Sharpening the intangibles edge

Intangible assets--patents and know-how, brands, a skilled workforce, strong customer relationships, software, unique processes and organizational designs, and the like--generate most of a company's growth and shareholder value. Yet extensive research indicates that investors systematically misprice the shares of intangibles-intensive enterprises. Clearly, overpricing wastes capital. But underpricing raises the cost of capital, hamstringing executives in their efforts to take advantage of further growth opportunities. How do you break this vicious cycle? By generating better information about your investments in intangibles, and by disclosing at least some of that data to the capital markets. Getting at that information is easier said than done, however. There are no markets generating visible prices for intellectual capital, brands, or human capital to assist investors in correctly valuing intangibles-intensive companies. And current accounting practices lump funds spent on intangibles with general expenses, so that investors and executives don't even know how much is being invested in them, let alone what a return on those investments might be. At the very least, companies should break out the amounts spent on intangibles and disclose them to the markets. More fundamentally, executives should start thinking of intangibles not as costs but as assets, so that they are recognized as investments whose returns are identified and monitored. The proposals laid down in this article are only a beginning, the author stresses. Corporations and accounting bodies should make systematic efforts to develop information that can reliably reflect the unique attributes of intangible assets. The current serious misallocations of resources should be incentive enough for businesses to join--and even lead--such developments.     

The growth crisis--and how to escape it

At a time when companies are poised to seize the growth opportunities of a rebounding economy, many of them, whether they know it or not, face a growth crisis. Even during the boom years of the past decade, only a small fraction of companies enjoyed consistent double-digit revenue growth. And those that did often achieved it through short-term measures--such as mergers and inflated price increases--that don't provide the foundation for growth over the long term. But there is a way out of this predicament. The authors claim that companies can achieve sustained growth by leveraging their "hidden assets," a wide array of underused, intangible capabilities and advantages that most established companies already hold. To date, much of the research on intangible assets has centered on intellectual property and brand recognition. But in this article, the authors uncover a host of other assets that can help spark growth. They identify four major categories of hidden assets: customer relationships, strategic real estate, networks, and information. And they illustrate each with an example of a company that has creatively used its hidden assets to produce new sources of revenue. Executives have spent years learning to create growth using products, facilities, and working capital. But they should really focus on mobilizing their hidden assets to serve their customers' higher-order needs--in other words, create offerings that make customers' lives easier, better, or less expensive. Making that shift in mind-set isn't easy, admit the authors, but companies that do it may not only create meaningful new value for their customers but also produce double-digit revenue and earnings growth for investors.     

Capitalizing on capabilities

By making the most of organizational capabilities--employees' collective skills and fields of expertise--you can dramatically improve your company's market value. Although there is no magic list of proficiencies that every organization needs in order to succeed, the authors identify 11 intangible assets that well-managed companies tend to have: talent, speed, shared mind-set and coherent brand identity, accountability, collaboration, learning, leadership, customer connectivity, strategic unity, innovation, and efficiency. Such companies typically excel in only three of these capabilities while maintaining industry parity in the other areas. Organizations that fall below the norm in any of the 11 are likely candidates for dysfunction and competitive disadvantage. So you can determine how your company fares in these categories (or others, if the generic list doesn't suit your needs), the authors explain how to conduct a "capabilities audit," describing in particular the experiences and findings of two companies that recently performed such audits. In addition to highlighting which intangible assets are most important given the organization's history and strategy, this exercise will gauge how well your company delivers on its capabilities and will guide you in developing an action plan for improvement. A capabilities audit can work for an entire organization, a business unit, or a region--indeed, for any part of a company that has a strategy to generate financial or customer-related results. It enables executives to assess overall company strengths and weaknesses, senior leaders to define strategy, midlevel managers to execute strategy, and frontline leaders to achieve tactical results. In short, it helps turn intangible assets into concrete strengths.     

The Relation Between Patent Citations and Tobin's Q in the Semiconductor Industry

The market value of a firm is largely determined by the expected returns to the firm's tangible and intangible assets. However, accounting data generally excludes intangible assets. Financial variables which are constructed in part from accounting data, such as Tobin's Q, are thus biased. If measures of intangible capital are successful in explaining variation in Q, then a case can be made for incorporating such measures into future research. In high technology industries, such as the semiconductor industry, valuing a firm's intangible assets requires the valuation of its technological capital. Past studies have relied heavily on simple patent counts and research and development expenditures to quantify the technological component of a firm's intangible assets. This paper examines the ability of measures of intangible capital to explain variation in Q and considers an additional data source, patent citations. We find that stock variables created from citation data contain relevant information about the market's valuation of intangible assets.     

