CFO Magazine

Grey Matters: CFO's Third Annual Knowledge Capital Scorecard

Valuing things like patents, R&D, and human capital may not be easy. But with intangible assets now driving corporate performance, assessing the investestment in those assets has become crucial.

Andrew Osterland
CFO Magazine

April 1, 2001

A corporate balance sheet, prepared according to generally accepted accounting principles, does a reasonable job informing about the physical assets and financial capital employed by a company. But when it comes to the increasingly important intangible assets of corporate enterprises, it provides next to no insight.

Under GAAP, expenditures made to increase brand awareness, to foster innovation, or to improve the productivity of employees cannot be capitalized. Instead, the logic goes, they must be expensed through the income statement, because the future benefits of such investments are so uncertain. The problem with that, says Baruch Lev, an accounting and finance professor at New York University, is that corporate investment in tangible assets has stagnated. "It's the investments in R&D, Internet applications, human resources, and customer acquisition that drive the performance of companies now. And there is no indication of the value of those investments in financial reports," he says.

The aim of CFO's third annual Knowledge Capital Scorecard, developed by Lev with the help of Marc Bothwell, a vice president and portfolio manager at Credit Suisse Asset Management, is to quantify those intangible values. On a more itemized basis, knowledge capital is intellectual and human capital, customer and supplier capital. It is the sum of all the intangible factors and qualities that enable a company to earn a better-than-average return on its GAAP-valued asset base. Thus, a company with a strong brand name gets better prices than its competitors. Those with effective R&D programs are better able to defend their markets and create new ones. And those with superior employee training garner a variety of productivity benefits.

This year's Scorecard, which ran the numbers for the leading companies ranked by knowledge capital in 22 nonfinancial industries, confirms the importance of such intangible assets. As was the case last year, companies with high levels of investment in R&D and advertising continued to show higher levels of knowledge earnings and far better stock performance than companies with lower levels of spending in those areas. Intel topped the list in 1999, with knowledge earnings of $9.5 billion. The semiconductor giant also came in with the highest level of knowledge capital--the present discounted value of all future knowledge earnings--at $209 billion, surpassing last year's leader, Microsoft, which saw its knowledge capital drop 10 percent, to $189 billion. Pharmaceuticals giant Pfizer posted the largest increase in knowledge earnings ($3 billion) for the year, due in large part to its acquisition of Warner-Lambert.

As the Scorecard shows, however, knowledge earnings and capital are relevant to more than just New Economy and pharmaceutical companies. Consider Ford Motor and General Motors. The book value of Ford as of its September 30, 2000, 10Q filing was $18.3 billion, compared with $31.5 billion for GM. Ford posted knowledge earnings of $6.7 billion, more than 50 percent higher than GM's $4.3 billion. This comparison suggests that Ford is doing a much better job managing the intangible drivers of value in the motor vehicles business. "Knowledge capital is not just a New Economy metric," says Lev. "It indicates a company's profitability, both historical and anticipated, above an expected rate of return on physical and financial assets."

This year's results also indicate the value of incorporating knowledge capital into investment analysis. For example, the Scorecard shows that the market valuations of such New Economy stars as Dell Computer, Microsoft, and Intel, as well as knowledge-intensive companies in the pharmaceutical and biotech industries, have very little to do with the assets reflected on their balance sheets. Their stocks trade at huge multiples of book value (examples: Dell, 17.5; Pfizer, 18.2). But when knowledge capital is added to book value (a sum deemed comprehensive value by Lev), the ratio of market value to that comprehensive value becomes far more reasonable: Dell, 1.26; Pfizer, 1.90.

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