Increasingly, intangible knowledge assets are dwarfing the value of tangible book assets at many companies. But don’t ask for details. While corporate reports heap praise on various efforts to capitalize on knowledge, they fail to supply reliable, objective benchmarks for measuring the values a company gets from its patents, brands, trademarks, capital expenditures, and research-and-development programs.
Intuition may allow observers to generalize about these elusive assets, but they certainly deserve sharper focus from the company’s own finance department, if only to help explain today’s spiraling market values. Despite critics who still insist that knowledge assets are unfathomable by nature, securities analysts, board members, and curious shareholders are clamoring for better information from corporate managers.
The drumbeat is not lost on Ron Soler, the Sunnyvale, California-based director of finance at Lockheed Martin Corp., in Bethesda, Maryland. “We currently have no formal measure of knowledge assets,” he notes, “but these assets are our survival assets, and the most strategic for our long-term viability.”
To assist financial managers in grappling with knowledge assets, CFO’s second annual Knowledge Capital Scoreboard updates and expands last year’s techniques–and its conclusions. (See “Seeing Is Believing,” CFO, February 1999.) In the 2000 edition, the methodology, designed at CFO’s request by Prof. Baruch Lev of New York University’s Stern School of Business, pierces the knowledge capital veil in more detail. Top companies in 20 industries were ranked according to their levels of knowledge capital, from a high of $211 billion at mighty Microsoft Corp., down to $332 million at our smallest knowledge-rated company, Adolph Coors Co. At our median company, $21 billion of knowledge capital amounted to three times book value.
In general, the most frequently used measures of knowledge capital emphasize input. Companies know to the nickel how much they are spending on various projects, including R&D. Professor Lev’s methodology, though, proposes ways to measure the earnings impact resulting from knowledge-based activities.
This year’s Scoreboard also offers striking evidence that knowledge capital predicts market performance with more accuracy than does either operating cash flow or net earnings. Further, companies that achieve high performance levels consistently show higher investments in three key drivers of knowledge capital: advertising, R&D, and capital spending.
Executive resistance to making routine use of knowledge-capital numbers is understandable, Lev notes. “With the incredible potential of knowledge assets comes great managerial difficulties and challenges,” he says. “It is much harder to manage knowledge assets than physical assets.”
That said, some companies have developed approaches to managing knowledge assets even without the aid of formal measurement tools. Genentech Inc., the pioneering biotech firm in South San Francisco, hasn’t had much luck finding a metric for knowledge. When the company looked at the biotech industry’s market values and compared them with R&D spending levels at the most research-intensive pharmaceuticals companies, for example, it found little correlation. Still, it says it believes it is doing well, benefiting from strategic R&D spending increases that were made in 1995 and 1996–increases that were made intuitively. “In our business, research and development–particularly development–is a very big component of our economic investments and of our expenses,” says Brad Goodwin, vice president, finance, at Genentech. Yet the asset created “does not get reflected on our balance sheet.”
Some companies can manage fairly successfully using homegrown definitions of knowledge capital, but the lack of a systematic tool precludes useful comparisons with competitors. A good measuring tool can also help companies evaluate their own skills in building knowledge capital, and devise a best-practices strategy.
Part of the exercise may sound exotic, but the Scoreboard’s calculations for measuring knowledge capital will strike a familiar chord with seasoned finance executives. As it did last year, our formula uses some commonly accepted analytical tools, and beyond information found on balance sheets, rests on three elements: an estimate of “normalized earnings,” the standard expected returns for broad asset classes, and a proxy for knowledge capital’s rate of return.
Capturing The Full Payoff
Absent hard and fast rules for computing normalized earnings, the Scoreboard relies on three years of historical profits through 1998, plus Wall Street’s consensus estimates of earnings through 2001. While expected growth rates can be computed at any number of levels of detail, the Scoreboard uses as a base only two broad classes of book assets: tangible assets and financial assets, with respective expected rates of return of 7 percent and 4.5 percent after tax. (When available, more detailed growth estimates can be substituted.)
In profitable, growing companies, normalized earnings ordinarily exceed earnings attributable to book assets. This excess in expected earnings constitutes “knowledge earnings.” Put another way, knowledge earnings are the portion of normalized earnings over and above expected earnings attributable to book assets.
With a credible figure for knowledge earnings in hand, corporate knowledge capital can then be estimated. This value, says Lev, is based on the present value of the future stream of knowledge earnings. Using consensus forecasts supplied by I/B/E/S International Inc., a market-data collection firm in New York, he assumes that knowledge earnings will grow at the company’s long-term growth rate. As five years of future growth expectations do not capture the full future payoff that robust knowledge capital bestows, the current Scoreboard expands the horizon.
