Strategy

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 in...
Andrew OsterlandApril 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.

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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.

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.

Industry Knowl. Capital ($ millions) Knowl Earnings ’99 ($ millions) Change in Knowl. Earnings ’98-’99 ($ millions) Knowl. Capital / Book Value Market Value / Book Value Market Value / Compre- hensive Value Market Value 8/31/00 ($ millions)
Aerospace & Defense 23,447 1,417 65 3.58 1.8 .50 11,407
Airlines 7,949 399 22 2.12 1.0 0.55 5,496
Biotech 4,393 171 40 5.18 16.3 3.07 13,940
Chemicals 9,948 632 42 3.08 2.2 0.75 7,746
Computer Hardware 49,857 2,490 389 6.69 17.5 1.85 202,719
Computer Software 38,908 1,782 279 5.68 15.2 2.40 48,465
Electrical 7,690 450 29 3.70 3.6 0.75 6,081
Electric Utilities 10,351 691 177 1.11 2.1 0.99 19,418
Food / Beverages 18,565 1,306 67 7.48 9.1 1.08 27,007
Forest Products 8,884 854 285 0.87 1.58 0.81 10,322
Home Products 19,296 1,097 109 8.10 6.6 1.11 29,257
Industrial 23,132 1,166 113 3.65 3.3 0.81 16,922
Media 16,759 646 119 0.94 2.7 1.40 82,396
Motor Vehicles 13,413 962 97 3.50 1.9 0.46 9,205
Newspapers 5,619 336 44 3.77 3.2 0.67 6,594
Oil 24,559 2,210 585 1.71 3.4 1.27 55,150
Pharmaceuticals 75,224 4,295 621 8.44 12.2 1.34 116,073
Retail 15,406 885 115 2.89 3.8 1.52 18,486
Semiconductors 42,029 1,859 1,051 6.23 12.6 2.08 89,911
Specialty Retail 10,320 512 84 2.62 8.0 1.77 17,154
Telecom 81,221 4,851 660 3.26 3.5 1.00 118,288
Telecom Equip. 26,947 1,684 615 3.25 7.7 1.78 96,184

THE SCOPE OF KNOWLEDGE

How knowledge capital compares at the top companies.

