INTANGIBLE ASSETS
Measurement, Drivers, Usefulness
By
Feng Gu and Baruch Lev[*]
Please note: The various intangibles value metrics discussed here were designed by Baruch Lev who retains exclusive rights to the measures, and has a patent pending for them. The measures should not be used or reproduced without a written permission from Baruch Lev.
April 2001
INTANGIBLE ASSETS
1. How are The Intangibles Metrics Computed?
It is widely accepted that intangible (knowledge or intellectual) assets are the major drivers of corporate value and growth in most economic sectors, but the measurement of these assets has eluded so far managers, accountants, and financial analysts valuing investment projects.
Why measure intangible assets? Evaluating profitability and performance of business enterprise, by say, return on investment, assets or equity (ROA, ROE) is seriously flawed since the value of the firm’s major asset— intangible capital—is missing from the denominator of these indicators. Measures of price relatives (e.g., price-to-book ratio) are similarly misleading, absent the value of intangible assets from accounting book values. Valuations for the purpose of mergers and acquisitions are incomplete without an estimate of intellectual capital. Resource allocation decisions within corporations require values of intangible capital. These and other uses create the need for valuing intangible assets, in practically all economic sectors.
Intangible (knowledge) assets, such as new discoveries (drugs, software products, etc.), brands or unique organizational designs (e.g., Internet-based supply chains) are by and large not traded in organized markets, and the property rights over these assets are not fully secured by the company, except for intellectual properties, such as patents and trademarks. The risk of these assets (e.g., drugs or software programs under development not making it to the market) is generally higher than that of physical assets.[1] Accordingly, many, particularly accountants and corporate executives, are reluctant to recognize intangible, or intellectual capital as assets in financial reports, on par with physical and financial assets. While such attitude concerning balance sheets may be understandable, it does not satisfy the need to seek information about and value of intangible assets.
Some have attempted to gauge the value of intangible assets from the difference between the company’s capital market value and its book value (the balance sheet value of net physical and financial assets). This approach is unsatisfactory because it is based on two flawed assumptions: (a) that there is no mispricing in capital markets (tell this to investors who bought Internet stocks in 1999 and saw them plummet in 2000), and (b) that balance sheet historical values of assets reflect their current values.
The market-minus-book approach to valuing intangibles is also unsatisfactory because it is circulatory. One searches for measures of intangibles value in order to provide new information to managers and investors. What is the use of a measure (market-minus-book) that is derived from what investors already know (market and book values)? There is obviously a need for a different approach to estimating the value of intangible assets.
1. Preliminaries:
Baruch Lev’s methodology for measuring the value of intangible assets is based on the economic concept of “production function,” where the firm’s economic performance is stipulated to be generated by the three major classes of inputs: Physical, financial, and knowledge assets. Thus:
Economic Performance = α(Physical Assets) + β(Financial Assets) + δ(Intangible Assets)
α , β and δ represent the contributions of a unit of asset to the enterprise performance.
A key ingredient in this approach is the definition of an enterprise economic performance as an aggregate of past core earnings (earnings excluding unusual and extraordinary items), and future earnings, or growth potential. A performance measure which is strictly based on past earnings or cash flows, or a modification of earnings (e.g., the various value added measures), misses a major part of what intangible assets are all about—creating future growth (e.g., by investment in R&D, Internet activities, or employee training).
Having thus defined enterprise performance, the next step is the measurement of the performance drivers—the three major asset groups. The values of physical and financial (stocks, bonds, financial instruments) assets are obtained from the firm’s balance sheet and footnotes (with proper adjustments, such as converting accounting historical costs to current values). The derivation of the value of the third performance driver— intangible capital—is, in a sense, the solution to the above production function for the one unknown (intangible capital). This is done by estimating the “normal rates of return” on physical and financial assets—the α and β coefficients in the above production function—and subtracting from the estimated economic performance of the enterprise the contributions of physical and financial assets, namely the normal asset returns multiplied by the values of physical and financial assets. What remains from this subtraction is the contribution of intangible assets to the enterprise performance, which I define as “intangibles-driven earnings.” Capitalizing the expected stream of these earnings yields an estimate of “intangible capital.”
The intangibles value measurement procedure is demonstrated graphically in Figure 1.
