How many companies call themselves “customer-centric” while failing to see issues through customers' eyes?

Larry Selden, professor emeritus of finance and economics at Columbia University, and Geoffrey Colvin, senior editor at large at Fortune magazine, argue in their book, Angel Customers & Demon Customers, that any company that claims it's customer-centric is “an outright fraud” unless it can pass a three-part test:

• Is there a specific person who “owns” the customer and can develop specific value propositions?

• Who is accountable for the profitability of a customer or segment?

• And how significantly does the company differentiate interactions with customers?

The subtitle of the book is Discover Which is Which and Turbo-Charge Your Stock, which summarizes the book's premise well. The only way to achieve a P/E superior to the market—not your industry—is to understand that a company is no more than a portfolio of customers.

Companies that want a superior stock price must understand the relative profitability of customers, develop different value propositions for customers of varying profitability and organize around customers.

Here's what the authors say:

You can build gross margin by making capital investments that reduce labor costs; it works because the capital costs aren't included in gross margin. You can buy market share with price cuts. You can increase customer satisfaction and retention through all sorts of giveaways to the customer that will cost the company dearly.

Only by looking at customer economic profit and a contribution to a premium P/E can one make a sound judgment about the success of an initiative….

Selden and Colvin offer a new way to calculate customer equity—although, curiously, the term is never used. A “Customer Segment Value Creation Scorecard” divides each demographic or other segment into current, new and lost customers.

Sales to each group are broken out by products, services or intellectual capital, and reflect cross-sells and up-sells. Costs include COGS (costs of goods sold), account management, acquisition costs and, interestingly, Customer Knowledge Management (CKM), which represents the costs of acquiring, maintaining and using customer information. Subtracting these costs (and taxes) from revenues gives the familiar figure of net operating profit after tax, reached in a new way.

Then the approach grows complex. Using these figures, companies can calculate return on invested capital (ROIC) for each category of customer. The ROIC for each customer segment is used to calculate current and future P/E.

Understanding the explanation of how to calculate future P/E would have required someone with much more financial expertise than I have. Knowing the current and future P/E lets companies determine which customer segments are profitable and which are dragging down shareholder value.

Once the Customer Scorecard is complete, companies must understand why the segments studied generate excellent or subpar returns, and alter strategies accordingly. The next step is to organize around specific, mutually exclusive customer segments instead of products, regions or functions.

Such an organization produces both higher returns on invested capital as well lower capital costs resulting from higher retention.

For example, Fidelity Investments transformed its structure from one based on marketing, distribution and other functions to one centered around four customer segments—private wealth management, active traders, core customers, and retirees.

Each segment's customers are then grouped by profitability designed to guide resource allocation. Once this grouping was done, Fidelity found that 10% of customers in the private wealth management segment—those with more than $2 million invested with Fidelity—were unprofitable, proving once again that customer size is no indication of profitability.

Finally, managers must create, communicate and execute a value proposition, defined as “the complete experience a company delivers to its customers.”

Based on customer interaction and profitability data, value propositions must be specific and desirable for each segment; otherwise, they degenerate into corporate blather like “world-class,” “service-focused” or “customer-centric.”

Hypotheses based on potential value propositions must be measurable—“churn rates will decline from 11% to 3%” or “pricing discounts will decline from 9% to 4%.”

The last step is hypothesis testing, complete with control groups. When Capital One developed hypotheses concerning value propositions for defecting credit card customers, it used three control groups to judge the impact of different offers.

A company organized around customers and able to calculate customer equity can establish cross-functional, profitable bonds more easily.

Royal Bank of Canada, which calculates customer equity for each of its 10 million customers each month, developed a campaign based around the life event of a home purchase. Instead of the usual advertising about mortgages, it developed a newspaper insert titled “First Home Buyers Guide,” filled with how-to information. It also bundled its mortgage with an innovative offer—$500 into a savings account every year for five years, free financial reviews for five years, free online banking, free AOL and a no-fee Visa.

The result: the bank increased its share of the total mortgage market and substantially increased its share among first-time homebuyers.

One interesting chapter discusses why so many mergers and acquisitions (M&As) fail. Companies think they are buying other companies, but most of the time they are buying customers.

Customer equity is rarely analyzed, which means that the acquiring company gets stuck with unprofitable customers that destroy shareholder value.

Rather than buying companies, Selden and Colvin suggest buying customer segments that are “darlings” or “dependables” while leaving the “duds” and “disasters” for others. Their Insight #5 about M&A: “Buying profitable customers at premium prices can be far superior to buying a company.”

Angel Customers & Demon Customers has flaws. The discussion of customer equity calculation lacked sufficient detail. It also would have been nice to get more details about how Fidelity, Royal Bank, Dell and other companies made the gut-wrenching shift to a customer-centric organization, especially since Colvin and Selden say changes “need to be implemented as a holistic, integrated system” in less than two years. If necessary, even other corporate initiatives must be abandoned “to make customer-centric transformation the only leadership priority.”

But it's still must reading for any company—or shareholder—that lives or dies based on stock price.