CFO Magazine

Grey Matters: CFO's Third Annual Knowledge Capital Scorecard

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Companies with a ratio of market value to comprehensive value significantly above 1 can be viewed as overvalued. Those with a ratio below 1 are probably undervalued. The negative correlation between this ratio and the subsequent stock returns of the 105 companies evaluated in the Scorecard was remarkably strong. Between the August 31, 2000, cutoff date for the Scorecard analysis and the end of last year, the average weighted return of 53 companies with a ratio of market value to comprehensive value below the median of 1.08 was 7 percent. For the 52 companies with a ratio above the median, the average return was -15.5 percent.

Companies with some of the highest ratios, such as Broadcom (8.5) and Siebel Systems (5.8), have since experienced some of the most severe slides in the stock market. Broadcom is down 80 percent since last August, and Siebel is down 60 percent. In contrast, companies trading at low multiples of comprehensive value fared far better. The shares of Rockwell International, for example, with a ratio of 0.62, and Georgia Pacific (0.35) were both up 15 percent over the same period.

"We compared it with other metrics, and this was a particularly strong result," says Bothwell. "If a stock looked overvalued according to our metric, the market realigned it." Giving further credence to the argument that intangible assets and knowledge capital are the real drivers of value in corporate enterprises.

BUILDING A BETTER SCORECARD

WHAT ARE KNOWLEDGE EARNINGS and knowledge capital? New York University accounting and finance professor Baruch Lev's methodology for computing these values begins with an estimate of a company's "normalized earnings." That figure is derived from the average of three years of historical core earnings, and three years of consensus analyst estimates as compiled by IBES International. Thus, knowledge earnings reflect both past performance and future growth potential.

These normalized earnings are then compared with the expected rates of return on the company's physical and financial assets as recorded on its balance sheet. In the competitive global marketplace, physical and financial assets have largely become commodities. The expected aftertax returns used in the broad cross-sectional Scorecard are 7 percent for physical assets and 4.5 percent for financial assets. In company- specific measurements, physical and financial assets are adjusted to fair values, and their expected returns are adjusted to company circumstances.

The portion of normalized earnings for any given year that exceeds the expected returns on book assets represents knowledge earnings--the performance contribution attributable to the intangible assets of a company. Knowledge capital is then computed as the present discounted value of all future knowledge earnings. Without a widely accepted expected rate of return for knowledge assets, the average 10.5 percent historical aftertax return of three knowledge-rich industries (software, biotechnology, and pharmaceuticals) is used as the discount rate.

ACROSS THE BOARDS

From aerospace & defense to telecom equipment, industry rankings of median knowledge-capital earnings.

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