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INTANGIBLE ASSETS
Past Earnings / + / Future EarningsNormalized Earnings
Subtract: /Return on Physical Assets
Subtract: / Return onFinancial Assets
Equal: /
Intangibles-Driven Earnings
Capitalize: / Intangible Assets17
2. Specifics:
v The measurement procedure outlined in Figure 1 starts with the estimation of annual “normalized earnings,” referred to earlier as the performance of the enterprise, which are based on an average of several (generally 3-5) historical years of reported core earnings (net earnings adjusted for extraordinary and other “one time” items), and same number of expected years earnings. For public companies, I use two alternative approaches to estimate expected earnings: consensus earnings forecasts by financial analysts, and an earnings forecast based on the pattern of the firm’s sales. In firm-specific applications, I use various public and proprietary sources to estimate growth potential. Normalized earnings is thus an annual weighted average of 6-10 earnings numbers, giving a heavier weight to expected earnings.
v Based on various economic studies and analyses, I estimate the average contributions of physical and financial assets, the α and β in the production function above. For public rankings of companies (Fortune, CFO magazine), I use after tax rates of 7% for physical assets and 4.5% for financial assets, reflecting economy-wide averages. For company-specific applications, I estimate specific rates of return on assets. These rates will change, of course, with market and company conditions.
I then subtract from normalized earnings (defined above), 7% of the value of physical assets and 4.5% of the value of financial assets.
What remains of normalized earnings after these subtractions is the contribution of intangible assets to the enterprise performance, which I define as “intangibles-driven earnings” (IDE).
v Lastly, I forecast the series of intangibles-driven earnings over three future periods (a 3-stage valuation model): Future years 1-5, using financial analysts’ long-term growth forecasts (or a sales-based forecast); years 6-10, linearly converging the forecasts to the long-term growth of the economy—3%; and years 11 to infinity, where IDE are assumed to grow annually by 3%—the expected long-term growth rate of the economy.
v The discounted value of expected IDE series, using a discount rate which reflects the above-average riskiness of these earnings, yields the estimated of “intangible assets.”
2. How do They Look?
Tables 1 and 2 present the 1999 intangibles measures computed for the five leading companies in 22 nonfinancial industries, followed by the industry median measures. These data constitute the CFO 2001 ranking. [2]
The metrics include the firms’ intangible capital (noted as knowledge cpital in the tables), as of August 2000; their 1999 intangibles-driven earnings; (noted knowledge earnings) and the new value measure—“market-to-comprehensive value” (third column from right). This measure modifies the well-known market-to-book ratio (market value of corporations divided by their book value—net assets on the balance sheet), by adding to the denominator of the ratio the estimated value of the firm’s intangible capital. Thus, the balance sheet value of physical and financial assets (book value), plus the value of intangibles missing from the balance sheet, comprises the “comprehensive value.”
Table 2 indicates, among other things, that many, so called “old economy” industries, are reach in intangibles: aerospace and defence, food and beverages (particularly brands), home products, industrial, oil and gas, retail. Figure 2, based on about 2000 companies for the period 1990-1999, provides a similar message.
We will see below the results of extensive tests demonstrating the unique usefulness of these measures reflecting intangibles assets.
