ) =

Plugging the survival curve in Equation 14 into Equation 11 allows us to predict the number

of active customers in future months for the month m cohort. Therefore, if we know C(m, m)

over all months, we can predict the remainder of the upper triangular matrix in Equation 1.

Prior to this work, the only retention model that has been used in empirical customer-based

14

corporate valuation work has been a constant geometric model. That is, all customers have

been assumed to share one common retention rate per quarter, r. Fader and Hardie (2010)

shows theoretically and by simulation that ignoring time dynamics in retention propensities

systematically undervalues the customer base.

Equation 14 also highlights how much the complexity of our modeling of losses increases

when we move away from a constant-retention world. In a constant-retention world, our estimate of the number of customer losses in a particular month m, L(m) from Equation 9, only

requires knowledge of the total number of customers from the end of the previous period. Assuming a constant monthly retention rate r,

b 0 ) = C(., m0 1) r.

L(m

(15)

In contrast, under our proposed model, the number of customers lost in month m0 requires

knowledge of the number of customers acquired in all months preceding month m0 :

b )=

L(m

0 1

m

X

m=1

(16)

While this may be inconvenient, we will show that the cost of assuming a constant retention

rate can be much worse.

Estimates of LOSSq and ENDq follow from Equations 7 and 10 for all q = 1, 2, . . .. We

may then estimate the model parameters (cR , rR , R , R ) by minimizing the sum of squared

differences between our model-based estimates of LOSSq and the reported numbers. However

this assumes we know monthly customer additions C(m, m) for all m, which we do not know.

We only have quarterly customer additions ADDq and some of these observations may be missing. We therefore need to develop a model of the acquisition process whose parameters can be

estimated using the reported ADDq data. Using this model in conjunction with our retention

model, we can backcast and in-fill the C(m, m) numbers needed for estimating the retention

model. We may then forecast C(m, m) and C(m, m0 ) for m0 > m into the future. We fully

15

specify the acquisition process in the next section.

3.4

Acquisition Process

At first glance, developing a model for the acquisition of customers over time seems to be a

relatively simple exercise. Given a fixed population size, we can use a standard model for the

time to adoption such as the Bass model (Bass (1969)), or a simplified version of it, as in GLS.

However there are four problems with this:

1. It assumes that all churning customers disappear forever once an acquired customer has

churned, he/she cannot re-enter the pool of potential adopters once again. Libai et al.

(2009) extend the basic Bass model to allow for lost customers re-entering the pool of

potential adopters (but they assume a constant retention rate).

2. It assumes the population size is fixed, when we know that the number of potential customers is increasing over time due to household formation / population growth.

3. The Bass model and its simplified variants have a number of unfavorable properties, most

notably the fact that the resulting acquisition curve must be symmetric about the period

of peak acquisition. In real datasets, skewness about the peak is almost always present.

4. It ignores the effects of seasonality and macro-economic events.

We develop a new model from first principles which addresses these issues. Each month

m, a new prospect pool forms, the size of which is M (m). We set M (0) as the initial time 0

population size when the firm first commences operations (P OP (0)), who may then be acquired

as customers in month 1 and thereafter. M (1) is the growth in population by the end of the first

month of operations:

M (1) = P OP (1) P OP (0).

In general, the month m prospect pool, M (m), is equal to the growth in the population during

16

the month, plus the number of customers who churned in the previous month:

m = 1, 2, . . .

Our model assumes that population growth is the only source of potential adopter growth over

time, aside from previously churned customers.1

Once a prospect pool has formed, some time will elapse until individuals within that pool

are acquired as customers. This is a timing decision for which we specify a hazard model. Let

FA (m0 m|m) denote the probability that a customer acquired in month m will be active by

the end of month m0 . Then the number of adopters in month m is equal to

C(m, m) =

m1

X

i=0

Our goal, then, is to specify an accurate yet parsimonious timing model for the duration of

time until a prospect becomes a customer. We model the time to adoption of individuals within

each prospect pool using a split-hazard model. Some individuals will never be acquired, but

for those who will be eventually, the duration of time until acquisition is characterized by a

Weibull baseline with covariate effects incorporated using the proportional hazard approach,

and cross-sectional heterogeneity in baseline propensity characterized by a gamma distribution.

Let FA (m0 m|m, , cR , X(m0 ), A , N A ) denote the probability that a customer from prospect

pool m will by the end of month m0 , m = 0, 1, ..., given his/her individual-specific baseline

propensity to be acquired (A ), homogeneous acquisition shape parameter (cA ), homogeneous

but possibly time varying acquisition covariates up to month m0 (XA (m0 )), coefficients for

acquisition covariates ( A ), and probability of never being acquired (N A ). Then

FA (m0 m|m, A , cA , xA (m0 ), A , N A ) = (1 N A )(1 exp(A BA (m, m0 m))), (18)

1

While this implies that product awareness is not changing over time, we do not have sufficient data to account

for such factors.

17

BA (m, m0 m) =

m

X

T

A xA (i)

(19)

i=m+1

the unconditional probability that a customer from prospect pool m will be acquired by the end

of month m0 is

FA (m m|m, cA , XA (m ), A , rA , A , N A ) = (1N A ) 1

0

A

A + BA (m, m0 m)

rA

(20)

This acquisition model is flexible yet quite parsimonious. Parsimony is especially important

in our limited data situation because, as was shown in Van den Bulte and Lilien (1997), illconditioning is a serious enough problem with small sample sizes that adding new predictors

to alleviate model misspecification concerns may make the resulting model fit (and forecast)

worse than it had been prior to the introduction of those covariates.

3.5

We estimate the above two models jointly using nonlinear least squares (Srinivasan and Mason

(1986)), minimizing the sum of squared differences between actual quarterly acquisitions and

losses during each period versus what we expected from our model via difference in CDFs.

Denoting the acquisition and retention parameters collectively by , so that

(rA , A , cA , A , N A , rR , R , cR , R ),

and letting Q be the number of quarters after the company commences commercial operations

to the end of the calibration period, if we observe the process from q = 1 onwards, our estimated

18

parameters are equal to

= argmin SSEF U LL (),

where

(21)

SSEF U LL S1 + S2F U LL ,

[ Q )2 ,

S1 (ENDQ END

and

(22)

S2F U LL

\ q )2 ,

[ q )2 + (LOSSq LOSS

(ADDq ADD

where

(23)

q=1

[q

ADD

3q

X

b

C(m,

m),

and

(24)

m=3q2

\q

LOSS

3q

X

b

L(m,

m).

(25)

m=3q2

b

b

Monthly customer additions and losses, C(m,

m) and L(m,

m) in Equations 24 and 25 respectively, are obtained using Equations 16 and 11. The size of the monthly prospect pools, M (m)

in Equation 11, are equal to

M (m) =

P OP (m),

m = 0,

\

P OP (m) P OP (m 1) + LOSS(m

1),

m = 1, 2, . . . , 3Q

(26)

We optimize over all parameters jointly because of the dependence of the acquisition process

upon the retention process (i.e., customers cannot churn until they have been acquired) and vice

versa (i.e., churning customers enter future prospect pools).

Equation 21 assumes that there is no missingness when in practice there often is missingness. Usually, not all data is available back to the beginning of commercial operations of the

company. Most companies begin disclosing total ending customer count some number of quarters after the company begins operations (call it qA ), then begin disclosing customer addition

and loss data in another later quarter number (call it qB , where qB qA ). In cases such as these,

19

we must replace Equation 21 with Equation 27:

= argmin SSEM ISS (),

Q

X

\ q )2 ,

[ q )2 + (LOSSq LOSS

(ADDq ADD

S2M ISS

(27)

(28)

(29)

q=

qB

qB 1

S3

X

2

[

[

(ENDq ENDq1 ) (ENDq ENDq1 ) ,

(30)

q=

qA +1

and S1 is defined as before, in Equation 22. This accounts for the shortened contiguous customer addition and loss data through S2M ISS in Equation 29, and the missingness present at the

beginning of the time series through S3 in Equation 30.

The parameter estimates thus obtained fill in the upper triangular matrix shown in Figure

1 and forecast the evolution of the total active customer base into the indefinite future. The final

element needed to forecast future monthly revenues is average revenue per user (ARPU).

3.6

With estimates for the number of customers at the end of every month in hand, we need a model

for the profitability of those customers over time. Prior literature has assumed a constant dollar

profit margin per user, ignoring ARPU. This is problematic because customer profitability is

rarely constant over time and is often very noisy, whereas revenue per user is stable and reliable.

Therefore, instead of modeling and projecting customer margin directly, we model ARPU and

then consider margin separately.

If we had monthly ARPU in month m (ARPU(m)), we could easily predict revenue in

20

month m (R(m)) by multiplying ARPU(m) by the average number of users within month m2 :

R(m) =

C(., m 1) + C(., m)

2

ARPU(m).

