Application of binomial option pricing theory to customer valuation

Abstract :

Companies today recognise that customer retention is a critical factor to the success of most businesses. Empirical evidence has shown a strong link between the level of customer retention and profitability. Accordingly companies have incorporated marketing approaches (such as relationship marketing) to capture the long-term benefit of customers. However, to properly manage customer defections, companies need to be able to value customers. The literature suggests that customers should be valued as the discounted cash flow (DCF) value of expected future earnings streams. However, DCF valuation models do not fully reflect the dynamic environment and the choices available to customers. This study analyses customers rather in terms of a series of call options, which can be valued using binomial option valuation techniques borrowed from financial markets. This study develops the optional valuation model in the context of a customer. The option valuation model incorporates not only the level of customer profitability per purchase but also the profitability of a customer making a purchase. The probability of purchase in turn is considered to be a function of the extent to which previous purchases influence customer decision. The outcome of the analysis suggests that in situations where the decision to purchase is significantly influenced by prior decisions, changes in the probability of purchase have greater impact on customer value than changes in the level of profitability. Through this analysis, new insights into the trade-off between profitability and customer retention are highlighted. In addition, this analysis provides new tools by which managers can measure and justify decisions with reference to the financial impact on customers.



Author Levett PA
Date Accessioned 2016-09-22T09:18:40Z
Date Available 2016-09-22T09:18:40Z
Date Created
Identifier URL 1997
Language English
Subject Business administration / Business leadership
Subject 2 Business administration / Business leadership
Alternative Title
Degree Type Masters degree
Degree Description  MBA