Innovation : CBI Journal 7 : Valuing Intangibles

Perspectives on Business Innovation Issue 7 : Valuing Intangibles

Published November 2001 - reprinted here by permission.

We print below the "big idea" article from the Journal ( The Invisible Advantage: Getting a Grasp on Intangible Assets ), the table of contents of the Journal, and also Christopher Meyer's Introduction to the Journal, setting out this issue's themes.

You can download the full Journal in Adobe acrobat format ( 1.7MB )


THE INVISIBLE ADVANTAGE: GETTING A GRASP ON INTANGIBLE ASSETS

About the Author

Jon Low was senior research fellow at the Cap Gemini Ernst & Young Center for Business Innovation. He was the director of the CBIís Intangibles Valuation initiative, which concentrated primarily on valuation of intangibles such as intellectual capital, organizational transitions, and inter-enterprise collaborations.

Jon co-authored "Invisible Advantage" ( Perseus, 2002 ) with Pam Cohen Kalufut.


On Labor Day, 1995, Omidyar launched Auction Web as part of his personal homepage that was hosted by his local Internet service provider ( ISP ) for $30 a month. Within a few months, the ISP demanded that he upgrade his service due to the heavy traffic his site was receiving. This site, which Omidyar had designed as a weekend hobby, evolved into a company called eBay, which makes markets in everything from Pez dispensers to professional graphic design services.

In 2000, eBay had revenues of $431.4 million, a peak stock market value or market cap of $34.2 billion and, rare for a dot.com, actual profits of $48.3 million. As of December 2000 eBay had 22.5 million registered users from more than 150 countries. Omidyarís net worth went from a few thousand to as high as $10.1billion. And by the way, the site has been able to serve its initial purpose. Omidyar bought an extremely rare Pez "Bride" dispenser in an eBay auction for $2,375 as a wedding present for Wesley.

This story illustrates one of the transformations our economy is undergoing. Value is no longer created solely or even primarily by the corporate behemoths of the industrial era. People and their ideas are the most significant drivers of wealth creation in today's global economy. The personal computer, the mobile phone, and the Internet have given every individual with access to electricity and a telephone line the ability to create products, services, and markets. While the dot.com bubble may have fueled false hopes about the illusion of easy money, an important underlying trend remains: Traditional measures of success tied to such factors as assets, number of employees, and other standards of size or quantity may, in fact, signal weakness rather than strength. Whether one works for an Internet start-up or a Fortune 500 corporation, today's success depends more on innovation, adaptability, and creative talent than asset base or current revenue stream. As a result, an entirely new way of collecting information and forecasting results is necessary.

These days, investors and managers must do a better job of revaluing the true economic potential of the companies under their purview to avoid inefficient capital allocation resulting in heightened market volatility and, potentially, downturns like the 1998 crisis in Asia and the collapse of the Nasdaq, NeuerMarkt, and other technology-oriented exchanges.

Our research at CGEY over the last five years demonstrates a dramatic shift in value creation. Until now, the benchmark for understanding value creation resided in audited financials like the balance sheet and income statement. But today, the answer lies in a set of elements that include ideas, innovations, human activities, work team efforts, and business processes. These new value drivers are called "intangibles."

The word ìintangiblesî is generally used to cover a broad range of factors that are created by or contribute to business value. Admittedly ungainly, the word intangibles was created in reaction to an existing concept, that of tangible assets. The prefix "in" is evidence of a relative lack of stature in the economic lexicon and the low level of comprehension regarding both the source of intangibles and their value. One may view this reactive or lack of permanence as a comment on the transitory nature of the debate surrounding their contribution to value creation.

Human capital, intellectual capital, social capital, and structural capital are among the concepts defined by the word "intangibles." What these subcategories refer to are the people, ideas, network connections, processes, and their offshoots that have not traditionally been defined within the organizational or business vocabulary, but that are increasingly recognized as legitimate sources of worth or merit in the global business context.

As assets, intangibles are increasingly the means by which companies deliver the value they provide to customers. According to research conducted by Harvard economist Zvi Griliches, 1998 investments in intangibles ( training, brand, and research and development ) exceeded investments in traditional benchmark tangiblesóproperty, plant, and equipmentóand have continued to do so. In addition to those mentioned above, examples of intangibles that might be thought of as assets include business or manufacturing process enhancements that increase productivity, new types of financial instruments designed to spread risk or better leverage the shifting value of underlying corporate assets, and the marketing or managerial strength that comes from a successful corporate culture.