(31)

Therefore, we need to model and project ARPU(m). While companies often publicly disclose

quarterly ARPU data, this data cannot be used in general because there are no well-accepted

standards for calculating ARPU. As Dish stated in its 2014 annual filing, We are not aware

of any uniform standards for calculating ARPU and believe presentations of ARPU may not be

calculated consistently by other companies in the same or similar businesses. Because there

is no standard definition of ARPU, different firms may have different definitions for it. This is

problematic because it implies revenue (the numerator of ARPU) often excludes certain sources

of revenue and thus may not be representative of all revenue derived from the customer base.

While revenue numbers are reliable, they are only provided quarterly, so we need to impute

monthly revenues. Assume without loss of generality that month m is within quarter q. Then

revenue in month m is equal to the customer-weighted total revenue in quarter q:

R(m) =

C(., m 1) + C(., m)

REVq ,

C(., 3q 3) + 2C(., 3q 2) + 2C(., 3q 1) + C(., 3q)

(32)

where C(., m) is defined as in Section 3.2 3 . After imputing R(m), we obtain ARPU(m) by

solving for ARPU(m) in Equation 31, given R(m) and C(., m).

Next, we apply time series methods to forecast ARPU(m). If we assume that pricing grows

at a fixed growth rate over time, time-trend regression would be appropriate, positing that

log(ARPU(m)) = 0 + 1 m + (m),

2

(m) N (0, 2 ).

(33)

Normally, one may consider multiplying ARPU(m) by C(., m) to obtain R(m). However this would not be

appropriate because ARPU is equal to total revenues divided by the average number of users within the period, not

total revenues divided by the number of users at the end of the period.

3

This calculation ignores changes in pricing within a particular quarter because monthly within-quarter changes

are effectively zero (rounding error amounts to less than 0.5%).

21

Had pricing growth been linear in nature, we would use the same regression above with respect

to ARPU(m) instead of log(ARPU(m)). However it is well known that in many economic and

financial time series, non-stationarity in the mean of the process is often present (Zivot and

Wang (2007); i.e., the level of macroeconomic aggregates, as well as product/service prices

like those considered here). In cases such as these, the fitted residuals of the regression shown

in Equation 33 may often fail tests for non-stationarity (Dickey and Fuller (1979)), the most

popular of which is the augmented Dickey-Fuller test (Elliott et al. (1996)). If this is the case,

estimates provided by the regression shown in Equation 33 are invalid, and we should use an

ARIMA(0,1,0) model instead:

(m) N (0, 2 ).

(34)

via maximum likelihood, which are then used to project ARPU(m) into the indefinite future.

Not included in our proposed model for ARPU is an estimate of heterogeneity in spend

propensity across the customer base. In addition to the fact that spend heterogeneity is not

identifiable from our sparse, aggregated data, ignoring spend heterogeneity does not affect our

resulting revenue point estimates, whereas incorporating retention-specific dynamics into the

retention model does affect the expected customer lifetime, often dramatically so (Fader and

Hardie (2010)). Furthermore, heterogeneity in spend across customers is generally tame in

contractual settings (and in the companies considered in our empirical analyses, in particular).

It is for these reasons that we believe it is important to incorporate heterogeneity in retention

but not ARPU.

3.7

Taking a step back, our goal since Section 3.1.1 has been to improve the accuracy of revenue

forecasts (and thus valuation) by decomposing revenue into total users and ARPU, modeling

22

both components precisely, then bringing those components back together again to make revenue forecasts. We now have the ingredients necessary to make these forecasts:

1. Obtain monthly total users over time, C(., m) (Equation 6), by projecting out the upper

triangular matrix shown in Figure 1 using the parameters estimated from Section 3.5.

2. Obtain monthly ARPU over time, ARPU(m), via time series forecasting off of imputed

historical monthly ARPU via Equation 32 or 33, or a linear variant.

3. Given C(., m) and ARPU(m), obtain monthly revenues, R(m), using Equation 31.

With revenues estimated, the remainder of our valuation model is for all intents and purposes

the same as what a financial professional would do when building a DCF model. In the next

section, we bring this valuation model to life from start to finish with two public companies.

Empirical Analyses

To demonstrate the model and its use for valuation and financial forecasting, we first apply it

to Dish Network Corporation (Nasdaq: DISH), a large pay-TV service provider. We estimate

the parameters of the model, evaluate in-sample fit, and value Dishs shareholders equity. To

evaluate the predictive validity of the model, we perform rolling 2-year-ahead forecasts over

all possible calibration periods and compare our performance to those of alternative methods.

To further establish the robustness of the proposed model, we then show that the same model

provides a well-calibrated valuation for a second publicly-traded company, Sirius XM Holdings

(Nasdaq: SIRI), a satellite radio service provider.

4.1

Dish Network

23

Dish commenced operations in March 1996 (DISH (2014))4 . End-of-period customer counts

began being disclosed when Dish commenced commercial operations in Q1 1996. However

gross customer acquisition data is left censored the first time that gross customer additions

were disclosed was 7 quarters later, in Q1 1998. Therefore, qA = 0 while qB = 7 in our

estimation procedure, as per Equation 27.

All historical customer data (ADDq , LOSSq and ENDq , using the notation in Equation 21

and throughout) as well as quarterly subscriber revenues (REVq from Equation 4) is disclosed

in Dishs quarterly and annual reports, Forms 10-Q and 10-K, respectively. We model this

customer data up through and including Q1 2015.

The vast majority, but not all, of Dishs revenues come from its subscriber base. In Q1 2015,

0.9% of Dish sales were derived from equipment sales, which are not core to the business and

have not been growing over time. In general, customer-based corporate valuation is less useful

the larger the proportion of sales coming from non-subscriber sources happens to be.5

We incorporate 4 time-varying covariates into our acquisition and retention processes through

proportional hazards 3 quarterly dummy variables to capture seasonal fluctuations in the

propensity to acquire and retain services, and a Great Recession dummy variable to account

for the diminished propensity to acquire services and inreased propensity to drop services during that recession6 . New monthly prospect pools (P OP (m) in Equation 26) are driven off of

US household growth, provided by the Census Bureaus CPS/HVS data tables. Customer metrics and revenues are provided in the Web Appendix, and all other data is available from the

authors upon request.

4

While Dish Network was technically incorporated in 1980, the relevant starting date for our customer acquisition/retention models is when Dish actually commenced commercial operations and could thus begin acquiring

customers.

5

Dish has made investments in wireless spectrum over the past three years. Wireless spectrum is a nonoperating asset the company earns no revenue from it, and the core operations of the business do not depend

upon it. We will discuss our handling of the value of this investment (and of non-operating assets in general) in the

Web Appendix.

6

As per the Bureau of Labor Statistics, the recession began in Q4 2007 and ended in Q2 2009.

24

Many public companies summarize acquisition and retention spending in one category, usually denoted as marketing or sales and marketing expenses. This would require modelers

to estimate subscriber acquisition expenses. In contrast, because Dish publicly discloses subscriber acquisition expense, no such estimation is needed.

4.1.1

In

Training upon all customer data, we estimate the acquisition and retention parameters .

Figure 2, we plot model estimates for gross customer additions, losses, and end-of-period total

customer counts against what we actually observed (grey indicates the duration of the economic

downturn).

We must back-cast gross customer additions and losses because the only missingness Dish

suffers from is non-disclosure of additions and losses data until Q1 1998. Our resulting fits are

visually appealing we see a clear seasonal pattern within acquisitions and losses, and lower

acquisitions and higher losses during the recession of 2008. Dish appears to be past the point of

peak adoption, a sentiment echoed by Dish CEO Charlie Ergen in Dishs Q1 2015 conference

call: My general sense is that the linear pay television business probably peaked a couple of

years ago and that its in a very slight decline.

ARPU is modeled and projected as per Section 3.6. Linear growth is assumed, consistent

with comments made in Dishs annual financial reports and with the materially improved goodness of fit over a 10+ year period when we assume linear growth. Because the residuals of the

resulting model failed the Augmented Dickey Fuller unit root test, we model ARPU using an

autoregressive integrated moving average (ARIMA) (0,1,0) model with an intercept term (see

Section 3.6)7 . We will see in Figure 4 that this fit is very stable over time. Parameter estimates

are provided in Table 2 alongside their associated standard errors and the fitted models sum of

squared error (Equation 27) 8 .

7

8

Differencing the data simplifies the model, has an R2 of 99.2%, and rejects the unit root null hypothesis.

MLE and SSE estimates for 0 in the ARPU model are the same.

