Reshaping business and the world by leveraging knowledge intangibles
IC and Business Valuation
I was recently sent a copy of a new Statement on Management Accounting about Business Valuation (free but registration required) from the Institute of Management Accountants.
It’s a great overview of the process used to value businesses. None of the information in the paper was a surprise to me. I learned the basics of this process years ago when I was a high-risk lender.
But when I read the paper with my intangible capital hat on, I was struck by how much the accounting challenges of intangibles are limiting and, perhaps, distorting the work of valuation professionals. Here are a few thoughts:
Valuation Analysis
In the paper, company analysis is a first step in the valuation and includes SWOT, Historical financial analysis and normalization of financials. The paper does not mention the goodwill/intangible information gap that exists in just about every company’s financials today. But those of us in the intangibles community know that financials today hide a big problem. Corporate value is today, on average, roughly 70% intangible. That means that the net book value shown on the balance sheet only explains 30% of the value of a company. Data from E&Y for 2007 shows that 23% of the average corporate purchase price in an M&A situation is booked to identified intangibles like customer lists and technologies. That leaves 47% as goodwill. To me, this shows that accountants are creating a dangerous information gap because this goodwill represents real value and investment. This gap exists in all companies; it only becomes visible in M&A because of accounting norms.
Valuation professionals will be quick to counter that their work captures the essence of intangibles through their projection of the income statement. That, while the balance sheet may not describe
intangibles, their effect is taken into account on the income statement.
This is true to an extent, except that it ignores:
- Because intangibles are not capitalized, they are expensed. So, for example, a lot of the money spent on implementing a new computer system along with the training of people to use it is shown as an operating expense. Macro level data from the Conference Board shows that the intangible/tangible split in U.S. corporate investments is 60/40 ($1.6 trillion intangible, $1.2 trillion tangible). Heavy investments in future intangibles capacity means that the income statement does not actually represent a true operating picture of the organization because
it is mixing investments with operating revenues and costs. - Many of the intangible costs of an organization are embedded in SG&A rather than CoGS. This lack of clarity limits a user of the financial statement’s ability to understand what is really going on in the operations. So the projections of the financials may not represent an accurate representation of the future.
- Lack of information about the intangible side of business (human capital readiness, health of key business relationships, quality of core processes, to name a few) limits the ability of an analyst to use past financials to project the future. Problems on the intangible side are often at the core of reputational crises that can drastically change the future earning capacity of a company.
Capital Asset Pricing Model (CAPM)
Once a set of projections are developed, the valuation process discounts that value of future cash flows using a discount rate. The theoretical foundation of the discount rate calculation is the CAPM. Basically, this approach enables the calculation of a weighted average cost of capital based on the relative use of different capital sources as a percentage of the balance sheet. Although I have never seen an analysis of this, I cannot help wondering how the CAPM is distorted by the fact that the total value of the balance sheet may include up to 50% unbooked goodwill. So if debt is $7 and equity is $3, equity would be 30% of the capitalization. But if there is unbooked goodwill, equity is $13 ($10 goodwill plus $3 equity) which is 65% of a $20 capitalization ($13 plus the $7 in debt). What would this do to the average valuation?
Finished Valuation
Of course, the ultimate value of a valuation is limited as a management tool if it ends up with a large goodwill component. This was very clear in a recent survey by the Hay Group on intangibles in M&A. In it, they found that executive typically value intangibles at about 30% (when the data tell us that intangibles make up 70%). To me, this means that the lack of accounting and valuation information about intangibles is coloring the ability of the executives to “see” the true value of their own and other companies.
What’s the answer here?
Well, this is one of the reasons we have written Intangible Capital and why we are expanding the IC Knowledge Center community. The answer involves developing a new understanding of intangibles across the business community. Two of the best places to start are in creating inventories of intangibles and then measurement systems for them (tracking intangibles investment is an important first step here). This will go a long way to filling in that enormous information gap. Hope you will join in the conversation about how to bridge this gap.