Where It All Began

Intangibles are not derived from the same sources of knowledge as are standard balance sheet and income statement data. The invention of double entry bookkeeping by Luca Pacioli, an Italian monk and mathematician, 500 years ago led to the development of modern financial reporting in the 19th century. Designed to serve the fragile global economy that began to emerge in the late Middle Ages in Europe, this system relied on relatively simple financial concepts based on the need to extend credit for sales and purchases between people who shared neither language nor currency nor value system. Furthermore, the transactions this system was originally created to underwrite could take place months or years before the actual payment reached the person or organization proffering the payment. Such a tentative web of relationships required measures easily understood by the few relatively educated participants in the trading economy. This meant that the concepts under consideration had to be kept to a minimum, in part because the common set of financial or managerial measures with which they were dealing was minimal.

With the dawn of the industrial revolution at the end of the 18th century, commerce and industry became more complicated, and financial reporting as we now know it began to evolve. It was really at the end of the 19th century, however that the financial statements we now recognize really emerged, primarily through the heft of the British Empire. The majority of bookkeeping in those days was on commodities such as coal, iron, and cotton textiles in which England was the world's leading producer. With the large British capital flows to all corners of the globe, the simple balance sheet of payouts vs. receipts was no longer adequate, and the income statement surpassed the balance sheet as the most important piece of the financial statement. Increasingly, business audiences found that measuring the actual flow of monies was more and more valuable, which led to the development of the funds statement in the early 20th century, now required to be included in annual reports. We are still grappling with these frameworks more than a century later.

Consideration of intangibles and the role they played in the economy began to emerge during the first half of this century, though, of course, the word intangibles was not yet in vogue. Battles at the turn of the century over antitrust issues driven by steel and oil industry consolidation set the stage by focusing attention on organizational dynamics: Were economies of scale really better for the organization, its shareholders, customers, and employees or not ? And if so, why ? These considerations lead to fascination with the achievement of an entrepreneur named Henry Ford who created the modern automobile industry.

The product itself captivated the public's imaginationóas it continues to do today. It was Ford's organizational and inspirational innovations, however, that actually set the stage for revolutionary changes. Ford's great achievement was not invention of the automobile itself, because that had actually been accomplished by several European and American inventors working alone but in parallel at the end of the 19th century. Rather, there were two concepts that differentiated Ford from his competitors: design of the intangible business process called the assembly line and the $5 a day wage, which was the first modern acknowledgement of human capital's contribution to value creation.

The assembly line proved to be the most effective way to leverage the benefits of standardization. Ford and his managers built on the research done by so-called "time and motion" study experts like Frank Gilbreth, Sr., who roamed industrial plants and mills with stop watches and slide rules to determine the steps a worker had to take to make a sheet of steel, an engine, or an automobile. They then analyzed their data to see where they could eliminate unnecessary steps while calculating how long the average worker should take to complete the remaining steps. Again, the focus was on intangible processesóand how they might contribute to financial results.

Ford and his managers then conceived a system that took account of the multidimensional factors contributing to cost and to productivity. By calculating the time and cost of every facet of the assembly process, the Ford team was able to reduce inventory and production costs and increase the speed at which the cars could be produced while offering the consumer a consistent, reliable, and affordable product.

The second major innovation for which Ford became justifiably noted was the "living wage" of $5 a day. At the time of this announcement, Ford was assailed by less perceptive business leaders who thought that he had made a devastating concession to labor that would fatally affect the cost structure of American industry. Ford, however, understood two things his detractors did not. The first was that by paying slightly above market, he would attract a more highly motivated and skilled worker from whom he could demand more. Secondly, Ford believed that to truly achieve what we would now call "scalability," he needed to create a market for his product. By paying $5 a day, he was putting his product within the financial reach of his own work forceóand those like them.

Ford's success has become the stuff of American legend. It led to an increase in interest in stories about the burgeoning world of business. No longer focused exclusively on stories about finance and stock prices, these new features recounted such sagas as the struggles of Alfred Sloan, the management genius who created the General Motors Corporation ( GM ), to reorganize that behemoth along the lines of what had become known as business principles.