Figure 2: Dish Network: Gross Customer Additions, Losses and End-of-Period Customer Counts (Recession in Grey)

25

600

400

Act

Exp

200

Customers (000)

800

1000

Q1 1996

Q1 1998

Q1 2000

Q1 2002

Q1 2004

Q1 2006

Q1 2008

Q1 2010

Q1 2012

Q1 2014

Calendar Quarter

600

400

Act

Exp

200

Customers (000)

800

1000

Q1 1996

Q1 1998

Q1 2000

Q1 2002

Q1 2004

Q1 2006

Q1 2008

Q1 2010

Q1 2012

Q1 2014

Calendar Quarter

10000

5000

Act

Exp

Customers (000)

15000

Q1 1996

Q1 1998

Q1 2000

Q1 2002

Q1 2004

Q1 2006

Q1 2008

Q1 2010

Q1 2012

Q1 2014

Calendar Quarter

These parameters are also consistent with what Dish has disclosed in its public filings. Consider what Dish says about the seasonality of its operations in its 2015 annual report: Historically, the first half of the year generally produces fewer gross new subscriber activations than

the second half of the year, as is typical in the pay-TV industry. In addition, the first and fourth

quarters generally produce a lower churn rate than the second and third quarters. While this

statement is true, we provide a much richer depiction of seasonal fluctuation in Dishs acquisition and retention (i.e., the fact that Q3 churn is seasonally quite severe).

26

Parameters

Acquisition

Retention

ARPU

Q1

Q2

Q3

Rec

N A

21.5

64407.1

2.03

.057

.063

.031

.096

.530

(8.4)

(23940.1)

(.007)

(.001)

(.001)

(.001)

(.001)

(.003)

1.62

84.2

1.44

.071

.044

.113

.122

(.75)

(27.4)

(.21)

(.002)

(.002)

(.002)

(.002)

0.226

(.085)

SSE

312,315

The negative effect of the 2008 recession on Dishs financials is unmistakeable its effect upon acquisition and retention propensities was greater than all of the respective seasonal

terms. The coefficient associated with acquisition is negative because customers have a lower

propensity to acquire services during recession, while the coefficient associated with retention is

positive because customers have a higher propensity to churn during recession, echoing Equation 14. Had we ignored the effects of recession upon acquisition and retention and instead

baked it into our baseline (as would be done by a model that assumes a time-invariant retention

rate), we would have materially underestimated future customer demand.

4.1.2

While Section 4.1.1 shows our in-sample goodness of fit is strong for Dish, it does not tell us

(1) how much data is needed to make a proper forecast of firm value, (2) how well-validated

our models predictions are, and (3) how the predictive validity of our model compares to that

of GLS and SSW. To shed light on these questions, we perform rolling predictions of future

customer metrics. The quality of stock price estimates from our model is a direct function of

the quality of the customer metric projections coming from our proposed acquisition/retention

model. Forecasting customer metrics facilitates predictive comparisons across models because

the customer metric forecasts are automatic, requiring no human intervention. While it is tempting to consider rolling stock price predictions, doing so would require retrospective forecasts of

future gross margins, operating costs, and balance sheet adjustments, which would be subjec-

27

tive. It is hard to say what we would have predicted, if we only had data up to and including all

historical points in time.

We calibrate our model upon all data up to and including quarter Q, and then predict what

ADDQ+q , LOSSQ+q , and ENDQ+q will be over forecasting horizons q = 1, 2, . . . , 8 quarters

ahead. We let Q = 10, 11, . . . , 77, corresponding to all possible calibration periods after and

including Q2 1998. Because of missing data, only 3 quarters of ADD and LOSS data are

available when Q = 10, making it a reasonable starting point to the rolling analysis. As a result,

we evaluate the performance of GLS, SSW, and our proposed model with 508 predictions made

over 68 different calibration periods.

In Figure 3, we plot all resulting predictions over all calibration periods for ADD (first

column), LOSS (second column), and END (third column) using GLS (first row), SSW (second

row), and our proposed model (third row). The grey dots in Figure 3 correspond to estimated

model predictions at the end of the calibration period.

While the general patterns of over-estimation and under-estimation are similar between

SSW and GLS, we see that SSW has materially superior predictive validity to GLS in general.

GLS underestimates future ADD, LOSS, and END figures, often severely so. This is primarily

because of the inability of a Technological Substitution model for ADD and a constant retention rate for LOSS to model customer metrics over time. Because SSW models END with

the Technological Substitution model, SSWs resulting predictions for END are generally quite

well-behaved and well-calibrated. Both methods have the most difficulty forecasting ADD, as

evidenced by the large deviations between the predictions in grey and the actual data in black.

This is important because ADD is the primary input which is used for these models respective

valuation models.

The proposed model forecasts ADD, LOSS, and END very accurately, as evidenced by the

tight correspondence between the grey and black lines in the bottom row of Figure 3. Correspondence remains tight even when the calibration period being considered is short, which

is further proof of the robustness of the models predictions. We provide the RMSE of ADD,

20040328

20040328

1000

Proposed

20120328

Proposed

Proposed

600

200

19960328

20120328

Act

Exp

20120328

20040328

Date

20040328

19960328

Act

Exp

400

Customers (000)

20120328

Act

Exp

Date

800

Act

Exp

15000

19960328

20120328

200

1000

10000

15000

10000

Customers (000)

800

20040328

15000

10000

Customers (000)

5000

5000

1000

600

400

600

19960328

Act

Exp

800

Date

Customers (000)

20120328

Date

400

Customers (000)

0

20040328

SSW

Customers (000)

1000

19960328

Date

19960328

SSW

800

Date

19960328

Act

Exp

SSW

600

5000

800

20120328

Act

Exp

400

Customers (000)

20040328

200

GLS

Act

Exp

600

0

19960328

200

400

200

Customers (000)

800

600

400

Customers (000)

1000

Act

Exp

200

GLS

1000

GLS

28

20040328

20120328

19960328

20040328

20120328

LOSS, and END forecasts across all time horizons for each of the three models in Table 3. The

RMSE figures corresponding to SSW are generally 30-50% smaller than GLS, while the RMSE

figures of our proposed method are generally 40-70% smaller than SSW.

These conclusions are not affected by the inclusion of covariates in our model. We created

variants of GLS and SSW which allow retention, acquisition, and/or ending customers to be

affected by quarterly seasonality and the Great Recession (through a logit formulation for retention, and through proportional hazards for acquisition and ending customers), and the results

did not change.

Table 3: DISH: RMSE of Predictions by Forecasting Horizon for ADD, LOSS, and END

Metric

ADD

LOSS

END

4.1.3

Horizon

+1Q

+2Q

+3Q

+4Q

+5Q

+6Q

+7Q

+8Q

+1Q

+2Q

+3Q

+4Q

+5Q

+6Q

+7Q

+8Q

+1Q

+2Q

+3Q

+4Q

+5Q

+6Q

+7Q

+8Q

GLS

590.4

627.2

661.1

695.5

735.1

774.2

814.6

859.2

196.7

202.3

206.0

214.0

225.6

239.0

249.4

260.7

2370.3

2588.2

2831.7

3115.5

3413.9

3751.4

4116.5

4519.1

29

SSW Proposed

337.5

175.7

370.1

192.5

374.5

203.8

357.0

211.2

363.8

239.4

383.7

251.7

414.0

257.0

428.6

256.7

193.1

109.5

242.1

106.8

221.2

110.8

185.6

108.1

218.4

110.3

235.5

101.7

205.6

100.1

183.1

111.8

1203.4

229.1

1318.4

409.5

1446.8

580.0

1585.7

737.8

1734.4

920.3

1888.1 1094.2

2055.8 1251.8

2252.1 1381.4

We first project revenues (Section 3.7) far enough into the future (i.e., for 50 years) that all

subsequent profitability/loss has a negligible effect upon valuation. Long-term projections such

as these remove the need to estimate a terminal value, common in DCF models but often calculated in a relatively arbitrary manner (Courteau et al. (2001)). In Figure 4 we provide actual

and expected end-of-period total customer counts (top panel), monthly ARPU (middle panel),

and monthly sales figures (bottom panel).

Our revenue projections drive detailed financial projections used to estimate future free

cash flows, weighted average cost of capital, non-operating asset value, and net debt. For all

aspects of this procedure, see Appendix C which provides a step-by-step guide to the process

30

we followed. We then add the value of the operating assets to the non-operating assets and

subtract the net debt to arrive at our best estimate of shareholder value using Equation 1.

Figure 4: Dish Network: Summary of Projections

10000

4000

Act

Exp

2000

2010

2020

2030

2040

Date

150

100

Act

Exp

50

ARPU ($)

2000

2010

2020

2030

2040

1000

1500

500

Act

Exp

Date

2000

2010

2020

2030

2040

Date

A summary of key valuation inputs and outputs from our analysis for Dish are provided in

Table 4, alongside the corresponding inputs and outputs for Sirius XM, which we will discuss

shortly. We estimate a stock price of 62.45 based on Q1 2015 results, which had been disclosed

on May 11th, 2015. The end-of-day stock price that day was 66.38, implying that we were

within 6% of the then-current stock price. Our price estimate is well-calibrated the stock had

been trading near our price estimate for over 10 months prior to Q1 2015 results, and fell back

down to the price we had estimated after results had been disclosed.

