In today’s environment of investor skepticism and tough market conditions, intangible drivers are influencing shareholder value like never before. Ernst & Young’s Measures that Matter study suggests that at least 50 percent of any company’s market value can be attributed to intangibles. ‘The idea that intangibles are soft or squishy is a misnomer and even though they are not necessarily on the balance sheet or income statement, they can be quantified,’ notes John Low, senior research fellow at the Cap Gemini Ernst & Young Center for Business Innovation.
Indeed, there is growing consensus among regulators, accounting experts and IR practitioners that companies should quantify the value of intangibles like CEO reputation, intellectual capital and management credibility; and that they should communicate their worth to investors.
The SEC is proposing to broaden the scope of 8K disclosures to include intangibles such as the appointment of new directors or the replacement of the CEO or CFO. Meanwhile the Financial Accounting Standards Board (FASB) is working on a project to establish quantitative and qualitative measures of companies’ intangible assets that would be included in M&A valuations. At the same time, IR consultants and researchers are coming up with new ways to identify and quantify drivers of intangibles in an effort to boost shareholder value by unlocking so-called hidden assets.
Sea change
The most compelling argument for quantifying intangibles is in the direct link between institutional buy decisions and intangibles drivers. ‘Increasingly, investment decisions are based on intangibles such as the quality of management and bench strength,’ notes Leslie Gaines-Ross, chief knowledge officer at PR giant Burson-Marsteller.
According to Ernst & Young, non-financial criteria – including management credibility, quality of corporate strategy, human capital and innovation – make up 35 percent of institutional buy decisions. Another study of 200 institutional portfolio managers by Rivel Research shows that quality of management is the most important factor influencing investors’ buy and sell decisions.
These studies suggest a sea change in terms of what drives institutional decision-making. As Brian Rivel, president of Rivel Research, says, ‘We have done this study for 23 years and every year up until now portfolio managers said the number one deciding factors were growth rate and earnings per share. Now it’s quality of management.’
Look no further than recent corporate failures for proof of how intangibles like CEO credibility determine the market value of a company. Dennis Kozlowski of Tyco, Kenneth Lay of Enron, Bernie Ebbers of WorldCom, John Rigas of Adelphia and Joseph Nacchio of Qwest Communications all resigned once it became clear their companies would not survive with them at the helm. In other words, a CEO with a bad reputation is a company’s worst liability; conversely, a CEO with a good reputation is a company’s best asset. According to Burson-Marsteller, CEO reputation accounts for close to half of a corporation’s overall reputation.
Another argument for measuring intangibles is the growing ‘gap between book value and market value,’ says Susan Herman, executive vice president of Arizona-based Christensen & Associates. While the collapse of the dot-com market has considerably lessened the gap between book value and market value, many stocks continue to trade at huge multiples. As Herman notes, ‘If 35-70 percent of a company’s value is attributed to intangibles – as various research suggests – then it stands to reason that by placing a dollar value on intangibles, the gap should close.’
When knowledge capital (or intangibles) are quantified and then added to book value, the gap between market value and book value is narrowed, according to CFO.com’s third annual Knowledge Capital Scorecard. Completed in April 2001, the study shows that for companies trading at huge multiples of book value, the ratio of market value becomes more reasonable when you add knowledge capital.
Keeping score
Many companies informally track intangibles. ‘But until you start keeping score, you are only practicing,’ claims Steve Finkelstein, a partner at Deloitte & Touche. The consensus among experts is that investor relations officers should be quantifying intangibles and communicating those measures beyond anything standard-setters like FASB are expected to propose.
Under its new standards, FASB will likely define intangibles as trademarks, patents, trade secrets, contracts, brands and anything you could sell in the marketplace. That leaves a lot of important intangibles unaccounted for. The new regulations exclude such things as an assembled workforce and R&D – two of the most fundamental aspects of what was traditionally considered to be intangible assets, says John Wood, president of the Playfair Group and advisor on the FASB project to disclose intangibles.
FASB’s final proposal for disclosing intangibles will not, however, prevent companies from disclosing the value of a broad scope of intangible assets. ‘FASB has no teeth really; the SEC does,’ Wood summarizes. It just means companies are left to their own devices when it comes to valuing things like management credibility and employee talent. But in the end, as Wood says, ‘It’s to the advantage of public companies [to quantify these intangibles] because of their effect on share price.’
Putting numbers on faces
How to quantify intangibles is the burning question. Baruch Lev, professor of accounting and finance at New York University’s Stern School of Business, has devoted much of his career to measuring intangibles. His model suggests that a company’s economic performance can be measured by adding physical, financial and intangible assets. Lev uses a mathematical equation to determine the value of intangibles. It goes like this: normalized earnings minus return on physical assets minus return on financial assets equals intangibles-driven earnings.
Other new models for measuring intangibles have also cropped up recently. The Playfair Group, for example, has come up with software that identifies, classifies and reports intangibles in accordance with intellectual property laws and in compliance with current – and expected – accounting standards. ‘This provides companies with a transparent and accurate understanding of what are their individual intangible assets so they now turn up on the balance sheet and are clearly defensible in a courtroom or shareholder situation,’ notes Wood.
Ernst & Young’s value creation index quantifies intangibles in relation to the company’s market value. ‘Through a series of statistical exercises, we can evaluate how intangibles influence a company’s market value and then we can drill down even further to look at how specific variables like human capital influence both general and specific measures like P/E,’ explains Ernst & Young’s Low.