Strategy as simple rules

The success of Yahoo!, eBay, Enron, and other companies that have become adept at morphing to meet the demands of changing markets can't be explained using traditional thinking about competitive strategy. These companies have succeeded by pursuing constantly evolving strategies in market spaces that were considered unattractive according to traditional measures. In this article--the third in an HBR series by Kathleen Eisenhardt and Donald Sull on strategy in the new economy--the authors ask, what are the sources of competitive advantage in high-velocity markets? The secret, they say, is strategy as simple rules. The companies know that the greatest opportunities for competitive advantage lie in market confusion, but they recognize the need for a few crucial strategic processes and a few simple rules. In traditional strategy, advantage comes from exploiting resources or stable market positions. In strategy as simple rules, advantage comes from successfully seizing fleeting opportunities. Key strategic processes, such as product innovation, partnering, or spinout creation, place the company where the flow of opportunities is greatest. Simple rules then provide the guidelines within which managers can pursue such opportunities. Simple rules, which grow out of experience, fall into five broad categories: how- to rules, boundary conditions, priority rules, timing rules, and exit rules. Companies with simple-rules strategies must follow the rules religiously and avoid the temptation to change them too frequently. A consistent strategy helps managers sort through opportunities and gain short-term advantage by exploiting the attractive ones. In stable markets, managers rely on complicated strategies built on detailed predictions of the future. But when business is complicated, strategy should be simple.     

Eclipse of the Public Corporation or Eclipse of the Public Markets?

The authors look back at Michael Jensen's 1989 article “The Eclipse of the Public Corporation.” They find some of his predictions have been borne out but other important ones, not. Jensen concluded that the publicly held corporation was in decline and had outlived its usefulness in many sectors. He argued that agency costs made public corporations an inefficient form of organization and that new private organizational forms promoted by private equity firms would likely replace the public firm. The number of public firms in the U.S. has declined significantly but there are still many hugely profitable and successful public companies. U.S. public markets are still well‐suited for firms with mostly tangible assets. So, what we are really witnessing is an eclipse not of public corporations, but of the public markets as the place where young firms with mostly intangible capital seek their funding. This is especially true when the usefulness of the intangible assets has yet to be proven. Sometimes the market is extremely optimistic about some intangible assets, but otherwise firms with unproven intangible assets may be better off funding themselves privately. This evolution has a downside: investors limited to public markets are cut off from investing in high intangible‐asset firms. Additionally, as fewer firms remain publicly listed, fewer firms will be transparent to society.     

How much cash does your company need?

In late 2001, the directors of Pfizer asked that very question. And with good reason. After its 2000 merger with rival Warner-Lambert, the New York-based pharmaceutical giant found itself sitting on a net cash position of $8 billion, which seemed extraordinarily conservative for a company whose products generated $30 billion in revenues. Most large companies with revenues that healthy would increase leverage, thereby unlocking tremendous value for shareholders. But knowledge-intensive companies like Pfizer, this author argues, are in a class apart. Because their largely intangible assets (like R&D) are highly volatile and cannot easily be valued, they are more vulnerable to financial distress than are firms with a preponderance of tangible assets. To insure against that risk, they need to maintain large positive cash balances. These companies' decisions to run large cash balances is one of the key reasons their shares sustain consistent premiums. Only by investing in their intangible assets can knowledge-based companies hope to preserve the value of those assets. A company that finds itself unable to do so because unfavorable market conditions reduce its operating cash flows will see its share price suffer almost as much as if it were to default on its debts. By the same token, with the right balance sheet, knowledge companies can profitably insure against the risk of failing to sustain value-added investments in difficult times. An optimal capital structure that calls for significant cash balances is certainly at odds with the results of a traditional capital structure analysis, the author demonstrates, but it explains the financial policies of many well-run companies, from Pfizer to Intel to ChevronTexaco.     