Sloan established the multidivisional corporation that, in effect, created a portfolio of brands. Sloan's idea was to offer a variety of price points aimed at consumers' ability to pay. The brands were structured so that GM could move their customers to more expensive cars as their incomes and families grew. In addition to the marketing advantages of his new system, Sloan created a divisional organization that optimized the parent corporation's ability to share costs over a broader set of assets. This lowered average costs for GM's products and permitted the rationalization of administrative and other expenses where possible.

In sum, what Sloan accomplished was designing a template for the modern multinational corporation. The pyramidal divisional structure offered a means by which the corporation could continue to grow while providing the means for inserting leadership at the appropriate level so as to optimize management supervision without unnecessarily multiplying the number of people who had to report directly to the chairman or CEO. In addition, it allowed for reorganization as market conditions dictated.

Sloan's organizational innovations, like Ford's, could be considered intangible because they did not directly address the balance sheet or income statement. They were improvements in the processes, managerial decision-making, brand extension, and compensation policies that contributed to improvements in productivity, profitability, and return on investment.

While Ford, Sloan, and others wrestled with the manifold problems and opportunities presented by the internal combustion engine and all that flew from it and into it, similar organizational issues were raised in other industries as well. The most famous example occurred in a 1927 productivity study at Western Electric's Hawthorne plant near Chicago, Illinois. The issue managers felt they needed to address was employee morale or motivation. Executives at the plant were concerned about flagging productivity, and the question in their minds was how best to raise it. They began by analyzing all of the systems and conditions on which the plant ran.

For various reasons, they decided to concentrate on lighting as the most likely culpritóand solution. Outside consultants interviewed plant workers and asked about their lighting preferences; did they want it raised or lowered ? When plant managers raised the lighting, they noticed that productivity increased in the subsequent period. They then decided to experiment by lowering the lighting and, to their surprise discovered that productivity went up again. Ultimately, they and the social scientists with whom they consulted decided that the real improvement in productivity came not so much from the lighting, but from the positive feelings they had imbued in the plant workers by giving them attention and asking for opinions about working conditions. The outcome of the experiment has been known ever since as "the Hawthorne Effect."

Today, the Hawthorne Effect can be seen across disparate fields ranging from healthcare satisfaction to religious affiliation.

The recognition that managerial style could affect employee performance spawned a market in managerial advice. Starting with the management analyses created by Robert McNamara and his fellow "Whiz Kids" at the War Department during World War II and then at Ford, the contributions of W. Edwards Deming and John Juran in the field of quality, and of the greatest living sage of management, Peter Drucker, who published On Managementin 1954, the business of providing advice to managers took off. The combination of Stagflation in the United States and the success of the Japanese automobile and consumer electronics manufacturers added kan ban, keiretsu, and other Japanese phrases to the business vocabulary. The management guru came into being with the publication of Bob Waterman and Tom Peters' Search for Excellencein 1983. Charles Handy, Stephen Covey, Peter Senge, and a host of others followed.

The larger point is that managers had created a market for advice on the intangibles of how to better manage people and processes and how to manage their role as managers. Management had become a profession separate from the functional specialties of Human Resources or Finance or Engineering, and from the industry-specific specializations created around steel rolling mills, direct mail marketing, or software design. The growth of business was now dependent on turning in better performance on those occupations that filled the interstices of the traditional business framework. What these new philosophers of business were doing was acknowledging the role of intangibles.

Valuing Intangibles Today

Today's management teams have a new challenge. They can no longer rely on reporting of their past and current financial performance. They are not only getting an incomplete view of their enterprise, but they are missing a forward view of their company and a significant opportunity to improve operating and capital market performance. Financial statements, designed to capture the linear, engineering-based assessments of railroads, steel mills, automobile factories, and electric generating plants are not necessarily the most effective methodologies for evaluating the potential of companies whose worth is based on intellectual constructs or human potential.

In addition, intangible value drivers complement each other in ways that traditional financial measures do not. It is difficult to separate one intangible from another because they function in such an interconnected fashion. This creates problems for the current management system, which, although it links related activities to one another in a sequential fashion, has a difficult time measuring contemporaneous activities that affect one another in real time. As such, measurement methods that are not widely understood or commonly used today will be needed to explain how intangibles create value.

