Did you know that assets comprising 86% of the market value of Dow Jones Industrial Average companies are not reported in financial statements? Perhaps not, if you think of company value strictly from an accounting standpoint.
As the late Roger Sinclair forcefully argued in three articles for CFO, it seems plain wacky that accounting rules still prohibit companies from including the value of internally created intangible assets alongside tangible assets in their financial statements.
After all, there’s no debate that today, a majority of most companies’ market value derives from brands, patents, technologies, and other intellectual capital. That wasn’t the case when the process of standardizing accounting practices began hundreds of years ago. It wasn’t even the case, for the most part, 30 years ago.
Sinclair was a brand valuation expert who largely spent his later years beating this drum. Put simply, he wanted the value of brands to be more visible to investors.
Another party beating the drum these days, but with a somewhat different purpose, is a firm called Talent Growth Advisors that specializes in helping companies build talent strategies that link to business value. Its co-founders and managing directors are Linda Brenner, a former human resources executive who also is CEO of an HR technology solutions firm, Skillsify, and Tom McGuire, a former CFO of Revlon who also had an eclectic career with Coca-Cola in finance, marketing, and talent acquisition.
Brenner and McGuire are pushing an idea that has two main components: (1) key talent is the only thing that drives the creation of intellectual capital; and (2) because internally created intellectual capital isn’t in the financial statements (only acquired intellectual capital is, in the form of goodwill), executives don’t pay enough attention to developing key talent.
Really? CEOs and CFOs don’t understand that critical roles — like product development talent at pharmaceutical and technology companies or marketing talent at consumer products companies — are enormously valuable?
“I think that intuitively they do,” says McGuire. “But because those values aren’t on the balance sheet, because they don’t put dollar signs beside those assets, they don’t have a metric that drives the right behaviors.” As discussed below, McGuire and Brenner have created a metric that, they say, achieves that end.
“The cost of developing and maintaining intellectual capital assets,” McGuire continues, “is recorded as an expense on the income statement — along with all other people costs like those for ‘HR director’ and ‘accounts payable clerk,’ which truly are expenses — rather than as an investment in those critical assets.”
For decades, says Brenner, companies have been failing at understanding the important difference between key talent and everyone else. That manifests itself in a number of ways, she notes.
For example, a large company typically has a recruiting department that may be responsible for filling thousands of jobs per year. “There is typically no framework for saying, ‘Let’s evaluate this, let’s fill this job differently than that one,’ or ‘Let’s put our best recruiter on this one,’ ” says Brenner.
“The same is true for performance management: it’s the same process for everyone,” she adds. “But no game will be won in this knowledge economy by spreading limited resources as thinly and evenly as possible in this way.”
Given the failure of accounting rules to account for the value of intellectual capital, McGuire and Brenner have created what they call a “workaround” metric for demonstrating that value.
The metric is calculated first by coming up with a company’s “enterprise value” — market capitalization, plus outstanding debt and marketable securities, minus cash and cash equivalents.
From that value, the adjusted book value — for purposes of this calculation, total shareholders’ equity, again adjusted by adding debt and subtracting cash and cash equivalents — is subtracted. The resulting value thus consists purely of internally created intellectual capital that’s not on the books.
To that resulting value, the calculation adds in the value of intangible assets that are recorded on the books, including goodwill (i.e., the value of acquired companies’ intangible assets) and trademarks. The result is called the “intellectual capital value.”
Finally, an “intellectual capital index” (ICI) is calculated by dividing the intellectual capital value by the enterprise value. The index shows how much of the company’s value is in its intellectual capital.
McGuire hopes to position the ICI as a tool that companies will actually use. “The ICI will help companies to manage the development of those internal assets and value them, even though they are not on the books,” he says.
So far, while McGuire intends to calculate an ICI for all Fortune 500 companies, he’s done so for only the Dow 30 companies — as of the end of their 2015 fiscal years — except the five that are in either the financial services or petroleum industries. (See the rationales for those exclusions at the end of this article.)
Four of the 25 companies — Boeing, Pfizer, Apple, and United Technologies — had an ICI of greater than 1.0, meaning that the value of their intellectual capital was actually greater than their enterprise value. Their ICIs were 1.04, 1.04, 1.04, and 1.01, respectively.
In each case, those companies have made acquisitions that provided enough goodwill that when added to their internally developed intellectual capital, it outweighed their net equity.
“Some have asked, does that mean those companies are undervalued?” says McGuire. “I don’t want to say that. It can be one conclusion, and it’s a good question.”
Among the 25 companies evaluated, the average ICI was 0.86. The lowest ICI was registered by Caterpillar, at 0.48, followed by American Express (0.52), Wal-Mart (0.57), and Cisco (0.64). (See a complete list at the end of this article.)
However, McGuire cautioned that a company in one industry with a higher ICI than a company in another industry is not necessarily a “better” company. Rather, companies should only be compared with others in their industry.
“For a company with a high ICI, its worth certainly depends more on intellectual capital and thus on its talent,” he says. “But every company should take the numbers in its industry and use them to develop talent strategies that maximize the value they get from talent.”
McGuire says that he expects when he performs calculations for the entire Fortune 500 that those in the Dow 30 will tend to be the leaders in their respective industries. “In each industry there will be a range,” he says. “If you’re at the bottom of the range, it will tell you where you could be and point you toward strategies that could let you get the most out of your position in the industry.”
Talent Growth Advisors also compiled a list of the 25 companies according to intellectual capital value per employee. In that category, one company, Visa, was an extreme outlier at more than $14 million per employee. Next was Apple, at just under $4.5 million.
Visa had relatively low headcount — approximately 11,000 employees for a $14 billion business — and very little investment in tangible assets, McGuire notes. Apple, by comparison, had about 10 times as many employees but 16 times greater revenue and far greater tangible assets.
“We will see others with similar characteristics as Visa in the Fortune 500, but I have a feeling Visa will still be at the top of the heap,” says McGuire.
Meanwhile, here are the stated rationales for excluding two industries from the ICI calculations:
Bank and insurance financial information does not lend itself to enterprise valuation, as the commingling of asset and liability groups in addition to heavy regulation on debt ratios makes such analysis arbitrary.
In the case of petroleum companies, enterprise valuation relies materially on the assumed value of petroleum reserves. While accounting rules and the SEC require disclosure of reserves valuation, the companies state explicitly in footnotes that they believe the estimates are unreliable.