Bridging Sustainability and Finance: The Value Driver Adjustment Approach

Even though most large corporations view sustainability considerations and concerns as having the potential to affect their revenue and profits, and studies have shown that sustainability can affect stock returns, investors and corporate managers continue to struggle to incorporate such concerns into their financial decision‐making. As a consequence, the valuation effects of sustainability issues are not fully reflected in either the valuation of companies by investors or in capital investment decisions by corporate managers. The author argues that sustainability can be integrated into both of these kinds of financial decision‐making by linking it to business models, competitive positions, and value drivers using what the author calls a “value‐driver adjustment” (VDA) approach. The basic idea is simple: material sustainability issues affect business models and competitive positions, which in turn affect the company's value drivers—notably, sales, margins, and capital. The VDA approach explicitly considers these linkages by taking three steps: (1) identifying a company's material sustainability issues; (2) analyzing how these issues are expected to affect the company's business model and competitive position; and (3) quantifying the effects of such changes in business model and competitive position on the company's value drivers, including its cost of capital. In the first part of the article, the author provides an investor perspective that shows how sustainability can be integrated into investment decisions by asset managers. There he explains how and why ESG integration has so far failed to become mainstream, and what needs to be done to make it successful. The second part of this article takes the corporate perspective and shows how sustainability can be linked to value drivers using much the same ingredients as in asset management, but slightly different tools that can help corporate managers incorporate sustainability concerns into strategy and operations, including the finance function. And in closing, the author brings together corporate and investor perspectives while showing how sustainability programs can be used to make the relationship between companies and their shareholders both stronger and longer‐lasting.     

Information technology and the board of directors

Ever since the Y2K scare, boards have grown increasingly nervous about corporate dependence on information technology. Since then, computer crashes, denial of service attacks, competitive pressures, and the need to automate compliance with government regulations have heightened board sensitivity to IT risk. Unfortunately, most boards remain largely in the dark when it comes to IT spending and strategy, despite the fact that corporate information assets can account for more than 50% of capital spending. A lack of board oversight for IT activities is dangerous, the authors say. It puts firms at risk in the same way that failing to audit their books would. Companies that have established board-level IT governance committees are better able to control IT project costs and carve out competitive advantage. But there is no one-size-fits-all model for board supervision of a company's IT operations. The correct approach depends on what strategic "mode" a company is in whether its operations are extremely dependent on IT or not, and whether or not it relies heavily on keeping up with the latest technologies. This article spells out the conditions under which boards need to change their level of involvement in IT decisions, explaining how members can recognize their firms' IT risks and decide whether they should pursue more aggressive IT governance. The authors delineate what an IT governance committee should look like in terms of charter, membership, duties, and overall agenda. They also offer recommendations for developing IT policies that take into account an organization's operational and strategic needs and suggest what to do when those needs change. Given the dizzying pace of change in the world of IT, boards can't afford to ignore the state of their IT systems and capabilities. Appropriate board governance can go a long way toward helping a company avoid unnecessary risk and improve its competitive position.     

Factores que explican la extensión de revelación de activos intangibles de los bancos que cotizan en la Bolsa de Valores de Panamá

This paper analyzes the level of voluntary disclosure of intangible assets, and identifies the factors that explain the disclosure of such information by the banks listed on the Panama Stock Exchange during the period 2005-2009. The information is recorded on an index that contains 158 indicators divided into five categories: human capital, technological structural, organizational structure, relational business and social relational. Three hypotheses are posed: H₁ there is a positive relationship between the size and extent of disclosure of intangible assets; H₂ a positive relationship between the extent of incorporation and disclosure of intangible assets; H₃ there is a positive relationship between leverage and the extent of disclosure of intangible assets. The results indicate that for Panama banks it is more important to disclose information on intangibles in the following order: business relational capital, social relational, organizational structure, human and technological structural. H₁ was accepted as a size category except for the structural capital; H₂ was accepted for the years in all categories, while H₃ was rejected.     

FREE CASH FLOW AND PUBLIC GOVERNANCE: THE CASE OF ALASKA

In a widely cited 1986 article in the American Economic Review, Michael Jensen gave the concept of free cash flow (FCF) a new twist by redefining it as cash flow in excess of that required to fund all projects with positive net present values. Put another way, FCF represents funds available in the firm that managers may choose to hold as idle cash, return to shareholders, or invest in projects with returns below the firm's cost of capital. In redefining FCF in this way, Jensen converted FCF from a measure of economic income and value into a measure of corporate assets available for discretionary, and potentially value‐destroying, use by firm managers. And, as he argued in his important article, managers in mature businesses with substantial free cash flow have a tendency to destroy value by plowing too much capital back into those businesses or, often worse, making ill‐advised acquisitions in unrelated businesses. Several methods have been developed in financial markets and internal corporate governance systems to discourage managers from wasting FCF. Better monitoring by boards of directors, large ownership blocks, and properly aligned management compensation contracts are all parts of the solution. And the extraordinary increase in stock repurchases in recent years, invariably applauded by investors, is another illustration of the market's success in encouraging companies to address their free cash flow problems. But if the “FCF problem” of the private sector has attracted considerable attention from finance scholars, the problem is even more acute in the public sector, where FCF can be thought of as tax revenue in excess of what is required to finance well‐defined and generally accepted levels of public services. Unlike the private sector, in the public sector there are neither measures nor mechanisms by which to monitor and constrain wasteful spending by elected officials. In this article, the authors attempt to measure the costs to taxpayers of government FCF using the case of Alaska, which since 1969 has received a huge windfall of tax revenue from North Slope oil leases. After examining the state's public finances from 1968 through 1993, the authors offer $25 billion as a conservative estimate of the social losses from Alaska's waste of free cash flow during that 25‐year period.     