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Replies to This Discussion
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Permalink Reply by James P Catty on -
Hi Mary
Thank you for your interest in the material I send you. Everything I pass on is intended to add to our knowledge. Your posting “Business Valuations and the Intangible Information Gap” is interesting as it shows the “Grand Canyon” that exists between the concepts of the valuator (who works mainly from accounting information) and the venture capitalists /managers who rely on the much greater range of data sources. Therefore I have prepared this mini response for comments from you, your readers and associates.
Terminology
First, some terminology: for the valuator, there are four two elements in what you refer to as IC, which we call Intellectual Capital, specifically:
1. Intangible Assets which meet the FASB/IASB definition of (i) either arising from a legal or contractual right or (ii) being transferrable. They are usually divided into the following six categories, with illustrative examples:
A. Marketing Related
i) Trademarks, trade names
ii) Service marks, collective marks, certification marks
iii) Trade dress (unique color, share or package design)
iv) Newspaper mastheads
v) Internet domain names
vi) Noncompetition agreements
B. Customer Related
i) Customer lists
ii) Order or production backlog
iii) Customer contracts and related customer relationships
iv) Non-contractual customer relationships
C. Artistic Related
i) Plays, operas, ballets
ii) Books, magazines, newspapers, other literary works
iii) Musical works such as compositions, song lyrics, advertising jingles
iv) Pictures, photographs
v) Video and audiovisual material, including motion pictures, music videos, television programs
D. Contract Based
i) Licensing, royalty, standstill agreements
ii) Advertising, construction, management, service or supply contracts
iii) Lease agreement
iv) Franchise agreements
v) Operating and broadcast rights
vi) Servicing contracts
vii) Employment contracts
E. Technology Based
i) Patented technology
ii) Computer software and mask works
iii) Unpatented technology
iv) Databases, including title plants
v) Trade secrets, such as formulas processes, recipes
F. Government Granted
i) Broadcasting license
ii) Use right such as drilling, water, mineral or timber cutting
iii) Taxi medallions and other transportation rights
iv) Building permits
v) Public accounting licenses
2. Intellectual Properties Rights which form a subset of Intangible Assets with special legal properties. The World Intellectual Property Organization (WIPO) divides them into five classes.
A. Patents & Plant Breeders Rights
B. Copyrights
C. Trademarks
D. Industrial Designs & Integrated Circuits
E. Trade Secrets (not every country)
3. Assembled Workforce which includes management, fits the definition of being an Intangible Asset but is specifically excluded from Fair Value, as this is an “exit price” and the techniques used to value an Assembled Workforce do not produce such an amount. As a result it is included in Goodwill.
4. Goodwill is a catchall of intangible items comprising all resources considered to contribute to the value of an entity excluding financial, physical and intangible assets.
Your categories of Intellectual Capital are all covered by one of the valuation groups
Human Capital Assembled Workforce
Relationship Capital Goodwill
Structured Capital Intangible Assets/Intellectual Property Rights
Strategic Capital Goodwill
Acquired Items Only
Within this framework, there is an important caveat. Only acquired items may be recognized in an entity’s financial statements. However, in calculating the fair value of a share and for step two of Goodwill impairment testing in the United States (but not under IFRS) the value of all Intangible Assets for a particular reporting unit (not necessarily for the total enterprise) must be identified and their fair values calculated.
In their working papers but not normally in published reports, many valuators and financial analysts try to divide the unrecorded intangible assets of a business, into the major categories discussed above, and give themvalues.. In many cases in the past, but not necessarily at the end of 2008, financial and physical assets, which are always recorded on the financial statements, less liabilities, amounted to only 30%, or less, of listed firms’ market capitalizations (for publicly traded securities the number of common shares outstanding times the reported price). This leaves a substantial amount of what was once, in the time of JP Morgan and Daniel Drew, called “water” and is now recognized as a mixture of recorded and unrecorded intangibles.