Knowledge capital represents the present value of all future knowledge earnings, discounted at an appropriate rate. It may seem fanciful to some observers, who note the impossibility of projecting growth beyond the near-term, but widely used growth models often take a longer view.
Lev’s solution: compute knowledge capital using a three-stage growth model that extends the scope of knowledge capital beyond 5 years. During the second stage, years 6 through 10, growth converges on the overall level of economic growth. The final stage, year 11, represents the present value of all subsequent earnings growing at the same pace as economic growth. To find a present value for knowledge capital, on which companies are ranked, the stream of future knowledge earnings is discounted at a rate commensurate with the average growth rate for three knowledge-rich industries–biotech, software, and pharmaceuticals.
These knowledge-capital and knowledge-earnings numbers spawn metrics that can help managers see intangible assets in a new and useful light. And computing them over time allows executives to benefit from seeing year-to-year changes. Intel Corp. led in the knowledge- earnings growth category by a wide margin, adding $1.1 billion last year. The biggest loser in knowledge capital: AT&T Corp., which shed $505 million. (The estimates of knowledge earnings will fluctuate whenever securities analysts raise or lower their growth expectations.)
Another Win For Dell
The ratios of knowledge capital to book value and of market value to comprehensive value (book value plus knowledge capital) allow the Scoreboard to serve as a window on corporate value. In the relation of knowledge capital to book value, Dell Computer Corp. blows away the competition–with a 37-to-1 ratio. Alone in the second tier behind Dell is Avon Products Inc., representing a much more traditional sector of the economy. Avon chalks up a knowledge-capital-to-book-value ratio of 31-to- 1, possibly a consequence of lofty brand values and the relatively low fixed costs of virtual manufacturing and a direct sales force.
Some evidence from the real world seems to validate the ability of this ratio to predict superior prospects. In the 1999 Scoreboard, Warner-Lambert Co. posted the highest ratio of knowledge capital to book value, nearly 4.3-to- 1. Last November, two other pharmaceutical firms launched competing bids for Warner- Lambert, with their bids stemming in large part from expectations for the future of Lipitor, a Warner-developed drug that has become the most-prescribed cholesterol- lowering drug in the United States.
Events that buffeted Monsanto Co. last year also highlight the predictive potential for knowledge capital. While still enjoying investors’ favor early in 1999, Monsanto chalked up only an average calculation of knowledge capital to book value. Although this metric was somewhat surprising at the time, the company soon tumbled from grace. In an effort to boost sagging performance, it proposed shedding some of its assets, only to succumb in December to a buyout bid.
Adding book capital to knowledge capital produces a comprehensive picture of corporate assets. The market-to-comprehensive-value ratio measures market valuation’s relationship to the aggregate worth of tangible and intangible assets with an eye to growth prospects. From a fund manager’s perspective, comprehensive value is very useful, says Marc Bothwell, vice president and portfolio manager at Credit Suisse Asset Management. It has the effect of making the balance sheet relevant in a period of sky-high stock valuations, says Bothwell, who was instrumental in developing the Scoreboard.
Overall, comprehensive ratios are much more modest than strict market-to-book ratios, and suggest a much more robust view of corporate assets than balance sheets alone convey. The Scoreboard’s richest premium here belongs to Texas Instruments Inc., with a market-to-comp ratio of 2.78-to-1. TI’s market-to-book is a whopping 10-to-1. Delta Air Lines Inc. is the lowest on our list in the market-to-comp category; its market value captures less than half the airline’s comprehensive value. Delta’s market-to-book ratio is a modest 1.5- to-1.
As many companies evolve from the old to the new economy, measuring knowledge capital will become an increasingly important mission. “Managing knowledge capital will be critical for organizations to create a sustainable, competitive advantage,” says Harvard University accounting professor Robert Kaplan. “Today, the long-term success of organizations comes from their knowledge-based assets–customer relationships; innovative products and services; operationally excellent processes; the skills, capabilities, and motivation of their people; and their databases and information systems. Physical assets may be important, but they are unlikely to be as effective a competitive weapon as knowledge assets.”
Balance sheets have rarely revealed the full corporate picture, of course. Decades ago, accounting guru Abraham Briloff compared a corporate balance sheet to a bikini bathing suit: What it reveals is interesting, but what it conceals is vital. These days, balance sheets convey a scantier picture of underlying value than ever. So tools like the Scoreboard help leave less to the imagination.
S.L. Mintz is New York bureau chief of CFO.