The Hidden Roots Of Value

Read a useful prospectus lately? How about an informative annual report?

How come few of these traditional reports anymore offer a clue about which emerging young company is about to take over the world, or about which established, blue-chip company is about to fall into a competitive black hole?

And even when these reports do manage to capture a glimmer of reality, how come those clues lie between the lines of the accompanying, barely legible text and not in bold type on the balance sheet? And why do brokerage houses publish buy or sell recommendations on stocks that seem to have nothing to do with the financial performance of the companies those stocks represent?

 

Most curious of all, why has the stock market set new records throughout the 1990s when the economy, even during upswings, is consistently weak?

The answer is that the traditional model of accounting, which so beautifully described the operations of companies for a half millennium, is now failing to keep up with the revolution taking place in business. Like the organization chart, printed corporate brochure and employee handbook, corporate financial documents are increasingly proving themselves too static and hidebound to keep up with the modern organization, with its fluid structure, strategic partnering, empowered employees, groupware, multimedia network marketing, and vital reservoirs of human intellectual resources.

The chilling fact is this: At this moment we have no idea which companies, large or small, young or old, have sustainable organizational capability.

Rich Karlgaard, editor of Forbes ASAP, identified this disaster and what it would take to fix it in a 1993 editorial:

As an index, book value is dead as a doornail, an artifact of the Industrial Age. We live in the Information Age, of course, though remarkably few people have come to terms with that fact. Failure to understand the declining relevance of book value - and the hard assets that form the ratio's numerator - is proof of this.

Human intelligence and intellectual resources are now any company's most valuable assets.

The economist who comes up with a better measure of core value will have to account for the new intangible assets so ascendant today... [For now] society utterly lacks the metrics needed to measure this new source of wealth.

There have always been occasional and temporary gaps between market perception and accounting reality. But now that gap is turning into a chasm. And that in turn suggests we are looking not at a temporary aberration but at a systemic flaw in the way we measure value. A fundamental discrepancy between the story told on corporate balance sheets and the real one played out daily by the organizations themselves.

The business pages of America's newspapers are filled with examples. Southwest Airlines is valued greater than veteran airlines many times its size. Intel suffers a major scandal from flaws in its flagship Pentium chip and its stock price barely breaks stride. Netscape, a $17 million company with fifty employees, goes public with an initial stock offering that values the company at $3 billion by the end of the day. Microsoft, an $8 billion company, announced its Windows 95 operating system and sees its stock climb to more than $100 per share, making the company more valuable than Chrysler or Boeing.

It has become obvious that the real value of these companies cannot be determined by only traditional accounting measures. The worth of an Intel or Microsoft lies not in bricks and mortar, or even in inventories, but in another, intangible kind of asset: Intellectual Capital.

In the words of Walter Wriston in his influential book The Twilight of Sover-eignty, Indeed, the new source of wealth is not material, it is information, knowledge applied to work to create value.

Toward a definition

What is intellectual capital? Until now, the definition has been elusive. But in recent years, driven by necessity, individuals and groups in diverse disciplines have begun to tackle the challenge of finding a standardized explanation.

SEC commissioner Steven M.H. Wallman includes under his definition of Intellectual Capital not just human brainpower but also brand names and trademarks, even assets booked at historic costs that have transformed through time into something of greater value (like a forest bought a century ago that now is prime real estate). All, in his words, are assets currently valued at zero on the balance sheet.

Other researchers include in their definition of intellectual capital such factors as technology leadership, ongoing employee training, even speed of response to client service calls.

For venture capitalist and business writer William Davidow (The Virtual Corporation), There's a need to move to a new level in accounting, he says, one that measures a company's momentum in terms of market position, customer loyalty, quality, etc. By not valuing these dynamic perspectives, we are misstating the value of a company as badly as if we were making mistakes in addition.

For H.Thomas Johnson, professor of business administration at Portland (Oregon) State University, Intellectual Capital hides within that most mysterious traditional accounting entry, goodwill. The difference, he says, is that traditionally goodwill emphasized unusual, but real, assets such as trademarks. By comparison, he says, Intellectual Capital looks beyond to more ineffable assets such as the ability of a company to learn and adapt.

Wrote Industry Week in early 1996:

Managers struggle in the here and now to adjust to the shift in the center of economic gravity from the management and measurement of physical and financial assets to the cultivation and leverage of knowledge as the most significant acts of value creation.

And it applies as much to Microsoft as it does to a knitting mill in the wilds of Canada weaving berets on a machine bought by the proprietor's great-grandfather in 1919. Ask an executive from either firm what percentage of total value they would attribute to intangible assets -- everything from individual skills and know-how to IT systems, designs, and trademarks to supplier relationships and customer franchise -- and you get the same answer: upward of 80 percent.

Then ask them to contemplate the ratio of value siphoned off into the accounting hot-air balloon called goodwill over assets actually inked into the balance sheet and you get paroxysms.

The magazine goes on to quote an angry Lars Kolind, president of Danish hearing aid maker Oticon Holding A/S, whose firm has grown in market value from 150 million Danish kroner in 1991 to 2.4 billion today -- yet only 400 million of those kroner show on the balance sheet. Says Kolind, All of our accounting, all of the rules of the government and stock exchange , all the resources, everything is focused on the equity, which is absolutely stupid because the 2 billion Danish Kroner of intellectual capital is five times as high!

Some observers have even suggested that intellectual capital actually subsumes what we usually think of as fixed assets, which on closer inspection prove to be less fixed than we thought. For example, Gary Hamel, a professor at the London School of Business, has argued that an asset is really only a perception of an opportunity about which a majority of people have agreed.

Whatever definition is used, it is apparent that the value of Intellectual Capital in the world's businesses is immense. Charles Handy, also of the London School of Business, has estimated that these intellectual assets may typically be worth three or four times a company's tangible book value. According to Morgan Stanley's World Index, the average value of companies on the world's stock exchanges is two times book value. In the United States, corporate market value typically ranges from two to nine times book value.

Says Professor Keith Bradley of the Open Business School (U.K.):

Over the past twenty years there has been a significant widening of the gap between the values of enterprises state in corporate balance sheets and investors assessment of those values. [The median market to book value ratio for U.S. public corporations over a twenty year period between 1973 and 1993 incr-eased from 0.82 to 1.692.] The gap in 1992 indicates that roughly forty percent of market value of the median U.S.Public corporation was missing from the balance sheet. For knowledge intensive corporations, the percentage assets missing from the balance sheet is over one hundred.

These distortions are also reflected in recent U.S. acquisitions. An examination of the relationship between the price paid for U.S. acquisitions over a thirteen-year period between 1981 and 1993 of some 391 transactions with a median value of $1.9 billion shows that the mean of the price of acquisition to book value is 4.4. This indicates that, on average, the real values of the acquired corporations were about four and a half times larger than the values reported in the balance sheets. Acquisitions, of knowledge-intense companies had price to book values larger than ten...

Do we have the tools to manage these hidden assets? The simple answer is