Industry Knowl. Capital ($ millions) Knowl Earnings ’99 ($ millions) Change in Knowl. Earnings ’98-’99 ($ millions) Knowl. Capital / Book Value Market Value / Book Value Market Value / Compre- hensive Value Market Value 8/31/00 ($ millions)
AEROSPACE & DEFENSE
Honeywell Int’l 33,839 2,157 235 3.60 3.3 0.71 30,891
Lockheed Martin 27,358 1,417 -333 4.20 1.8 0.34 11,407
Boeing 23,447 1,590 614 1.90 3.8 1.30 46,270
Northrop Grumman 15,901 894 65 4.50 1.5 0.28 5,440
Raytheon 8,356 800 -595 0.80 0.9 0.50 9,457
AIRLINES
Delta Airlines 10,792 709 -15 2.10 1.2 0.38 6,071
AMR 9,230 425 -174 1.40 0.7 .31 4,920
Southwest Airlines 6,668 374 68 2.20 3.7 1.17 11,280
U.S. Airways 3,420 251 60 NM NM 0.72 2,280
BIOTECH
Amgen 20,786 1,041 136 6.0 22.4 3.20 77,958
Medimmune 4,409 124 36 6.1 24.3 3.44 17,651
Biogen 4,377 219 44 4.4 10.2 1.90 10,229
Chiron 1,508 80 17 0.8 5.4 2.95 9,863
CHEMICALS
DuPont 49,085 2,543 23 3.7 3.5 0.75 46,779
Dow Chemical 29,091 1,844 748 3.2 2.0 0.47 17,761
PPG Industries 9,948 632 63 3.1 2.2 0.53 7,045
Air Prods & Chems 6,245 379 42 2.4 2.9 0.87 7,746
Rohm & Haas 4,656 280 -29 1.3 1.8 0.77 6,356
COMPUTER HARDWARE
IBM 128,186 6,597 212 6.7 12.1 1.58 232,413
Dell Computer 83,519 2,490 547 12.9 17.5 1.26 113,251
Hewlett – Packard 49,857 2,598 -340 3.4 8.2 1.85 119,385
EMC 45,958 1,569 389 6.9 32.2 4.06 213,677
Sun Microsystems 44,560 1,849 470 6.1 27.7 3.91 202,719
COMPUTER SOFTWARE
Microsoft 188,787 8,526 2,406 4.6 8.9 1.60 368,819
Oracle 54,304 2,314 904 8.4 39.4 4.19 254,509
Computer Associates 39,908 1,782 279 5.7 2.7 0.41 18,763
Veritas Software 16,988 176 143 5.3 15.1 2.40 48,465
Siebel Systems 6,180 176 53 6.9 45.6 5.76 40,715
ELECTRIC UTILITIES
AES 28,486 691 197 7.1 7.3 0.90 29,119
Duke Energy 15,380 934 211 1.6 2.9 1.10 27,531
Southern 10,351 847 177 1.1 2.1 0.99 19,418
FPL Group 5,385 391 67 0.9 1.7 0.85 9,488
Dominion Res 3,358 418 77 0.5 1.8 1.22 12,604
ELECTRICAL
Emerson Elec. 24,717 1,426 130 3.9 4.5 0.91 28,273
Rockwell Int’l. 9,431 536 16 3.5 2.8 0.62 7,534
Cooper Industries 5,950 363 27 3.3 1.8 0.43 3,292
American Pwr Conversion 4,311 199 32 4.3 4.6 0.87 4,629
FOOD/ BEVERAGES
Coca-Cola 67,165 3,484 394 7.3 14.2 1.71 130,326
PepsiCo 50,480 2,334 67 7.5 9.1 1.08 61,593
H.J. Heinz 18,565 1,064 85 11.4 8.1 0.65 13,223
Unilever 18,390 1,306 36 3.0 4.4 1.10 27,007
Campbell Soup 13,022 835 47 95.1 81.3 0.85 11,140
FOREST PRODUCTS
Kimberly- Clark 25,308 1,579 201 4.5 5.6 1.02 31,514
International Paper 11,369 1,103 841 0.9 1.2 0.63 15,361
Georgia Pacific 8,884 854 369 2.2 1.1 0.35 4,568
Weyerhaeuser 5,762 572 285 0.8 1.5 0.81 10,322
Williamette Industries 1,044 221 69 0.5 1.5 1.01 3,331
HOME PRODUCTS
Procter & Gamble 63,450 3,882 143 5.2 6.6 1.07 80,719
Gillette 26,145 1,343 124 11.0 13.3 1.11 31,590
Colgate- Palmolive 19,296 1,097 109 11.8 17.8 1.40 29,257
Clorox 8,151 502 96 4.5 4.7 0.86 8,517
Avon Products 7,675 455 24 NM NM 1.27 9,304
INDUSTRIAL
Tyco International 56,184 2,970 640 3.7 6.3 1.34 96,177
United Technologies 25,856 1,564 438 3.4 3.9 0.87 29,231
Caterpillar 23,132 1,166 54 4.2 2.3 0.44 12,705
Illinois Tool Works 15,800 957 113 3.1 3.3 0.81 16,922