Isolating intangibles
Some companies have a tough time quantifying intangibles because they don’t know which drivers move the stock. ‘Most organizations don’t know what their intangibles are because they may have grouped them under goodwill and now they are a big black hole,’ notes Wood. This ‘big black hole’ may be contributing more to shareholder value than the tangible assets a company sells. Indeed, 91 percent of Coca-Cola’s market capitalization of US$112.5 bn is intangible assets, according to Interbrand’s World’s Most Valuable Brands study.
The process of isolating a company’s intangible drivers begins with asking investors, analysts, customers and employees what they think drives the bottom line. Some companies have no problem coming up with a long list of intangibles – 300 in some cases. ‘You have to do quantitative research among your shareholders,’ notes Rivel. ‘It’s much more then a perception study because a perception study gives you perceptions, but not the ability to benchmark against your peers and measure progress.’
Companies need to isolate what is most important to communicate and what is shaping their reputation, says Gaines-Ross. Cisco’s IR department, for example, has isolated five key differentiators that drive shareholder value. ‘A good portion of these are intangibles like intellectual property, strong management and IP [internet protocol] expertise,’ notes Roberta DeTata, senior manager of investor relations at Cisco.
‘You need to sit down with management and come up with a list of four or five [drivers] and then constantly reference them in your investor communications,’ adds DeTata. Cisco refers to those intangible drivers in all its communications including conference calls, investor presentations, analysts meetings and one-on-ones.
Having identified a list of intangible drivers, it’s important to set tangible goals that investors and analysts can follow. ‘From an IR point of view, the single most important activity that a company can engage in to build credibility is to develop a guidance policy through which it communicates its vision for the future and makes that tangible in terms of goals,’ suggests Ed Owens, managing director of Burson-Marsteller’s US investor relations and financial services unit. GE, for example, recently announced it would have the best quality standards with the fewest errors per million parts, and then the company delivered on that promise. As Gaines-Ross says, ‘Intangibles are built by delivering on tangibles.’
Promoting intangibles
Playfair’s Wood estimates that less than 10 percent of companies in the S&P 500 currently quantify and communicate the value of their intangibles. These companies have incredible assets but they don’t always disclose them. He says many companies focus strongly on one intangible that is intrinsic to its business but neglect other key areas. ‘You’ll find organizations like pharmaceutical companies that focus on patents all day long but have not looked at other areas like their domain name.’
There are, of course, companies that do an excellent job of promoting and disclosing the value of their intangibles. BP is a great case study of a company that understood early on that being in the global business of oil and gas meant it was also in the business of having to convince customers, potential employees and voters in countries where it wanted to explore that the company was honorable and would live up to its commitments, Low notes. ‘They were one of the first companies to produce a sustainability report and their stock price has performed consistently above average,’ he adds.
BP, Shell, Nike and Timberland are already producing supplements to their annual reports that focus solely on intangibles. Other companies highlight messages about intangible drivers like employee talent, management credibility and branding in annual reports. GE’s 2001 annual report, for example, featured 84 pictures of people (not products), many of them employees.
The Limited is a good example of a retail company that has built its core strategy around communicating the value of intangibles. ‘Brands, talent and developing operating capabilities have been our strategies for the last four years,’ says Tom Katzenmeyer, vice president of investor relations for The Limited. He says he spends a lot of time educating the company’s investment base about the three-to-five-year plans for each of the company’s brands including its most popular ones: Victoria’s Secret, Bath & Body Works and Express.
‘The best way to communicate [the value of the brand] is to bring investors into the store, show them how it looks, and let them try the product with a sales associate,’ says Katzenmeyer. That’s what Katzenmeyer did with investors for the launch of Bath & Body Works’ spa and aromatherapy products. To demonstrate the tangible side of his company’s talent, Katzenmeyer introduces investors to employees. ‘We show them we have functional expertise at the center of our company and low turnover.’
Intangible assets like management credibility, talent, culture, brands and CEO reputation now play a critical role in a company’s success. In 1970, intangibles made up only 15-20 percent of a company’s market cap; now that figure is 85 percent, notes Wood: ‘For investors, these are the crown jewels.’ For companies to succeed, it’s essential to isolate, measure and promote the value of these immaterial assets in all investor communications.
Communicating intangibles is also part of restoring investor confidence in capital markets. With so few companies communicating the value of intangible drivers, it’s ‘no wonder there is such volatility in the marketplace’, says Wood.
‘If investors understand and respect the decision-making that goes into the way a company makes managerial choices, that will reduce uncertainty and have a positive influence over stock price performance,’ adds Low.
In coming months, with FASB expected to deliver its proposal for intangibles disclosure, there will undoubtedly be more discussion about how companies should quantify such assets. In the meantime, any investor relations officer who hasn’t yet done so should begin to identify their company’s key intangible drivers. As Low says, by isolating and measuring intangibles internally, they will gain the confidence to disclose them.
Tangible texts
A summer reading list on intangibles:
Invisible Advantage: How intangibles are driving business performance, by Jonathan Low and Pam Cohen Kalafut
Intangibles, by Baruch Lev
Strategy-Focused Organization: How balanced scorecard companies thrive in the new business environment, by Robert Kaplan and David Norton
The HR Scorecard: Linking people, strategy and performance, by Mark Huselid, David Ulrich, and Brian Becker
