Anxiety as a Cost

The airline industry operates according to a simplistic theory of customer value. In Eleven Things Organizations Can Learn From Airports (January 2013), Seth Godin criticizes this theory.

"By removing slack, airlines create failure. In order to increase profit, airlines work hard to get the maximum number of flights out of each plane, each day. As a result, there are no spares, no downtime and no resilience. By assuming that their customer base prefers to save money, not anxiety, they create an anxiety-filled system."

Alan Patrick (@freecloud) believes that the airline theory is correct: "fwiw the work we did show that many customers value price, fewer value low anxiety".

Sometimes it is not hard for companies to collect evidence to reinforce their assumptions, but we need to examine and interpret such evidence carefully. Here are some things to consider.

• Statements about customer preference may be based on survey (asking them about their preferences) or behaviour (inferring preferences from their choices). Behaviour might seem to be a more reliable indicator than survey.

• However, people make choices based on the information they have. If they appear to choose between airlines based solely on price, that might mean they think other factors don't matter, but it might also mean they don't expect any airline to be better than any of the others. Furthermore, obsessive attention to price may represent a suppression of more difficult issues.

• Many people simply don't fly at all, or choose alternative forms of transport wherever possible, because they find flying such an unpleasant or frightening experience. If you only look at the people who do fly, this is a biased sample. See for example Liesl Schillinger, The Cost of High Anxiety About Flying (New York Times Jan 2010). 

• People often don't acknowledge anxiety, they just find other reasons not to be your customer.

In economic terms, we can regard anxiety as a cost. This cost doesn't appear on the airlines' financial accounts, for two reasons. Firstly, because it is not easily represented in monetary terms, and secondly because it is not directly incurred by the airlines but by their customers. See my post on the Calculus of Cost (January 2013).

For that matter, companies don't always recognize the anxieties experienced by their own employees, although there is some awareness of this question in some sectors (such as military and healthcare) where anxiety can have life-and-death consequences.  Robert Johnson explores this factor in the US Army.

"People take shelter, as it were, behind their official roles. One becomes, in essence, an anonymous member of the institution's "collective instrumentality". Under these conditions, one may feel little or no personal responsibility for one's actions. Alternatively, one may feel personally responsible for one's conduct but view any guilt or anxiety as a cost of maintaining one's honorable commitments to the institution."

More fundamentally, organizations such as military and healthcare derive much of their structure and culture from the psychological pressures faced by people in these organizations. There is a broad literature on this, going back to the work of Menzies Lyth and her colleagues at the Tavistock Institute. So to understand the costs of anxiety, we shouldn't just consider the effects experienced by individuals, but also the organizational costs of protecting people from these effects.

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Robert Johnson, Institutional Violence: Organizational and Psychological Issues in the Military Context (ARI Research Note 90-117 Sept 1990)

Isabel Menzies Lyth, Social Systems as a Defense against Anxiety (1959)

Liesl Schillinger, The Cost of High Anxiety About Flying (New York Times Jan 2010)

Bruce H. Smith, Anxiety as a cost of commuting to work Journal of Urban Economics, 1991, vol. 29, issue 2, pages 260-266 (abstract only)

Company Value

What is a company worth? There are several possible ways of answering this question.

Book Value / Balance Sheet Value	This is the value that is calculated by accountants and verified by auditors, largely based on a historical view of the company's past and present transactions. This value is published periodically (typically 1, 2 or 4 times a year). However, in principle it could be calculated or estimated in near real-time, given sufficient access to company transaction data.
Market Capitalization	This is the value that is derived from the current share price. It is largely based on investor's views of the company's future prospects, as well as general market sentiment.
TakeOver Value	This is the value that someone is prepared to pay to win control/ownership of the company. (There may be different take-over scenarios, with a different valuation attached to each scenario.)
BreakUp Value Sum-of-the-Parts	This is the value that the company would be worth if broken into separate parts. (There may be different ways of breaking up the company, resulting in different valuations.)

We can make a number of observations.

1	In an idealized rational world with perfect information, we might expect all these values to be the same.
2	In the real world with imperfect information, these generally yield different answers. Some people may like to think that one of them reflects the "true" value of the company. But it is generally better to regard them as simply reflecting different kinds of truth about the company, each valid in its own terms.
3	These also vary on a different timescale. The shareprice of a large company (and therefore the market capitalization) may fluctuate many times in an hour, but it is unlikely that the book value changes with this degree of volatility.
4	A company should normally be worth more than the sum-of-the-parts, because there is some synergy between the parts. But this isn't always the case. When the market capitalization is considerably less than a sum-of-the-parts valuation, it is possible to make money by buying the company and immediately breaking it up. One version of this is known as Asset Stripping, where the new owners profit by selling assets that are worth more than the book value.
5	In a takeover situation shareholders usually expect to be offered a premium to the share price, as an incentive to give up their shares. When a takeover is rumoured or announced, the share price usually rises to a value close to the expected takeover price, and so the market capitalization converges with the takeovervalue.
6	After a takeover, some parts of the acquired company may be immediately sold. This may be to recoup or repay the money that was staked on the acquisition, or to satisfy the demands of the regulator. But where these sales are forced or hurried, they may not realize the most favourable sum-of-the-parts valuation.
7	In the long term, these different valuations cannot continue to diverge. The valuations remain coupled, although extremely loosely, and there are various ways in which the valuations may be brought back into alignment. (These are basically feedback loops with very long delays.) Speculators sometimes make large amounts of money by betting on future market adjustments. But the timing of these adjustments cannot be accurately predicted, and speculators sometimes lose large amounts of money by predicting the right adjustment at the wrong time. As Keynes noted, markets can often remain irrational far longer than an individual investor can remain solvent.

One way of experiencing this complexity is by tracking the shareprice and newflow of a large company over a period of some weeks or months. Sometimes shareprice changes can be explained in terms of the newsflow of the company, including takeover rumours; sometimes they can be explained in terms of the economic environment (competitor newsflow, commodity prices); and sometimes they appear to be little more than random fluctuations.

In Spring 2005, we picked four companies quoted on the London Stock Exchange, and asked our students to track one of these companies and interpret the results. This assignment was intended to give students a practical awareness of the extent to which shareprice could be a meaningful indicator of the present value and future viability of a company, as well as practice in interpreting data. By a happy chance, two of the companies were subject to acquisition speculation during the tracking period, which generated some interesting data for the students to work with.

Productivity

The annual Value Added Scorecard from the UK Department of Trade and Industry (DTI) measures the wealth-creation efficiency and labour productivity of UK and European companies. In other words, how much wealth is being created, and how much labour is needed to produce it.

The scorecard measures wealth created in terms of value added, defined as operating profit + employee cost + depreciation + amortisation. (This is roughly equivalent to gross margin - total revenues minus all input costs except the cost of labour and capital equipment.)

Two productivity ratios are defined. P1 is labour productivity - the value added per employee (expressed as an amount of money). P2 is wealth creation efficiency - the value-added divided by the cost of labour and capital equipment (expressed as a percentage).

From all this research, the Investors Chronicle (8th April 2005) spots a practical tip for investors. Over the past six years, a portfolio of companies with growing value-added and above average P2 would have produced investment returns for investors of 139 per cent, while the FTSE 350 index fell by ten percent. In other words, P2 seems to be a good indicator of viability, at least from an investment perspective.

DTI website: http://www.innovation.gov.uk/