Ingersoll- Rand 14,453 819 77 4.5 2.3 0.42 7,340
MEDIA
Walt Disney 53,012 2,126 59 2.2 3.5 1.07 82,396
Viacom 16,759 646 188 0.3 2.1 1.55 102,113
Clear Channel Comm. 9,536 447 119 0.9 2.7 1.40 27,518
MOTOR VEHICLES
Ford Motor 90,338 6,685 1,680 3.7 2.1 0.44 50,951
General Motors 55,026 4,257 282 1.9 1.3 0.46 38,758
Delphi Automotive Sys 13,413 962 97 3.8 2.6 0.54 9,205
Johnson Controls 8,573 480 74 3.5 1.9 0.42 4,589
Paccar 4,159 306 -4 1.9 1.5 0.51 3,246
NEWSPAPERS
Gannett 17,733 1,087 137 3.8 3.2 0.67 14,928
Tribune 10,388 502 140 1.7 1.7 0.66 10,999
New York Times 5,619 336 44 4.2 4.9 0.95 6,594
Knight Ridder 4,921 329 12 3.0 2.5 0.63 4,127
Dow Jones 3,562 210 10 6.6 10.1 1.33 5,467
OIL
Exxon Mobil 114,347 8,544 878 1.7 4.2 1.57 284,382
Royal Dutch Petroleum 27,258 3,818 585 0.8 3.7 2.10 131,204
Chevron 24,559 2,210 1,026 1.3 2.9 1.27 55,150
Phillips Petroleum 8,697 877 198 1.7 3.1 1.14 15,756
Unocal 8,453 376 42 3.4 3.3 0.74 8,106
PHARMACEUTICALS
Pfizer 128,610 5,796 3,017 8.6 18.2 1.90 273,069
Merck 109,217 6,583 902 8.6 12.6 1.32 160,694
Johnson & Johnson 76,446 4,336 699 4.3 7.1 1.35 127,891
Bristol Myers Squibb 74,002 4,254 424 8.3 11.7 1.26 104,255
Pharmacia 55,373 2,193 543 4.7 6.5 1.13 75,998
Eli Lilly 48,163 2,641 328 8.7 15.0 1.54 82,453
RETAIL
Wal-Mart Stores 81,239 4,867 1,167 2.9 7.5 1.94 211,872
Sears Roebuck 23,457 1,421 115 3.6 1.7 0.36 10,697
Target 15,406 885 128 2.6 3.5 0.98 20,999
Costco 6,006 349 40 1.5 3.8 1.52 15,404
Kohls 5,504 250 50 2.9 9.8 2.50 18,486
SEMICONDUCTORS
Intel 208,641 9,502 2,749 5.7 13.7 2.05 502,711
Applied Materials 44,667 1,856 1,090 7.3 11.4 1.38 70,011
Texas Instruments 39,390 1,860 1,012 3.1 8.7 2.11 109,810
Broadcam 5,704 137 38 6.8 65.8 8.48 55,509
SPECIALTY RETAIL
Home Depot 48,849 2,230 621 3.5 8.0 1.77 111,287
Lowes 10,962 567 171 2.1 3.3 1.06 17,154
CVS 10,320 512 84 2.6 3.7 1.02 14,504
Walgreen 9,243 510 73 2.3 8.2 2.50 33,231
Radioshack 4,552 271 60 6.3 15.2 2.08 10,962
TELECOM
Verizon Communications 114,464 6,462 1,277 3.3 3.5 0.80 118,573
SBC Communications 113,618 6,903 2,730 4.0 5.0 1.00 141,514
AT&T 81,221 4,851 -222 0.7 1.1 0.62 118,288
Bellsouth 53,812 3,568 660 3.3 4.3 1.00 70,185
Worldcom 23,277 1,772 30 0.4 1.9 1.35 104,734
TELECOM EQUIPMENT
Cisco Systems 162,218 4,910 2,434 6.1 18.5 2.60 489,845
Lucent Technologies 62,824 3,220 315 2.4 5.3 1.57 139,633
Motorola 26,947 1,684 1,016 1.3 3.7 1.62 78,639
Owens Corning 24,786 867 210 3.3 12.6 2.97 96,184
Qualcomm 19,317 672 192 3.3 7.7 1.78 44,610

NM = Not meaningful
The various measures of knowledge earnings included in this survey were designed by Prof. Baruch Lev, who retains the exclusive rights to the measures. These knowledge-based measures should not be used in any form without the written permission of Professor Lev. Marc Bothwell, vice president and portfolio manager at Credit Suisse Asset Management, contributed to the development of the measures and performed the required programming and computations. Professor Lev has a patent pending on these measures. For more information, see http://www.baruch-lev.com/.