4.2

Dish

Sirius XM

Subscriber Variable Cost Margin ((1 VCq ) in 4)

WACC

Total Paying Customers

Monthly ARPU ($)

Operating Margin

Average New Customer Lifetime (years)

SAC / Customer ($)

$2.71

23.3%

6.9%

13.8MM

$88.6

13.0%

5.60

$716.5

$0.49

49.3%

7.4%

22.9MM

$16.8

30.1%

4.20

$82.8

+ Non-Operating Assets - Net Debt

= Shareholder Value

/ Shares Outstanding

= E(Stock Price)

Actual Stock Price9

% Over(under)-estimation

$15.0B

$13.9B

$28.9B

462.1MM

$62.45

$66.38

(5.9%)

$25.6B

-$3.7B

$21.9B

5513.7MM

$3.97

$3.90

0.5%

31

Sirius XM

To test the robustness of the proposed valuation method, we repeat our valuation exercise for a

second company, Sirius XM, a large music services provider. Virtually all assumptions made

for Sirius XM are consistent with the approach outlined for Dish in Web Appendix C. As with

Dish, Sirius XM publicly discloses the magnitude of its subscriber acquisition expense, so no

estimation of this quantity is required.

Sirius XM is a complementary example for a number of reasons:

1. Sirius XM is a very high-growth business, while Dish is a mature business. ADD, LOSS,

and END are all past peak for Dish (Figure 2), while they are increasing for Sirius XM.

2. Sirius XM suffers from more severe missingness than Dish. While Sirius XM began commercial operations in Q4 200110 , no ADD, LOSS, and END data for paying customers

was publicly disclosed for almost 6 years, until Q3 2008. Data became available after its

predecessor, Sirius Satellite Radio, completed its acquisition of XM Satellite Radio. As

10

Both predecessor companies, Sirius Satellite and XM Satellite, began commercial operations at nearly the

same time February 2002 and November 2001, respectively.

32

a result, all back-casted figures represent the paying users of the combined entity. The

missigness is even more severe when we consider that Sirius XM is a younger company

than Dish. As a result, almost half of Sirius XMs customer data is missing.

3. Sirius XM is a high fixed-cost business because its satellite radios are pre-installed in

most new vehicles, while Dish Networks is a high variable-cost business. A regression of

operating expenses (net of SAC) upon revenues implies that nearly 40% of Sirius XMs

Q1 2015 operating costs are fixed in nature, while the corresponding regression for Dish

implies nearly virtually all of Q1 2015 costs are fixed. This substantially increases the

marginal profitability of Sirius XMs new users, all else being equal.

4. Sirius XM has a very different customer base and customer profile than Dish. Sirius

XM has a larger number of customers, each of whom generates less revenue but is much

cheaper to acquire (Table 4). We will discuss how the unit economics of customers compare in Section 4.3.

5. Sirius XM sells almost entirely into cars, whereas Dish sells almost entirely into homes.

All else being equal, this makes Sirius XM a more cyclical business than Dish.

Despite these differences, we proceed with virtually the same model. The only modifications we make to the proposed model for Sirius XM are to account for the fact that Sirius XM

sells primarily into the car and not into the home

11

model as well as their associated standard errors and the models sum of squared error (Equation 27) are provided in Table 5. Unlike with Dish, non-stationarity in the mean of the ARPU

process was neglible with Sirius XM, so the ARPU coefficient estimates (0 , 1 ) provided in

Table 5 come from a simple linear regression model (Equation 33) and not an ARIMA(0,1,0)

model (Equation 34).

11

The market size for Sirius XM is equal to the number of vehicles on the road, as provided by the Bureau

of Transportation Statistics. Corresponding, we use Total Vehicle Sales, as defined/provided by St. Louis Fed,

as our macroeconomic covariate. We denote the coefficient associated with the Total Vehicle Sales covariate by

T V S . Forecasts for these statistics are provided by two national automotive organizations, IHS and the National

Automobile Dealers Association. For more detail, please see Web Appendix D

33

Parameters

Acquisition

Retention

ARPU

9.64

.041

.223

.002

78.9

249389.4

1.55

(17.0)

(82080.1)

2.05

(.769)

Q1

Q2

Q3

TVS

N A

.116 .057

.051

.015

.032

(.047)

(.003)

(.005)

(.004)

(.001)

(.156)

397.3

2.00

.031

.037

.002

.003

(207.3)

(.287)

(.004)

(.005)

(.005)

(.001)

SSE

180,604

In Figure 5, we plot model estimates for ADD, LOSS, and END against what we actually

observed (grey indicates the duration of the Great Recession). We overlay 2-year rolling predictions as we had done for Dish in Section 4.1.2. As was the case with Dish, the in-sample and

out-of-sample fits for Sirius XM in terms of all three customer metrics are satisfactory.

As with Dish, we project revenues 50 years into the future. In Figure 6 we provide actual

and expected end-of-period total paying customer counts (top panel), monthly ARPU (middle

panel), and monthly subscriber sales (bottom panel). ARPU is modeled assuming linear growth,

because as with Dish, goodness of fit is materially better under this assumption. ARPU is

modeled as a simple linear function of time because the residuals of this fit did not fail the

Augmented Dickey Fuller unit root test. As with Dish, the goodness of fit of this simple ARPU

model is high, with an R2 of 87%.

From the top panel of Figure 6, we see that the proposed model predicts continued growth

in the total number of paying customers for approximately another decade before declining. Estimated monthly ARPU growth for Sirius XM is nearly the same as what we had estimated for

Dish after accounting for the absolute level of monthly ARPU for the two companies (approximately 3% of Q1 2015 ARPU; see Table 4). As a result, we predict that subscriber revenues

will grow for the next two decades before plateauing.

We perform a detailed margin and cash flow analysis to turn the revenue projections in

the bottom panel of Figure 6 into monthly free cash flow projections. From Table 4, we infer

that paying customers are far cheaper to acquire for Sirius XM, generate smaller (but more

Figure 5: Sirius XM: Gross Customer Additions, Losses and End-of-Period Customer

Counts (Recession in Grey)

34

1500

Act

Exp

Rolling Predictions

500

Customers (000)

Q4 2001

Q4 2003

Q4 2005

Q4 2007

Q4 2009

Q4 2011

Q4 2013

Date

500 1000

Act

Exp

Rolling Predictions

Customers (000)

20011228

20031228

20051228

20071228

20091228

20111228

20131228

Date

25000

Act

Exp

Rolling Predictions

10000

Customers (000)

20011228

20031228

20051228

20071228

20091228

20111228

20131228

Date

profitable) ongoing revenue streams thereafter, and churn more quickly, with average customer

lifetimes that are approximately 25% shorter. We predict that Sirius XM will experience very

favorable margin expansion over the next decade, as its fixed costs become a smaller proportion

of its rapidly growing revenue base. All assumptions made are documented in Web Appendix

D.

We estimate Sirius XMs operating assets to be worth $25.6B. After adding non-operating

assets (Sirius XM has approximately $1.1B in net operating loss carry-forwards) and subtracting

net debt, we arrive at our best estimate of shareholder value of $21.9B using Equation 1. This

implies a fair value per share of 3.97, which is 0.5% higher than Sirius XMs stock price the

35

25000

10000

Act

Exp

2000

2010

2020

2030

2040

2050

2060

Date

30

20

Act

Exp

10

ARPU ($)

40

2000

2010

2020

2030

2040

2050

2060

Date

1500

500

Act

Exp

2000

2010

2020

2030

2040

2050

2060

Date

In summary, our proposed model slightly over-estimates Sirius XMs stock price and slightly

under-estimates Dishs stock price, further evidence that our models price estimates are wellcalibrated.

4.3

Additional Insights

Confident that our model provides sensible valuation estimates, we return to Dish to study other

insights that we are able to draw from the model beyond stock price estimates. We look at the

remaining lifetime, CLV, and residual lifetime value (RLV) of Dish customers as a function

of their tenure with the firm. We first compare and contrast expected remaining lifetime and

36

RLV for customers with differing tenures with the firm, before looking at the entire probability

distribution. Next, we decompose Dishs current customer equity (CCE) by tenure. We finish

by introducing a customer profitability metric derived purely from firm financial and customer

data which investors may use to identify companies that earn high rates of return on their SAC.