HOW TO FIX ACCOUNTING—MEASURE AND REPORT ECONOMIC PROFIT

Bending accounting rules has become so ingrained in our corporate culture that even ethical business leaders succumb to the temptation to “manage” their earnings in order to meet analysts' demands for smoothly rising results. The author of this article argues that such behavior reflects not a general decline in ethical standards so much as executives' growing sense that accounting itself has become “unhinged from value.” For example, clearly valuable expenditures on R&D, customer acquisition, and employee training are generally expensed immediately against earnings. And reported corporate income is often further reduced by provisions for losses that most companies never expect to incur, by “book” taxes they never expect to pay, and by depreciation charges on assets that are actually increasing in value. At the same time, the opportunity costs associated with employee stock options and the corporate use of equity capital are not reflected in the accountant's measure of profit. To improve the quality of corporate governance and revitalize the public's faith in reported earnings, the author proposes a complete overhaul of GAAP accounting to measure and report economic profit, or EVA. Stated in brief, the author's concept of economic profit begins with an older, but now seldom used, definition of accounting income known as “residual income,” and then proposes a series of additional adjustments to GAAP accounting that are designed to produce a reliable measure of a company's annual, sustainable cash‐generating capacity. Besides expensing the cost of equity capital as well as stock options, the author recommends bringing off‐balance‐sheet items such as pension assets and liabilities back onto the balance sheet, eliminating reserve accounting, capitalizing R&D and other expenditures on intangible assets, and recording economic rather than accounting depreciation. Such changes, by replacing the accountants' current flawed definition of earnings with a comprehensive new statement of value added, could restore investor confidence in financial statements. Even more important, managers would be less likely to pursue their now common practice of boosting earnings by making value‐reducing operating and investment decisions and more likely to use financial reporting not to mislead the market but as an opportunity to communicate relevant, forward‐looking information.     

The myth of secure computing

Few senior executives pay a whole lot of attention to computer security. They either hand off responsibility to their technical people or bring in consultants. But given the stakes involved, an arm's-length approach is extremely unwise. According to industry estimates, security breaches affect 90% of all businesses every year and cost some $17 billion. Fortunately, the authors say, senior executives don't need to learn about the more arcane aspects of their company's IT systems in order to take a hands-on approach. Instead, they should focus on the familiar task of managing risk. Their role should be to assess the business value of their information assets, determine the likelihood that those assets will be compromised, and then tailor a set of risk abatement processes to their company's particular vulnerabilities. This approach, which views computer security as an operational rather than a technical challenge, is akin to a classic quality assurance program in that it attempts to avoid problems rather than fix them and involves all employees, not just IT staffers. The goal is not to make computer systems completely secure--that's impossible--but to reduce the business risk to an acceptable level. This article looks at the types of threats a company is apt to face. It also examines the processes a general manager should spearhead to lessen the likelihood of a successful attack. The authors recommend eight processes in all, ranging from deciding how much protection each digital asset deserves to insisting on secure software to rehearsing a response to a security breach. The important thing to realize, they emphasize, is that decisions about digital security are not much different from other cost-benefit decisions. The tools general managers bring to bear on other areas of the business are good models for what they need to do in this technical space.     

On the Role of Intangible Information and Capital Gains Taxes in Long‐Term Return Reversals

Prior studies have linked long‐term reversals to the magnitude of locked‐in capital gains suggesting that reversals are driven by tax effects and not overreaction. I find that locked‐in capital gains do not explain the reversals in winners when winner returns are based on intangible information. In fact, the reversals for intangible return winners are long lasting and robust to controls for growth in assets and capital expenditures. To the extent that reversals associated with intangible information stem from investors’ overreaction to intangible information and given the prior results linking reversals only to intangible information, my results suggest that overreaction still explains reversal patterns in US stock returns.     