The Valuation Process
As you rightfully point out, the first step in any supportable valuation is analyses of the entity or enterprise (a group of entities that file consolidated financial statements). The processes will normally include (i) a SWOT review (ii) determination of how cash flows are generated (iii) historic financial analyses (iv) economic and market outlook and (v) financial forecasts (most likely situation) or projections (alternative scenarios) for the next five or so years. Historic and projected Balance Sheets (Statements of Financial Position) are usually used for the analysis of working capital and financing requirements.
Often pro forma economic balance sheets are created reflecting both the intangible assets every firm owns (trade name, customer relationships and assembled workforce), as well as any entity specific items such as technologies. This economic balance sheet will also include any appreciated real estate and impaired physical assets such as property, plant & equipment.
While a figure of 30% or so for the portion of market capitalization represented by net financial and physical assets was true for much of the 2000s, I suggest that as a result of the 2008-2009 “Deep Recession” and the lack luster recovery, the figure now is above 50%; the average of five recent valuations was 56%; in one, a defense contractor, it was 100%. Rounding it off at 55% and using the E&Y data for 2007 (long out of date) gives the following breakdown:
Net Financial & Physical - 55%
Identified Intangible Assets - 27%
Assembled Workforce - 9%
Unidentified (Goodwill) - 9%
100%
The 9% for assemble workforce is as good a figure as I can get; it is the average of my sample of five, which ran 16%, 15%, 10%, 4%, 0%.
Elements of Goodwill
What is in Goodwill. The answer is, nearly anything. The most common components are the mandatory assembled workforce plus the customer base. For branded products, which are usually sold by retailers, the customer relationships (intangible assets) are with the stores. They in turn have the relationships with the consumers (the customer base/market share) from which the profits flow.
Expensing Intangibles
Mary, you are quite right that internally developed intangibles are expensed but those acquired in a Business Combination are capitalized and amortized. Very few intangible assets have an indefinite life. In most cases they expire relatively quickly and are replaced by new items whose development has been expensed.
For most high tech companies, capitalizing the R&D spent each year and amortizing it on a not unusual three-year product cycle, has very little effect on the discounted cash flow value. Entities like aircraft manufacturers, capitalize product (plane, engine etc.) development costs and write them off to match the expected flow of unit or dollar sales; movies and TV series are treated in a similar manner; the objective is to match the costs with the revenues.
Capital Expenditures
I do not doubt the Conference Board’s estimate of $1.6 trillion in capital expenditures on intangibles (57%) and only $1.2 trillion on physical assets (43%). However, as mentioned above this does not mean that profits and values are understated by more than $1.0 trillion. All intangible assets have short lives relative to physical ones and require more maintenance. For example, if not supported a brand dies quickly. As a kid in Connecticut, I used to drink Pabst Blue Ribbon beer, that then (the 1950s) ranked second only to Bud; not supported it died
When my father retired in England in the late 1950s, he bought and restored a Tudor house (circa 1580) with no plumbing (only an earth closet in the garden). It had last been renovated in 1811 (they found a newspaper from then in the walls as part of the insulation). Yet its structure was completely sound.
Supporting Expenditures
The “investment spending” that generates the most intangibles are advertising and R&D. Both of those amounts can be and are identified by valuators and taken into account in the value conclusion. The quote “Half the money I spend on advertising is wasted, the trouble is I don’t know which half”, from John Wanamaker (1838-1922) supports the view that a portion of such expenditures should be capitalized; the trouble is how much. Accountants don’t know and so, being conservative chaps, write them all off. Valuators get around finding a figure to capitalize by valuing the brand based on estimated of future cash flows; same objective, different techniques. In my view, the relationship is non-linear, up to a certain, hard to measure, amount for support, everything should be expensed. After that most adds value and ought to be capitalized.
Capitalized Asset Pricing Model
Mary CAPM is rather 2000s; with the collapse of the stock market in 2008-2009 and the subsequent recovery, the concept that the Beta of a share can capture all the risks involved has gone the way of the Dodo. Many techniques have attempted to replace it but he most acceptable, at least to valuators, as far as I know, is the Risk Rate Component Model that attempts to quantify a relevant premium for each potential risk by benchmarking. It takes into account the extra return needed for equities together with appropriate size and entity specific items.