4.3.1

Let us consider a Dish customer acquired in Q1 2015 who we call Recent Robin, and another

Dish customer acquired 10 years earlier in Q1 2005 who we call Longtime Larry. One quantity

of managerial interest is the expected future lifetime of Recent Robin and how it compares to

the expected future lifetime of Longtime Larry. Under GLS, all customers are assumed equal

and thus Recent Robin and Longtime Larry are expected to share the same expected future

lifetime. We intuitively know, however, that Longtime Larry is likely to remain a customer for

a longer period of time because his long history with Dish thus far implies he has a lower churn

propensity. Under our model, the expected residual lifetime of a customer acquired in month

m, active in and relative to month M , is by definition equal to

Z

E(m,M )

i=0

di.

S(M m|m, cR , X(M ), R , rR , R )

(35)

Because there is no closed form expression for Equation 35, we estimate it via Monte Carlo

simulation. For details regarding this procedure, please see Appendix A.

The expected total lifetime of Recent Robin and Longtime Larry are 5.6 years and 9.5

years, respectively, in line with our intuition. Investors want to know the expected lifetime

of customers. Longer expected customer lifetimes imply more stable future cash flows, all else

being equal, because future cash flows are less reliant on the acquisition of new customers.

At Dish, we see not only that older customers have longer residual lifetimes, but also that all

customers live for a relatively long time, which should be heartening to investors. Reducing

investors perceived risk of future cash flows improves cost of capital, raising firm valuation.

37

Another quantity of managerial interest is (pre-tax) residual lifetime value (RLV), i.e., the

net present value of all variable profit associated with a customer. Calculating this using nothing

but information provided in firm financial statements requires careful consideration of what expenses are fixed versus variable, and proper handling of subscriber acquisition cost (for details,

see Appendix A). We estimate that the pre-tax RLV associated with Recent Robin is $1,407,

excluding average initial acquisition costs of $854 (implying a pre-tax CLV for newly acquired

users of $554), while Longtime Larry is worth $1,931.

This information is useful to many stakeholders:

1. Investors may track CLV relative to SAC over time, viewing these metrics as financial

barometers of customer health. Unfavorable trends in these figures (as has been evident

at Dish, for example) are indicative of decreasing customer (and thus firm) profitability.

2. Competitors, comparable companies, and investors will be interested in the absolute level

of CLV for benchmarking purposes. If a competitor estimates its own CLV to be less than

Dishs, there may be opportunities to close the gap, identifying what it could be that is

causing the gap in average customer profitability. Investors may ask the same question

and demand that changes be made to improve CLV. In this regard, it is interesting to note

that the pre-tax CLV associated with a newly acquired customer at Sirius XM is $354,

excluding average initial acquisition costs of $83 while the expected post-acquisition

profit is smaller at Sirius XM than at Dish, the cost of acquisition is smaller still. We will

revisit this concept when we study the internal rate of return on newly acquired customers

below.

While all of the preceding analysis pertains to point estimates of future lifetime and value,

our probability model provides us with the entire distribution for both across all possible Recent

Robins and Longtime Larries. In Figure 7 we plot the distribution of pre-tax CLV for Recent

Robin and Longtime Larry. The fact that we estimate expected CLV via Monte Carlo simulation

naturally gives us the distribution of CLV as well.

38

Figure 7 provides us with additional color regarding the riskiness of future cash flows associated with new and existing customers at Dish, for example, we estimate that there is a 41%

chance that the company will earn incur a loss on a Recent Robin (i.e., the present value of the

pre-tax contribution margin for Recent Robin falls below her initial acquisition cost) 12 . Unsurprisingly, we infer a long right tail to Longtime Larrys pre-tax RLV this drives up Longtime

Larrys expected pre-tax RLV, but also implies a much higher variance about that expectation.

Longtime Larry is more valuable but is also more risky (McCarthy et al. (2016)).

3e04

Longtime Larry

Recent Robin

0e+00

1e04

2e04

Density

4e04

5e04

Recent Robin versus Longtime Larry

1000

2000

3000

4000

5000

4.3.2

Customer-Base Decomposition

The raw data available from virtually any public source reveals nothing about the tenure of

existing customers or how these lifetimes vary across the customer base. As hinted in the ex12

We tested for the existence of an on contract segment which is unable to churn for a two-year period, before

being able to churn. The model inferred only 1 segment of customers.

39

amples of Recent Robin and Longtime Larry, this can be vital information to outside investors.

Fortunately, our proposed model allows managers to easily infer these lifetimes and to perform

customer base segmentation on this basis. The proportion of currently active customers (i.e.,

active in quarter Q) who were born in month m is equal to

b

C(m,

3Q)

,

pm,3Q P3Q

b 3Q)

C(i,

i=1

(36)

While knowing the count of customers within each segment is helpful, the value of those

customers is what matters most to investors and managers. The proportion of total current

customer equity as of quarter Q coming from customers who were born in month m is the

CLV-weighted analog of Equation 36:

b

C(m,

3Q)E(Pre-tax CLVm,3Q )

,

pm,3Q P3Q

b 3Q)E(Pre-tax CLVi,3Q )

C(i,

(37)

i=1

where CLV is defined as in Section 4.3.1. The resulting barplot of customer base and firm CLV

proportions segmented by tenure is provided in Figure 8. We estimate, for example, that approximately one-eighth of Dishs customer base is comprised of highly loyal/inertial customers who

have been Dish subscribers for 10+ years. We also infer that longer-lived segments comprise

more of the total value of the customer base because they are inferred to have higher residual

lifetime values, as is evident from our comparison of Recent Robin and Longtime Larry above.

4.3.3

Investors are interested in simple profitability metrics that serve as proxies for corporate health,

and often filter/screen on stocks using these metrics to identify companies they may consider for

investment. One of the most popular metrics amongst financial analysts is return on invested

capital (ROIC, Damodaran (2007), Greenblatt (2006)), a measure of a companys ability to

create operating profit per dollar of investment into the business. Businesses that are able to earn

Figure 8: Inferred Customer Base and Firm CLV Decomposition by Tenure, Q1 2015

40

0.15

0.00

0.05

0.10

% of Customer Base

0.20

0.25

0.30

Customer Count

CLV

02

25

510

10+

Tenure (Years)

higher rates of return on invested dollars will generate faster-growing and thus more valuable

future cash flow streams.

While ROIC is a useful measure of a companys overall ability to generate high rates of

return, it is also valuable to know the marginal profitability of investments in newly acquired

customers. Investors may consider investment in companies that are able to earn high rates

of return on their subscriber acquisition dollars because these companies will also be able to

generate future cash flow at a fast rate by continuing to invest in customers, even if previous

investments in infrastructure/distribution encumber traditional metrics like ROIC.

For this reason, we propose a financial metric called the internal rate of return on a customer (IRRC). IRRC represents the internal rate of return on a marginal customer the rate of

return which makes the customer investment a net present value zero project (see Section 4.3).

A mathematical expression is provided in Appendix A.

IRRC is an important quantity for investors to take heed of if IRRC falls below WACC,

the firm would be earning an inadequate return on its acquisition spending and investors should

41

demand that the firm cease such spending. Conversely, a very high IRRC could indicate that

the firm may want to increase its acquisition budget, because the expected return on customer

investments is well in excess of what the capital markets are demanding of the firm as a whole.

Dishs IRRC is currently 25%, a respectably high rate of return on acquisition dollars. This

rate is high enough that Dish should certainly not curtail subscriber acquisition spending yet,

even though IRRC has been in decline. In contrast, Sirius XMs IRRC is a staggering 108%, far

higher than Dishs, indicative of far superior unit economics and a harbinger of growing future

profitability. This high rate of return on new customer acquisition spending, coupled with the

healthy number of new customers we expect Sirius XM to acquire as per Figure 6, drive Sirius

XMs valuation premium vis a vis Dish.

This profitability metric and other granular inferences that can be drawn from our model

can provide useful context to investors. In some sense, the overall corporate valuation shown

earlier isnt necessarily very insightful by itself; it merely captures the voice of the financial

market and suggests that the company is a bit overvalued in this case. But the real value of our

proposed approach is the ability to go beyond the macro valuation to offer useful, operational

diagnostics to better understand where that value is coming from, and what it might mean to the

firm, its competitors, investors, and possibly even public policy makers. In the case of Dish, the

considerable amount of value coming from long-lived customers is indicative of a very mature

business, and implies that the valuation of the business as a whole will be much more dependent

on and sensitive to changes in the companys ability to retain existing companies, rather than

acquire new ones. In contrast, Sirius XMs valuation is far more dependent on the the firms

ability to acquire new users and to earn a high rate of return on the firms investment in those

new users. This is important information for investors and managers alike.