The Hay Group, which produces the Global Most Admired report for Fortunemagazine, has this to say about the characteristics of the companies that make it on to the Most Admired list, "The findings revealed that the Most Admired companies set more challenging goals, linked compensation . . . more closely to the completion of those goals and are generally more oriented toward long-term performance." Specifically, "Almost 60 percent of the Most Admired companies rely on customer indicators like satisfaction, loyalty and market share. Only 38 percent of their peers do. And 40 percent of Most Admired companies chart retention, career development and other employeeoriented measurements; that's more than triple the percentage of companies that didn't make the list."

One example, BP Amoco, "maps the progress of its 'people' targetsóqualitative performance measures such as innovation, mutual trust and respect, teamwork, and diversity. Like many of the companies on this year's list, BP Amoco recognizes that achievements in these areas are just as important to the success of the company as revenues, profits, and other financial measures. With intangibles contributing so dramatically to the value creation process, it is becoming increasingly clear that financial results themselves explain less and less about corporate performance.

  • Market to book ratios continue to increase ( see Figure 1 ).
  • The correlation among balance sheet and income statement ( asset and price/earnings ) measures and market value continues to decrease.
  • Investment in intangiblesóR&D, training, and brandóoutweighs investment in tangibles like property, plant, and equipment.
  • Most Fortune 500 companies are experimenting with alternative forms of measurement like the Balanced Scorecard and Economic Value Added ( EVA ).
  • Global demand foróand returns toócorporate information transparency are increasing

The Search for New Measurement Systems

The current system for measuring and disclosing corporate performanceódeveloped 500 years ago and changed only marginally sinceóis no longer adequate to meet the needs of the information age economy. Companies and their executives must take the initiative to measure, manage, and disclose information that provides insights into how the organization creates value for shareholders, employees, customers, and the rest of its investors.

"Ideas drive today's economy," says Federal Trade Commission Chairman Robert Pitofsky. "In past eras, control of land, oil, or large pools of capital held the key to amassing money and power. Today, it is intellectual property. The essential feature that is new about the New Economy is its increased dependence on products and services that are the embodiment of ideas."

Information Gathering and Reporting in an Intangible Economy

Technological innovation, globalization, and increases in the percentage of households owning stocks have hastened the demand for better information about business performance and prospects. Furthermore, they have hastened the transition from an industrial economy to a service economy. Technology and its promise have produced outsized returns on investment for the last several years and whetted the public's appetite for more detailed knowledge about how these companies work. Globalization has forced businesses to learn to sell products and financial instruments to cultures with which they are not familiar. Knowledge of value in one culture may be suspect in another.

This has driven demand for more "transparency" in corporate reporting. The threat is that government financial regulators in all the major economies, concerned about the increasingly poor correlation between business management data and stock market performance, will begin to mandate the disclosure of new kinds of information that business executives are unprepared to provide. In the U.S., the SEC and FASB are already studying disclosure innovations. The Brookings Institution, The American Enterprise Institute, and other think tanks are also examining this issue.

In Europe, the European Union is funding research on these issues and most of the major European governments ( U.K., the Scandinavian countries, the Netherlands, France, Italy, Spain, Switzerland ) are as well. The OECD is considering the creation of a committee to design principles for intangibles disclosure. At the supranational level, organizations of securities regulators and accounting oversight boards are studying changes for global financial reporting.

In sum, global capital markets have rendered a verdict of "inadequate" on the current system and are demanding better. If the private sector does not take the initiative to provide improved management and reporting models, regulators will do if for them. Given those pressures, there has never been a better time to provide a lucid analysis of the present and a set of prescriptions for the future.


download the full Journal in Adobe Acrobat format ( 1.7MB )

4 WELCOME TO THE CONVERSATION

THE BIG IDEA

7 THE INVISIBLE ADVANTAGE : GETTING A GRASP ON IN TANGIBLE ASSETS
Today's companies are driven more than ever before by intangible assets like ideas, brand, and management. Understanding the role intangibles play and how to manage and measure them is the key to today's market success.


15 COMMUNICATIONS CAPITAL: THE HIDDEN MESSAGE
A company's ability to communicate the value of its nonfinancial assets is critical to building shareholder value. The CEO plays an important role in determining a strategy for channeling such information to investors.