Whatever technique is chosen to obtain the cost of equity in the Weighted Average Cost of Capital (WACC), it is applied using market value as the weight. For the debt portion the cost is fixed but the market value may be more or less than book. In a high risk environment with corporate debt spreads of 300-500 basis points (100 basis points equals one percentage point) over Treasuries for lower quality credits the debt component would have a weight of less than book value while the equity portion would reflect the unrecognized intangible assets.
In practice, for privately held entities, valuators use book value for the debt and an iteration process in which a new DCF value is repeatedly used as a weight in calculating the WACC to establish the fair value of the entity. It is complex but works well.
Well Mary, I have rambled on for pages. Now I await the feedback of not the “other side” but “partners in seeking better truths”.
Regards
Jim
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Permalink Reply by Mary Adams on
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Jim - Thank you for your thoughtful reply! First of all, I want to say that I am not criticizing the valuation profession. You are doing a great job working (as we all are) within a system that is broken. All my comments are (hopefully) in the spirit of trying to think about how to fix the system.
Your List
Thanks for the great list of intangibles, it is helpful.
What’s the Value of Intangibles?
I believe the large goodwill that deals have (albeit less right now in the recession) shows how much more work we need to do on intangibles). In fact, my attitude is: thank goodness we have acquisitions because they give us a little bit of a view into the difference between a full picture of corporate value and the one produced by current accounting standards.
I’m sure you are right about tangibles comprising a larger percentage of value during the recession. But that doesn’t mean that intangible value went away, it just means that our method of valuing intangibles as a plug figure (which is how I would define goodwill) is not very accurate. I maintain that there is investment behind the goodwill and the intangible value. While it cannot be capitalized until we understand it better, companies should be encouraged to begin to track it so they and we (the broader business community) can learn about the true patterns (and cost) of intangible value creation.
Process is Ignored
There is one category of intangibles that does not get discussed a lot in the business community but economists are teaching us about it... It falls under the category of structural capital. This is the collection of knowledge that has been captured by a business in the form of databases, systems, software, IP, trade secrets and processes. Processes are really the most powerful of these. In a new book From Povery to Prosperity: Intangible Assets, Hidden Liabilities and the Lasting Triumph Over Scarcity (which I highly recommend), Kling and Schulz call this “recipes.”
A simple example is Fedex--they have an end-to-end process for tracking a package. It includes hardware, software, work patterns, databases, etc. Collectively this “process” is a core asset of the company. But where can a stakeholder see the cost to build, operate and maintain this process? I know that pieces of it are in the balance sheet and income statement but it is too important to be scattered from an information perspective.
I am not saying valuators should be filling in this gap today. But I think that it is something that you could be helping us think about….
Useful Life of Intangibles
So if we consider the example of processes and “recipes,” I have to disagree with your statement that very few intangible assets have short life.
We do need to appreciate that knowledge assets are different. An idea never goes away. And it can become a foundation for new ideas. Remember what we learned with the Y2K challenges: that it was the software that had a lasting value, not the hardware.
Of course, in business the only ideas that have value are those that are put to work solving a problem for a customer. In the Fedex example, even when a procedure is changed, there is some residual value of the learning from the previous procedure and the reasons for the change. We don't yet know what that means for "amortizing" the cost of this learning--but we cannot ignore the fact that companies do invest in this.
I do think you concern about permanence is valid with two intangible investments that are already tracked: advertising and R&D.
Advertising is part of the investment in brand and reputation. This is a whole different topic. I won’t go into it here except to say that I view reputation as the “bottom line” on intangibles management. If you manage it all well, communicate proactively and with transparency, you will build and preserve a good reputation. But failures here can absolutely wipe out value. How we deal with that is more challenging.
R&D obviously has challenges too.
CAPM
I was just thinking out loud on this one. I don’t know what difference it would make but I think that if our understanding of the full value of a company is off, then our ways of calculating rates of return have to be off too.
Thanks again Jim--Love to hear your reaction and to hear from others!
© 2012 Created by Mary Adams.