42

As noted at the outset of the paper, our objective has been to create the right model for customer

acquisition and retention, and embed it within the right framework for corporate valuation. But

beyond the methods developed here, we hope this paper will serve as a call to action for firms

to perform these kinds of analyses on a more regular and rigorous basis. We have provided

a number of use cases for the analytics that can be derived from the model, including but not

limited to benchmarking the internal rate of return on customers, tracking CLV and IRRC over

time as key performance indicators for the business, comparing CLV and IRRC across comparable/competing firms, performing customer/firm value segmentation, and providing investors

with improved forward-looking sales visibility. All of this is possible because we have a flexible, general-purpose model.

While our model is particularly suited to publicly traded companies using their public disclosures, we contend that this same exercise can and should be done internally as well. Firms

can easily implement an equivalent version of this model using internal company data, enhancing its overall versatility. While estimation may differ a bit, the model for customer acquisition/retention and the valuation framework proposed here would remain essentially the same.

Measuring, tracking, and acting upon CLV can improve the ROI of company acquisition and

retention spending, and our valuation framework gives company executives the ability to estimate how much value this ROI improvement has created for the overall value of the firm. This

provides executives with an important key performance indicator to hold themselves and their

marketing managers accountable to.

While our model is considerably more flexible than previously published customer-based

corporate valuation models in terms of the dynamics that it can accommodate, it must nevertheless remain parametrically parsimonious because available data is so limited and will likely

stay that way for the foreseeable future. For example, it is highly unlikely that firms will begin

to disclose the kinds of data required to properly account for other sources of customer value,

such as the referral value of a customer (Kumar et al. (2007), Kumar et al. (2010) Kemper

43

(2009)), the impact of social media (Yu et al. (2013), Luo et al. (2013)), or customer satisfaction (Anderson et al. (2004), Homburg et al. (2005), Luo and Bhattacharya (2006)). At the same

time, indirect proxies for these factors may be obtainable in some cases through external data

sources for a small subset of companies.

Furthermore, it may seem tempting to add in other bells and whistles to further enrich the

model specifiction used here. We are open to such possibilities but are cautious about our ability

to do so. For instance, it may be the case that individual-level acquisition and retention propensities are correlated (i.e., customers who take longer to acquire may have a lower propensity to

churn once they have been acquired or vice versa see Schweidel et al. (2008a)), but our ability

to empirically identify such a correlation is very limited, increasing the risk that we over-burden

the limited data we have available. Many other theoretically reasonable extensions (e.g., allowing for cross-cohort effects (Gopalakrishnan et al. (2015)), or specifying a more complicated

market potential model) will likely suffer from similar issues. Bodapati and Gupta (2004) note

that when data is highly aggregated, even the ability to identify heterogeneity (in their setting,

latent class structure) can be challenging. For this reason, even though fits and forecasts dramatically improve when we allow for heterogeneity, it may be that some of the heterogeneity

we have inferred is due to other causes, including but not limited to state dependence. Their

paper reinforces the need for model parsimony.

Another limitation we readily acknowledge is that our framework is appropriate only for

subscription-based businesses, for whom attrition is observed (Fader and Hardie (2009)). It

may be possible, in theory, for an acquisition/retention model to be specified and fit for a

non-contractual business (i.e., with latent attrition), and/or for an upper triangular matrix to

be modeled and projected upon purchases instead of active customers as in Figure 1, in practice

non-contractual firms disclose less customer data than do contractual businesses, while also being more complex to model due to attrition being unobservable. It is not even clear what kinds

of metrics a non-contractual company would have to disclose in order for an outside analyst to

be able to perform a valuation task in a valid manner.

44

There are several other areas of future research that build upon the valuation framework

proposed in this paper. We have strictly focused our attention upon one company, but our

predictive accuracy may be improved if we were to develop a hierarchical Bayesian model,

estimating the parameters for many companies at the same time. This may alleviate some of

our data inadequacy issues by borrowing strength across firms, but will require considerable

methodological advancements to properly share information across firms and handle aggregated

missing data. Our analysis also motivates acquisition/retention spending optimization. This

would only be possible however for firms that disclose acquisition and retention spending, under

the imposition of (possibly strong) assumptions about the return on spending in both categories.

Beyond the methodological improvements, our valuation framework provides perspective

to the ongoing discussion amongst marketing scholars regarding the accounting of customer

equity and advertising spending. Consistent with Srinivasan (2015), the vast majority of Dishs

SAC is expensed and not capitalized (82% in Q1 2015) the primary component of SAC which

is capitalized is spending to purchase satellite receivers, which are then owned by Dish and

depreciated over a useful life of approximately 4 years. In contrast, acquired customers have

a much longer useful life of 5.6 years, on average (Section 4.3), and yet are not considered

assets (Wiesel et al. (2008)). As a result, SAC creates costs that are inflicted immediately while

benefits are received in the future, making the income statement not reflective of the underlying

economic condition of the business. It is no surprise, then, that Dish was generally unprofitable

earlier in its history, and profitable in recent years.

As companies increasingly recognize the importance/merit of customer-centric business

strategies (Fader (2012)), and in turn disclose customer data on a more regular and thorough

basis, there will be a growing opportunity for marketing scholars to study the behavior of large,

publicly traded companies through their customer data in conjunction with their financial statements. We hope that this paper lays a sound foundation for how future analyses will incorporate,

and shed further light upon, company valuation.

45

In this Section, we elaborate upon the procedure used to compute the results provided in Section

4.3.

The expected remaining or residual lifetime of a customer acquired in month m, active in

and relative to month M , is equal to the average of many samples drawn from its true distribution:

K

1 X (k)

E(m,M ) =

,

K k=1 m,M

(38)

(k)

where K is a large number (in practice, we set K = 100, 000). m,M , the kth sampled residual

lifetime of a customer born in month m, given he/she is active in month M , relative to month

M , is obtained using a simple conditional probability based upon Equation 16:

(k)

P (m,M = ) =

SR ( 1|m) SR ( |m)

,

1 SR (M m|m)

{1, 2, }.

(39)

In general, the pre-tax CLV of a customer born in month m, active in and relative to month

M , is equal to the average of pre-tax CLV of this customer over many sampled lifetimes:

E(Pre-tax CLVm,M ) =

(k)

Pre-tax CLVm,M =

K

1 X

(k)

Pre-tax CLVm,M ,

K k=1

(40)

1(m m,M )

EBITDASAC(m + m )

,

b m + m 1) + C(.,

b m + m ))/2 (1 + W ACC) m12

(

C(.,

m =1

(k)

where C(.,

EBITDASAC(m+m ) is equal to earnings before interest, taxes, depreciation, amortization and

subscriber acquisition costs in month m + m (monthly EBITDA and SAC are estimated using

(k)

the procedure outlined in Web Appendix B and operationalized in Web Appendix C); m,M is

the kth sampled residual lifetime of a customer born in month m, given he/she is still active in

month M , relative to month M (Equation 39); and W ACC is the firms weighted average cost

46

of capital. In English, we are computing the discounted sum of all future cash flows associated

with a customer, averaging over sampled realizations of his/her residual lifetime.

The IRRC of the company in quarter q is equal to

IRRCq : SACq +

(k)

K

1(m 3q,3q+m

)

1 XX

EBIDASAC(3q + m )

=0

b 3q + m 1) + C(.,

b 3q + m ))/2 (1 + IRRC)m /12

K k=1 m =1 (C(.,

(41)

where SACq represents the subscriber acquisition expense per user acquired in quarter q;

EBIDASAC(3q + m ) represents earnings before interest, depreciation, amortization, and subscriber acquisition cost in month 3q + m (monthly EBITDA, SAC, and taxes are estimated

using the procedure outlined in Web Appendix B and operationalized in Web Appendix C);

(k)

m,M is defined as in Equation 39; and C(.,

m, using Equation 11.

Web Appendix W1

In this Appendix, we provide additional detail regarding our DCF model so that scholars may

reproduce our analysis and perform similar analyses upon other companies. We begin by elaborating further upon the weighted average cost of capital (WACC) in Equation 2. WACC is equal

to the proportion of debt within the capital structure multiplied by the after-tax cost of debt (rD ),

plus the proportion of equity within the capital structure multiplied by the cost of equity (rE ):

WACC =

E

D

rD (1 TR) +

rE ,

D+E

D+E

(42)

where D is the market value of the companys debt, and E is the market value of the companys

equity, rD is equal to the value-weighted average current yield on the companys debt instruments, and rE is equal to the risk-free rate (rf ) plus the levered stock beta () multiplied by the

47

equity risk premium (ERP, or the required rate of return on the market (rm ) over and above rf ):

rE = rf + ERP.

(43)

The final key elements of Equation 1 are NOA, which is equal to the market value of all assets

that are not required for the ongoing operations of the business (i.e., deferred tax assets, ownership interests in unrelated businesses, etc.), net of associated liabilities, and ND, which is the

firms net debt.