23 JOURNEY TO THE ENTERPRISE OF THE FUTURE
Successful businesses of the future will need to seize opportunities that come from today's
connectivity and new alliances.

INNOVATION IN ACTION

31 EVALUATING INTANGIBLE CAPITAL : THE EUROPEAN PERSPECTIVE
The European economy's history and evolution is markedly different from that of the U.S. Europeans' approach to valuing intangibles has come a long way but is still maturing.


35 BUILDING BRAND THROUGH PEOPLE: LVMHíS LUXURY TALENT
LVMH, one of the world's largest luxury goods conglomerates, has learned how to attract and retain great talent. As a result, the company's brands have endured and diversified.


40 MANAGING INTANGIBLES IN THE TELECOMMUNICATIONS INDUSTRY

The telecommunications market has been extremely volatile in recent history. Here's a look at which intangible drivers influence some of the big players' market value.


A BLUEPRINT FOR CHANGE

 

45 WHEN THE NUMBERS DONíT ADD UP: VALUING INTANGIBLES IN THE FINANCIAL SERVICES INDUSTRY
As the financial services industry evolves, a new focus on intangibles will change the way these companies operate and strategize.


50 A REFINED LOOK AT MEASURING VALUE IN THE OIL AND GAS INDUSTRY
The refining industry's financial performance has long failed to meet expectations. Today, the industry is redefining value and seeking new ways of improving performance.


ON THE HORIZON

 

56 SCANNING THE FUTURE
The CBI has determined the most important business trends that companies need to consider today for tomorrow's success.

62 PERFORMANCE AND SUSTAINABILITY OVER THE LONG HAUL
The correlation between sustainability indicators and performance is stronger than ever, especially as investors turn more to forward-looking indicators.

SHARED CONVERSATION


Perspectives on Business Innovation promotes a Shared Conversation among business practitioners and observers. Here are some vital perspectives we've heard lately . . . 

67 TRAVELS IN SILICON

 

71 SONGS OF EXPERIENCE : EVERYONE'S A USER

 

75 INSIGHTS FROM THE CENTER FOR BUSINESS INNOVATIONíS VISITING FELLOWS


DEPARTMENTS


79 TECHNOLOGY WATCH
The increasing significance placed on intangible valuation has lead to many new software
tools that determine and measure these hidden assets.
 

86 WELL-READ MANAGER

A review of Unseen Wealth: Report of The Brookings Task Force on Intangibles and other
recommended reading.
 

90 HEADS-UP
A listing of upcoming events not to be missed.

 

91 RESEARCH ROUNDUP
Updates on the latest research projects and other news from Cap Gemini Ernst & Young.

 

97 IN CONCLUSION
The true value of an employee has always been abstract. Do you know what you are worth ?
 


WELCOME TO THE CONVERSATION

GETTING TO FULL DISCLOSURE

Einstein pointed out "there is no measurement without theory." He meant that without a theory of how the world workedóthermodynamics and the nature of heat, for exampleóthe reading on the thermometer had no useful meaning. Similarly, without a theory of economic value, the meaning of our measurementsóbook value and market capitalization, to name twoócannot be interpreted.


The accounting rules we use to develop book value were developed for an industrial economy, where value was highly tangibleótons of coal or wheat, hundreds of automobiles or refrigerators, thousands of units of manufacturing capacity. The notions of depreciation, inventory, and standard costing all derive from the properties of physical goods and assets. But the nature of value has changed since these concepts were encoded in Generally Accepted Accounting Principles. In the past century, the mass of U.S. GDP has not grown at all, while the value of GDP has risen twenty-fold.


The capital markets recognize thisóthe average ratio of market capitalization to book value has been hovering between two and three. But, as recent market volatility suggests, the financial markets' views of value are capricious. The value to the economy of the Internet has changed very little, though the value of the players has drastically shrunk.


If neither accounting rules nor market assessments are reliable indicators of value, where can we look ? The CBI has been researching this issue for over five years, because we believe that the replacement of our accounting rules is overdue. This issue of Perspectives on Business Innovation focuses on the question of Valuing Intangiblesóknowledge, customer franchise, talent, reputationóand how companies can maximize both their true economic value and their market value as well. Our lead article, by Jon Low, the director of intangibles research at the CBI, is an excerpt from his forthcoming book The Invisible Advantage, and provides an overview of the history of intangible assets and points to the development of nonfinancial indicators for the future.