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The Scope of IntangiblesName / Industry / Knowledge Capital 8/31/2000 / Knowledge Earnings 1999 / Change in Knowledge Earnings '99-'98 / Knowledge Capital / Book Value / Market Value / Book Value / Market Value / Comprehensive Value / Market Value 8/31/2000 / Return 8/31/2000 - 2/28/2001
HON / HONEYWELL INTL INC COM / Aerospace & Defense / 33,839 / 2,157 / 235 / 3.6 / 3.3 / 0.71 / 30,891 / 22%
LMT / LOCKHEED MARTIN CORP COM / Aerospace & Defense / 27,358 / 1,417 / -333 / 4.2 / 1.8 / 0.34 / 11,407 / 32%
BA / BOEING CO COM / Aerospace & Defense / 23,447 / 1,590 / 614 / 1.9 / 3.8 / 1.30 / 46,270 / 17%
NOC / NORTHROP GRUMMAN CORP COM / Aerospace & Defense / 15,901 / 894 / 65 / 4.5 / 1.5 / 0.28 / 5,440 / 21%
RTN.B / RAYTHEON CO CL B / Aerospace & Defense / 8,356 / 800 / -595 / 0.8 / 0.9 / 0.50 / 9,457 / 21%
DAL / DELTA AIR LINES INC DEL COM / Airlines / 10,792 / 709 / -15 / 2.1 / 1.2 / 0.38 / 6,071 / -15%
AMR / AMR CORP COM / Airlines / 9,230 / 425 / -174 / 1.4 / 0.7 / 0.31 / 4,920 / 1%
LUV / SOUTHWEST AIRLS CO COM / Airlines / 6,668 / 374 / 68 / 2.2 / 3.7 / 1.17 / 11,280 / 23%
U / US AIRWAYS GROUP INC COM / Airlines / 3,420 / 251 / 60 / NM / NM / 0.72 / 2,280 / 21%
AMGN / AMGEN INC COM / Biotech / 20,876 / 1,041 / 136 / 6.0 / 22.4 / 3.20 / 77,958 / -5%
MEDI / MEDIMMUNE INC COM / Biotech / 4,409 / 124 / 36 / 6.1 / 24.3 / 3.44 / 17,651 / -48%
BGEN / BIOGEN INC COM / Biotech / 4,377 / 219 / 44 / 4.4 / 10.2 / 1.90 / 10,229 / 4%
CHIR / CHIRON CORP COM / Biotech / 1,508 / 80 / 17 / 0.8 / 5.4 / 2.95 / 9,863 / -13%
DD / DU PONT E I DE NEMOURS & CO COM / Chemical / 49,085 / 2,543 / 23 / 3.7 / 3.5 / 0.75 / 46,779 / -1%
DOW / DOW CHEM CO COM / Chemical / 29,091 / 1,844 / 748 / 3.2 / 2.0 / 0.47 / 17,761 / 28%
PPG / PPG INDS INC COM / Chemical / 9,948 / 632 / 63 / 3.1 / 2.2 / 0.53 / 7,045 / 28%
APD / AIR PRODS & CHEMS INC COM / Chemical / 6,245 / 379 / 42 / 2.4 / 2.9 / 0.87 / 7,746 / 13%
ROH / ROHM & HAAS CO COM / Chemical / 4,656 / 280 / -29 / 1.3 / 1.8 / 0.77 / 6,356 / 29%
IBM / INTERNATIONAL BUSINESS MACHS COM / Computer Hardware / 128,186 / 6,597 / 212 / 6.7 / 12.1 / 1.58 / 232,413 / -24%
DELL / DELL COMPUTER CORP COM / Computer Hardware / 83,519 / 2,490 / 547 / 12.9 / 17.5 / 1.26 / 113,251 / -50%
HWP / HEWLETT PACKARD CO COM / Computer Hardware / 49,857 / 2,598 / -340 / 3.4 / 8.2 / 1.85 / 119,385 / -52%
EMC / E M C CORP MASS COM / Computer Hardware / 45,958 / 1,569 / 389 / 6.9 / 32.2 / 4.06 / 213,677 / -58%
SUNW / SUN MICROSYSTEMS INC COM / Computer Hardware / 44,560 / 1,849 / 470 / 6.1 / 27.7 / 3.91 / 202,719 / -69%
MSFT / MICROSOFT CORP COM / Computer Software / 188,787 / 8,526 / 2,406 / 4.6 / 8.9 / 1.60 / 368,819 / -15%
ORCL / ORACLE CORP COM / Computer Software / 54,304 / 2,314 / 904 / 8.4 / 39.4 / 4.19 / 254,509 / -58%
CA / COMPUTER ASSOC INTL INC COM / Computer Software / 38,908 / 1,782 / 279 / 5.7 / 2.7 / 0.41 / 18,763 / -2%
VRTS / VERITAS SOFTWARE CO COM / Computer Software / 16,988 / 176 / 143 / 5.3 / 15.1 / 2.40 / 48,465 / -46%
SEBL / SIEBEL SYS INC COM / Computer Software / 6,180 / 176 / 53 / 6.9 / 45.6 / 5.76 / 40,715 / -61%
AES / AES CORP COM / Electric Utilities / 28,486 / 691 / 197 / 7.1 / 7.3 / 0.90 / 29,119 / -15%
DUK / DUKE ENERGY CORP COM / Electric Utilities / 15,380 / 934 / 211 / 1.6 / 2.9 / 1.10 / 27,531 / 10%
SO / SOUTHERN CO COM / Electric Utilities / 10,351 / 847 / 177 / 1.1 / 2.1 / 0.99 / 19,418 / 6%