Next, we further define the key financial items presented in Section 3.1:

NFWC is equal to current assets (CA) minus current liabilities (CL), excluding excess

cash and cash equivalents (XCASH) and short term debt (STD):

(44)

The variable operating margin (1 VC%) is equal to the gross margin, net of variable

operating expenses in a given period, expressed as a percentage of revenues:

1 VC%m =

GPm VOPEXm

.

REVm

(45)

VOPEXm and fixed operating expenses (FOPEXm ), are obtained by regressing total operating expenses (OPEXm ) against total revenues:

E(VOPEXm ) = 1 REVm ,

where

(46)

(47)

All public, domestic companies report income statement and balance sheet data via SEC

EDGAR quarterly; for reference, relevant financial metrics for our real data example are

available upon request by the authors). ND (Equation 1); CAPEX and D&A (Equation

48

3); REV, and TR (Equation 4); CA, CL, XCASH, and STD (Equation 44); and OPEX are

all directly obtainable through EDGAR in this way.

The companys equity, E (Equation 42), is conventionally set equal to the then-current

market capitalization of the companys stock (available through data sources such as Yahoo!Finance.

The market value of the firms debt and cost of debt (D and rD , respectively, from Equation

42) can be obtained from the market price of corporate bonds traded in secondary markets,

available through FINRAs Trace and other vendors.

The risk-free rate, rf , within Equation 43 is commonly taken to be the then-current yield

on 10-year Treasury bonds, and the same rate is used in the estimate of ERP (available

from the US Treasurys website).

within Equation 43 is available through data vendors (i.e., Bloomberg), and is commonly benchmarked off of comparable firms.

ERP estimates are made available on the website of Aswath Damodaran (Damodaran

(2015)).

WACC (Equation 42) may theoretically vary over time due to fluctuations in each of these

components, WACC is often assumed fixed, particularly for firms who appear to target a

particular ratio of debt to equity within their capital structures (i.e., Dish).

The market value of non-operating assets (Equation 1) is sometimes difficult to estimate,

because reported balance sheet figures represent their book value and not their market

value. Care must be taken when estimating the value of these assets. Historical nonoperating asset value estimates can be obtained from analyst reports.

For more detail regarding valuation theory, see Damodaran (2012). For reference, all relevant historical financial information for Dish are available upon request from the authors.

49

Using the results presented above, we may easily obtain historical free cash flow estimates.

Estimating the stock price requires the following additional steps:

Projecting monthly future revenues: This represents the core of our valuation model and

its implementation is presented in Section 3.6, which concludes with future monthly subscriber revenue estimates in Equation 31.

Projecting non-subscriber revenues: Even though subscriber revenues should represent

the majority of total revenues (in the case of Dish, for example, subscriber revenues represented 99% of total sales in Q1 2015), value derived from non-subscriber cash flows

should not be ignored.

Projecting NOPAT (see Equation 4): We must make a number of margin projections:

We project SAC expenses, driving these expenses off of the historical evolution of

SAC costs relative to customer additions.

We project non-SAC G&A expenses through a decomposition into fixed and variable cost, the variable component of which is driven off of our revenue projections.

We project capital expenditures, D&A and other expense, which are often fixed in

nature for the existing operations of mature businesses.

We project the corporate income tax rate.

Projecting future changes in NFWC: Changes in NFWC are typically driven off of historical sales over the previous twelve months.

We discuss operationalization of these additional steps for Dish, as well as the specific assumptions driving our projections, in Section C.

Web Appendix W2

50

In this Web Appendix, we provide additional information needed to replicate our analysis of

Dish Network. In Table 6, we provide a table containing Dish Networks most important customer metrics, as well as total subscriber revenues each quarter. All other data corresponding

to Dish is available upon request from the authors. For most of Dishs corporate history, all

relevant figures are contained in Other Data, within the first table of the Results of Operations section of Managements Discussion and Analysis of Financial Condition and Results

of Operations.

Below we provide all assumptions made to obtain FCF projections for Dish which are not

described above.

Estimating WACC: The total market value of Dish equity as of the filing date of Q1 2015

results is $30.7B. The total estimated value of Dishs debt is $14.4B. This implies that

68% of Dishs capital structure is comprised of equity. The proportion of equity within the

capital structure has been relatively stable over time, implying a constant future WACC

assumption is reasonable. Dishs levered beta is 1.05, implying an unlevered beta of

0.82. For ERP, we use the smoothed ERP estimate from Aswath Damodarans website

(Damodaran (2015)) as of May 2015 of 6.2%. The risk free rate is taken to be the thencurrent long-term Treasury Bond rate of 2.13%. We estimate a cost of debt of 5.5%,

estimated via then-current market yields on public debt.

Projecting non-subscriber revenues: Non-subscriber revenues for Dish represent only 1%

of total sales in Q1 2015, and thus are not material to the valuation of the business. This

business primarily relates to the sale of equipment. We estimate future equipment sales by

estimating trend-line growth over the prior 7 year period from Q1 2008 to Q1 2015, after

accounting for fluctuations in equipment sales in 2011-2012 due to end of year accounting

adjustments. As a result, we expect future growth for this segment of approximately 0.5%

per year, in line with the slow growth we have seen historically.

51

Projecting subscriber gross margin: We predict future subscriber gross margin to be equal

to the Q1 2015 subscriber gross margin, 36.4%. Because Dishs gross margin has experienced some gross margin erosion in recent quarters, taking a 3-year historical average is

likely to over-state future gross profitability. Gross margin is purely variable in nature, in

line with convention.

Projecting non-subscriber gross margin: Equipment sales gross margin had been historically relatively stable prior to the Q4 2014-Q1 2015 period. Therefore we assume future

equipment sales gross margin equal to the historical average over the period Q1 2014-Q3

2014, 26.6%. As with subscriber gross margin, this implies that equipment gross margin

is assumed to be variable in nature.

Projecting SAC expense: Our acquisition model provides us with monthly future expected

gross customer acquisitions. We multiple this by the expected ratio of SAC expense to

b

historical gross customer acquisitions, C(m,

m) (see Equation 17), estimated using linear

extrapolation off of the recent trend-line growth observed over the past 8 years. This implies future growth in acquisition expense per gross customer addition of approximately

3.4% per year.

Projecting non-SAC G&A expense: While G&A is often argued to be purely fixed in

nature, non-SAC G&A at Dish has historically been remarkably stable as a percentage

of total sales. This suggests that non-SAC G&A is effectively a pure variable cost. We

project future non-SAC G&A to be equal to the trailing 1 year average, or approximately

5.6% of quarterly sales.

Projecting depreciation and amortization expense: We project D&A expense each future

quarter to be equal to the year-earlier period, because we are valuing the existing operations of the business and not incorporating any future growth options the firm may

explore in the future into our revenue projections. This implies D&A fluctuates between

$246MM and $287MM per quarter into the future.

52

Projecting capital expenditures: We project capital expenditures to be equal to D&A,

which should be a reasonable maintenance level.

Projecting corporate tax rate: We assume a standard corporate tax rate of 40%.

Projecting changes in NFWC: We assume changes in NFWC as a percentage of trailing

twelve months will be equal to the prior two year average to smooth out quarterly noise,

or -0.5%.

Infilling costs: All expense items discussed thus far are reported quarterly, while our

modeling is performed using estimated monthly revenue figures. To infill expenses, we

assume all variable costs are a fixed percentage of monthly sales within each quarter, and

all fixed costs represent one third of quarterly total fixed costs.

Estimating non-operating asset value and net debt: Dish has made a number of very

large wireless spectrum asset purchases over the past 3 years, most recently in Q1 2015.

These assets are not related to the ongoing operations of the core business. Because

our customer-based corporate valuation model does not offer us any special insights into

the value of non-operating assets such as these, we estimate the following valuations via

the midpoint of Wall Street analyst reports (see, for example, Swinburne et al. (2014),

Manning (2015), and Hodulik et al. (2015)):

Wireless asset value post-tax: $25B

Hughes Retail Group Tracking Stock: $0.5B

Net present value of Tax Assets: $2.2B

Web Appendix W3

In this Web Appendix, we provide additional information needed to replicate our analysis of

Sirius XM. In Table 7, we provide a table containing Sirius XMs most important customer

53

metrics, as well as total subscriber revenues each quarter13 . All other data corresponding to

Sirius XM is available upon request from the authors.

Data regarding the number of vehicles on the road is provided by the Bureau of Transportation Statistics. We make this time series isotonic (monotone increasing) to ensure non-negativity

over time.

Below we provide all assumptions made to obtain FCF projections for Sirius XM which are

not described above.

Revenues: We add Subscriber Revenue, Advertising Revenue and Other Revenue together

into the Revenues column in Table 7 because revenue generated through all three channels

is strongly driven off of the size of the customer base.