We began our "Valuing Intangibles" research with a study called Measures that Matter. What we found was that there is a certain mystery around how institutional investors value things like customer satisfaction or the quality of management. Also somewhat cryptic is how the nonfinancial measures influence share valuation or "buy" decisions. The survey we conducted was designed to investigate the impact of nonfinancial factors on investor decision-making and the extent to which they are leading indicators of future financial performance. We found that nonfinancial criteria constitute 35 percent of the investor's decisionóand the more they use nonfinancial data when evaluating companies, the more accurate are their predictions. All companiesómature and start-up alikeómake their own decisions about nonfinancial performance and then act upon these evaluations.


Our follow-up report, Managing the Success of the IPO Process, supported the notion that the IPO should be viewed more as a transformation process than a transaction, a process that requires a "value journey." We studied the value journey with a number of companies who had recently gone through an IPO to determine which nonfinancial measures created positive financial results. And in the end, we created a roadmap to success for companies yet to pursue an IPO with a series of steps a company must take to maximize its value prior to the IPO, then to ensure it continuously delivers value to shareholders as a public company. A subsequent research initiative is underway to identify the trends of the IPO transformation process over the last fifteen years. This study will incorporate survey responses from the executive team members of companies that have gone public in the last four years.


In a further effort to understand how firms measure and manage organizational performance, we created the Value Creation Index( VCI ), a tool that quantifies the link between an organization's nonfinancial performance and its valuation in the markets. The VCI not only quantifies the impact of nonfinancial performance on market value, but also identifies the specific intangibles that drive value for a given industry. Models have been created for a number of industries including many you will see in this issue of Perspectives ( see: "Managing Intangibles in the Telecommunications Industry"; "When the Numbers Don't Add Up: Valuing Intangibles in the Financial Services Industry"; and "A Refined Look at Measuring Value in the Oil and Gas Industry" ). We determined that while crucial nonfinancial value drivers do vary from industry to industry, there are consistent and critical categories of intangible performance that determine corporate value creation in every industry. Several of these intangible assetsóbrand, customer relations, management capabilities, alliances, technology, and environmental and community issuesóare illustrated in the articles to follow through a series of case studies, consulting stories, and vision/thought pieces.


Our current research continues to explore the vast landscape of intangible valuation. We have already analyzed and identified the important intangible drivers of long-term economic valueónow we are looking at the gaps that exist between these drivers and the use of measures for internal decision-making and external reporting. Decisions that Matteris a study that addresses this issue and offers tactics for minimizing these gaps and ultimately creating better market performance. Our "TechWatch" article illustrates some of the software tools that help manage information for better decision-making. Another piece, "Communications Capital," gives some suggestions for important disclosure approaches.


Finally, keep your eyes peeled for our upcoming book, The Invisible Advantage, ( Perseus, 2002 ). There, you'll find a complete guide to understanding the importance of intangible valuation and some interesting and provocative company stories to learn from.


"First we shape our institutions, then they shape us," said Churchill, and the same is true for accounting conventions. Until companies change their systems of measurement, they will not be able to capture the full opportunities of the connected economy. We hope this issue of Perspectives will provide a thoughtful and comprehensive lens through which to view the span of intangibles in a variety of industries today. As always, we look forward to your feedback.


Christopher Meyer was the director of the Cap Gemini Ernst & Young Center for Business Innovation in Boston. The Center was charged with identifying the issues that will be challenging business in the future, and defining responses to them. His own current research interests include the development of a New Theory of the Firm, the implications for management of new discoveries in complexity and self-organizing systems and the development of the "connected economy."

Chris established the BIOS Group, Cap Gemini Ernst & Young"s initiative to develop complexity-based solutions for management. He has more than 20 years of general management and economic consulting experience. With Stan Davis he co-wrote "BLUR: The Speed of Change in the Connected Economy" ( Addison-Wesley, 1998 ), "Future Wealth" ( Harvard Business School Press, 2000 ), and "Itís Alive: The Coming Convergence of Information, Biology, and Business" ( Crown Business, 2003 ).

Chris can be reached at Chris.Meyer@gotnerve.com.


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