Enterprise Risk Management: Theory and Practice

The Chief Risk Officer of Nationwide Insurance teams up with a distinguished academic to discuss the benefits and challenges associated with the design and implementation of an enterprise risk management program. The authors begin by arguing that a carefully designed ERM program—one in which all material corporate risks are viewed and managed within a single framework—can be a source of long‐run competitive advantage and value through its effects at both a “macro” or company‐wide level and a “micro” or business‐unit level. At the macro level, ERM enables senior management to identify, measure, and limit to acceptable levels the net exposures faced by the firm. By managing such exposures mainly with the idea of cushioning downside outcomes and protecting the firm's credit rating, ERM helps maintain the firm's access to capital and other resources necessary to implement its strategy and business plan. At the micro level, ERM adds value by ensuring that all material risks are “owned,” and risk‐return tradeoffs carefully evaluated, by operating managers and employees throughout the firm. To this end, business unit managers at Nationwide are required to provide information about major risks associated with all new capital projects—information that can then used by senior management to evaluate the marginal impact of the projects on the firm's total risk. And to encourage operating managers to focus on the risk‐return tradeoffs in their own businesses, Nationwide's periodic performance evaluations of its business units attempt to refl ect their contributions to total risk by assigning risk‐adjusted levels of “imputed” capital on which project managers are expected to earn adequate returns. The second, and by far the larger, part of the article provides an extensive guide to the process and major challenges that arise when implementing ERM, along with an account of Nationwide's approach to dealing with them. Among other issues, the authors discuss how a company should assess its risk “appetite,” measure how much risk it is bearing, and decide which risks to retain and which to transfer to others. Consistent with the principle of comparative advantage it uses to guide such decisions, Nationwide attempts to limit “non‐core” exposures, such as interest rate and equity risk, thereby enlarging the firm's capacity to bear the “information‐intensive, insurance‐ specific” risks at the core of its business and competencies.     

La medición del capital intelectual y su impacto en el rendimiento financiero en empresas del sector industrial en México

Currently knowledge is considered an essential resource to contribute to the creation and generation of competitive advantage in organizations. The human factor as an intangible resource of a company has become a main value generator, and even though both knowledge management and intellectual capital are intangibles that can be measured in the financial reports of companies, their position as main value generators is not reflected in financial information. In Mexico, industrial sector companies need to promote the creation of intellectual added value based on its own abilities, which reside on their intellectual capital. The value added intellectual coefficient (VAIC?), with its components, is a tool that contributes to achieving this goal, and helps to identify the positive impact on key factors such as financial profitability, market capitalization and level of share value.     

The surprising economics of a "people business"

When people are your most important asset, some standard performance measures and management practices become misleading or irrelevant. This is a danger for any business whose people costs are greater than its capital costs-that is, businesses in most industries. But it is particularly true for what the authors call "people businesses": operations with high employee costs, low capital investment, and limited spending on activities, such as R&D, that are aimed at generating future revenue. If you run a people business-or a company that includes one or more of them how do you measure its true performance? Avoid the trap of relying on capital-oriented metrics, such as return on assets and return on equity. They won't help much, as they'll tend to mask weak performance or indicate volatility where it doesn't exist. Replace them with financially rigorous people-oriented metrics-for example, a reformulation of a conventional calculation of economic profit, such as EVA, so that you gauge people, rather than capital, productivity. Once you have assessed the business's true performance, you need to enhance it operationally (be aware that relatively small changes in productivity can have a major impact on shareholder returns); reward it appropriately (push performance-related variable compensation schemes down into the organization); and price it advantageously (because economies of scale and experience tend to be less significant in people businesses, price products or services in ways that capture a share of the additional value created for customers).     

Value Creation in the Insurance Industry

Using the insights of current research in corporate finance and financial institutions, the authors briefly present a consistent economic framework for looking at insurance. Shareholders of insurance companies provide risk capital that is invested in financial assets and therefore earns the market return of the assets it is invested in. However, due to the legal and fiscal environment insurance companies are in, they have a competitive disadvantage at investing, and this gives rise to frictional capital costs. The core competence of insurers is in managing the size of these frictional capital costs. Insurers must ensure that they can sell insurance for a price in excess of what they need to produce the cover they sell and compensate the incurred frictional costs on risk capital. It is through the ability to do so that insurers create shareholder value.