Estimating WACC: The total market value of Sirius XM equity as of the filing date of

Q1 2015 results is $21.6B. The total estimated value of Sirius XMs debt is $5.1B. This

implies that 81% of Dishs capital structure is comprised of equity. The proportion of

equity within the capital structure has been relatively stable in recent years, implying

a constant future WACC assumption is reasonable. Sirius XMs levered beta is 1.01,

implying an unlevered beta of 0.91. For ERP, we use the smoothed ERP estimate from

Aswath Damodarans website (Damodaran (2015)) as of April 2015 of 6.2%. The risk

free rate is taken to be the then-current long-term Treasury Bond rate of 2.00%. We

estimate a cost of debt of 6.4%.

Projecting non-subscriber revenues: As was the case with Dish, non-subscriber sales are

a very small proportion of total revenues, at approximately 2.2%. Unlike Dish, Sirius

XMs equipment sales are growing modestly at a linear rate, at approximately $0.6MM

per quarter. We project this modest growth will continue into the future.

Projecting subscriber gross margin: Unlike Dish, Sirius XMs subscriber gross margin

13

As noted above, Sirius XM disclosed its own revenue figures prior to Siriuss merger with XM Satellite Radio,

and neither Sirius nor XM disclosed paying customer metrics until after the merger took place. This makes premerger data not meaningful.

54

has been relatively stable. We predict future subscriber gross margin to be equal to its

3-year historical average, or 62.9%. Results are not sensitive to the choice of look-back

period. Gross margin is purely variable in nature, in line with convention.

Projecting non-subscriber gross margin: Equipment sales gross margin had been historically relatively stable. We assume the non-subscriber gross margin will be equal to its

prior 5-year average of 57.1%. Results are not sensitive to the look-back period (the

full-year 2014 non-subscriber gross margin is 57.6%).

Projecting SAC expense: Unlike with Dish, Sirius XMs ratio of SAC to ADD has been

declining instead of rising, but at a declining rate. Linear extrapolation of this ratio into

the future would eventually result in negative numbers, and would not be consistent with

the deceleration evident in this ratio over time. We assume that this decline in the cost

to acquire new paying customers will continue for another 5 years (estimated using a

quadratic fit), driving the acquisition cost of a new paying user to $73 from its most

recent level of $80. Thereafter, we assume a flat SAC/ADD ratio.

Projecting non-SAC operating expenses: We run a regression of real sales against real

operating expenses (inclusive of depreciation and amortization) net of subscriber acquisition costs using data from Q4 2008 through Q1 2015. The resulting regression estimates

imply total real fixed costs of approximately $99MM per quarter, and variable costs equal

to 13% of real revenues. We predict that future fixed costs will grow at the rate of inflation

while future variable costs are equal to 13% of predicted future revenues.

Projecting capital expenditures: Unlike Dish, Sirius XM is still growing and investing in

growth capital expenditures, over and above the capital expenditures required to maintain

the existing operations of the business. We assume capital expenditures are equal to their

historical 2 year average of $85.1MM per quarter (depreciation and amortization averages

to $65.4MM over the same period).

Projecting corporate tax rate: We assume a standard corporate tax rate of 40%.

55

twelve months will be equal to the prior two year average to smooth out quarterly noise,

or -19.7%.

Infilling costs: All expense items discussed thus far are reported quarterly, while our

modeling is performed using estimated monthly revenue figures. To infill expenses, we

assume all variable costs are a fixed percentage of monthly sales within each quarter, and

all fixed costs represent one third of quarterly total fixed costs.

Estimating non-operating asset value and net debt: Sirius XM has a substantial amount

of net operating loss carry-forwards (NOLs), which will reduce Sirius XMs future tax

payments, due to previously incurred losses. The net present value of these NOLs is

$1.1B.

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62

Customer Data (000) and Subscriber Revenues ($MM) [Web Appendix]

Period

Q1 1996

Q2 1996

Q3 1996

Q4 1996

Q1 1997

Q2 1997

Q3 1997

Q4 1997

Q1 1998

Q2 1998

Q3 1998

Q4 1998

Q1 1999

Q2 1999

Q3 1999

Q4 1999

Q1 2000

Q2 2000

Q3 2000

Q4 2000

Q1 2001

Q2 2001

Q3 2001

Q4 2001

Q1 2002

Q2 2002

Q3 2002

Q4 2002

Q1 2003

Q2 2003

Q3 2003

Q4 2003

Q1 2004

Q2 2004

Q3 2004

Q4 2004

Q1 2005

Q2 2005

Q3 2005

0

0

0

0

100

6

190

15

350

40

479

58

590

76

820

99

1040

122

204

44

1200

140

236

36

1400

161

267

67

1600

187

395

55

1940

218

400

40

2300

271

414

114

2600

318

500

100

3000

372

580

170

3410

392

585

95

3900

492

618

218

4300

577

648

148

4800

634

705

245

5260

668

688

248

5700

797

656

286

6070

886

684

324

6430

925

692

292

6830

998

619

289

7160

1019

642

342

7460

1080

722

402

7780

1124

804

404

8180

1207

687

337

8530

1293

701

431

8800

1343

746

461

9085

1366

759

419

9425

1438

785

425

9785

1494

851

511

10125

1661

897

547

10475

1733

907

477

10905

1837

801

476

11230

1894

799

574

11455

1990

900

645

11710

2008

Period

Adds

Q4 2005 897

Q1 2006 794

Q2 2006 824

Q3 2006 958

Q4 2006 940

Q1 2007 890

Q2 2007 850

Q3 2007 904

Q4 2007 790

Q1 2008 730

Q2 2008 752

Q3 2008 825

Q4 2008 659

Q1 2009 653

Q2 2009 731

Q3 2009 887

Q4 2009 847

Q1 2010 833

Q2 2010 747

Q3 2010 819

Q4 2010 653

Q1 2011 681

Q2 2011 572

Q3 2011 656

Q4 2011 667

Q1 2012 673

Q2 2012 665

Q3 2012 739

Q4 2012 662

Q1 2013 654

Q2 2013 624

Q3 2013 734

Q4 2013 654

Q1 2014 639

Q2 2014 656

Q3 2014 691

Q4 2014 615

Q1 2015 554

Losses

567

569

629

663

590

580

680

794

705

695

777

835

761

747

705

646

598

596

766

848

809

623

707

767

645

569

675

758

648

618

702

699

646

599

700

703

678

688

Ending

12040

12265

12460

12755

13105

13415

13585

13695

13780

13815

13790

13780

13678

13584

13610

13851

14100

14337

14318

14289

14133

14191

14056

13945

13967

14071

14061

14042

14056

14092

14014

14049

14057

14097

14053

14041

13978

13844

Revenues

2137

2183

2325

2374

2541

2552

2676

2699

2764

2810

2876

2886

2883

2865

2878

2863

2933

3036

3141

3186

3181

3199

3311

3229

3232

3225

3296

3267

3277

3348

3453

3464

3500

3556

3645

3648

3656

3689

63

Customer Data (000) and Subscriber Revenues ($MM) [Web Appendix]

Period

Q4 2001

Q1 2002

Q2 2002

Q3 2002

Q4 2002

Q1 2003

Q2 2003

Q3 2003

Q4 2003

Q1 2004

Q2 2004

Q3 2004

Q4 2004

Q1 2005

Q2 2005

Q3 2005

Q4 2005

Q1 2006

Q2 2006

Q3 2006

Q4 2006

Q1 2007

Q2 2007

Q3 2007

Q4 2007

Q1 2008

Q2 2008

0

0

0

0

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

<NM>

Period

Adds

Q3 2008

Q4 2008 1189

Q1 2009 909

Q2 2009 911

Q3 2009 962

Q4 2009 1182

Q1 2010 1014

Q2 2010 1164

Q3 2010 1182

Q4 2010 1292

Q1 2011 1126

Q2 2011 1331

Q3 2011 1353

Q4 2011 1385

Q1 2012 1329

Q2 2012 1514

Q3 2012 1502

Q4 2012 1629

Q1 2013 1488

Q2 2013 1447

Q3 2013 1479

Q4 2013 1539

Q1 2014 1380

Q2 2014 1538

Q3 2014 1624

Q4 2014 1778

Q1 2015 1621

Losses

830

1023

926

926

935

944

860

924

941

1005

968

989

1010

1029

1051

1131

1100

1183

1024

1106

1127

1207

1158

1244

1269

1227

Ending

15191

15550

15436

15421

15457

15704

15774

16078

16336

16687

16808

17170

17534

17909

18208

18671

19042

19570

19875

20298

20670

21082

21255

21635

22015

22523

22917

Revenues

477

632

577

580

608

657

650

681

700

715

708

727

747

761

788

821

850

870

879

922

944

974

974

1008

1034

1061

1144

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