proposal that CEO compensation be restricted to no more than 100 times that of the average employee, Cendant (one of the Catholic Fund’s targets) replied to the Securities and Exchange Commission: “How will the com- pany distinguish between those achievements stemming from the C.E.O.’s contribution versus those that are a result of favorable economic conditions or other factors?”5Exactly.
In the real world, it is a lot harder to attribute results with certainty. So, we should record the CEO as a proto-asset. We know he adds something—
positive along the economic benefits dimension; and we know he is rela- tively certain to stay put—positive along the ownership dimension.
Brand strength, in turn, is measured along seven attributes:
1.Market 2.Stability 3.Leadership 4.Trend 5.Support 6.Geography 7.Protection
A brand valuation of the CEO would combine these analyses to determine the incremental benefit the CEO’s brand provides and then would discount it relative to a CEO of average ability.
The Interbrand model does not provide any easy answers—it is still going to be most difficult to assign a proportion of value to the CEO. (A real valuation requires more than a seat-of-the-pants estimate of 10 percent of excess profit.) Nonetheless, the model adds some interesting insight, espe- cially in the calculation of the discount rate and how that can change over time as a brand ages. A young, untested brand, say Coca-Cola of 100 years ago, has a far higher risk profile than Coca-Cola of today. And while Marl- boro today may not be any less risky than it was 100 years ago, it certainly does not hold the promise of its former self.
Danish Experience
Some 17 Danish firms that participated in the creation of the Danish Agency for Trade and Industry’s Guideline for Intellectual Capital State- ments7put in place something very much like the PIE-B. These statements reveal a profound understanding that there is more to the value of firms than can be expressed on balance sheets. According to appendix 3 of the guidelines, “The objective of the intellectual capital statement is to state the company’s resource basis and explain the activities the management puts into action to develop it.”
Most relevant to mention here are the Danish firms’ collection of indica- tors. These are metrics used to count intangibles. Some worth mentioning are:
■ Proportion of staff with a university degree
■ Training investment per employee
■ Staff turnover
■ Social events including theme days (show what the company does to increase employees’ social network)
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■ Cooperation agreements with universities and business schools
■ Number of currently approved patents
■ Shared knowledge documents on the Internet
■ Product innovation rate
Take, for example, the number and character of cooperation agreements that a business has with universities. These may be formal knowledge- sharing agreements, or they might be right-of-first-refusal licensing arrange- ments. They also might be informal but nonetheless important network relationships between university researchers and company executives. We should include them in the PIE-B. Such agreements would rate highly on the ownership scale. Then we would need to measure their value along the benefits side, which would involve one of the valuation approaches in the next chapters.
To give readers a preview, we might compare income attributable to projects that came about from the university connection to those the firm generated on its own. Or we might compare this firm’s relationships to those of its competitors’ and devise a way to quantify the economic impact they have. Better lead flow, higher royalties, fewer vulnerable patents, reduced research and development expenditures, and lower recruiting costs are just some of the ways that good relationships with a university might translate into measurable benefits over a firm without those connections. It is not a coincidence that many innovative smaller firms locate in research parks at or near major academic institutions. Areas such as Boston’s 128 Corridor, Chapel Hill’s Research Triangle, and Silicon Valley or Sand Hill sprout intermediary technology and venture capital firms that often turn university research into marketplace products.
Accounting Perspective
Once we have determined that there is a nonzero value along both the own- ership and economic benefit metrics, the intangible factor becomes a proto- asset. But the relationship between various intangibles need not follow a pattern. Although it is true that some proto-assets are more weakly owned than others, and some proto-assets are farther along in terms of generating hard, cold economic benefits, it is not true that younger or weaker intangi- bles evolve into more mature ones or that they will look familiar when they are mature. Often proto-assets cannot be patented, copyrighted, or trade- marked. Workplace camaraderie, for example, is more ethereal than a secret. But it does have value.
Portfolio of Intangible Economic Benefits (PIE-B) 69
As we touched on in Chapter 4, in accounting, this idea plays out in the decision whether to expense or capitalize what we would call a proto-asset.
As we move along the scale of increasing ownership and increasing benefit, accounting conventions generally would have us move the asset onto the balance sheet.
This accounting convention is really no different from our two- dimensional model of portability and economic benefit, with the distinction that the accounting rules are not continuous. Assets are classified by the par- ticular characteristics that govern whether expensing them as costs or cap- italizing them as assets is appropriate. At first blush, the classification may seem crude. But there are good reasons for prohibiting too much account- ing creativity—at least in the financial statements of publicly traded firms.
Outside investors want to know that the method used at different firms for valuing assets is the same, even if this consistency may make balance sheet values less meaningful. It is difficult enough to be certain that firms capi- talize tangible assets similarly. If we cannot be certain that each firm has the same way of assigning value to a proto-asset, then we will only cloud com- parisons about the relative value of each firm. Indeed, commentators are undecided on the net effects of the Financial Accounting Statements (FAS) 141 and 142. On one hand, the rules provide much-needed detail about intangibles; on the other hand, there is wiggle room for firms to make dis- closures about their intangibles when they see fit—not necessarily as soon as investors might want.
Disclosure Benefits
NYU’s Lev argues that disclosing as much as possible about a firm’s intan- gible assets is not only in the interest of the investor, it is also in the inter- est of the firm. Lev underscores the theory of inevitable disclosure: If one believes that most information eventually is revealed in efficient capital markets, those who reveal more information sooner are interpreted as bet- ter managers and, hence, are rewarded by the market with higher valua- tions, presumably because investors believe such companies are less risky.
Lev’s proposal to assist in disclosure is called the Value Chain Scoreboard.
It is a framework for classifying intangibles in three stages of development:
discovery and learning, implementation, and commercialization. For most firms, each stage would represent increasing certainty along the PIE-B’s eco- nomic benefit dimension. For example, under discovery and learning, Lev counts “internal renewal” (like R&D and workforce training); under imple- mentation, he places “intellectual property” (i.e., patents and trademarks);
and under commercialization lies “customers” (e.g., brand values) and
“performance” (i.e., revenues, earnings, market share, and royalties).8
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SUMMARY
The most important feature of the PIE-B is that it represents an effort to ana- lyze intangibles that is not required or even permitted by the accounting rules. The Danish government’s initiative listed many benefits from the process to create intellectual capital statements. It cites the organization’s creating of a culture of knowledge sharing, positive external signaling to cus- tomers and investors, as well as creating a common identity—all themes that sound remarkably similar to what branding experts refer to as the benefits of brand strategy and what Lev captures in the Value Chain Scoreboard.
Most of our discussion has been about fitting human capital into the PIE-B. In general, it is more difficult to identify and measure human capital than intangibles such as patents, copyrights, or trademarks. But the same themes apply to more identifiable assets—those that are probably just far- ther up the ownership scale.
Last, it should not surprise readers that few firms would publish their PIE-B. It is hardly always to a firm’s advantage to reveal everything it con- siders to be a proto-asset. Firms may treat their proto-assets much like trade secrets. At times it makes sense to keep some things from one’s com- petitors. This is true even if a firm is public—firms always weigh a disclo- sure’s inevitability against the value of keeping a secret. In other words, it is not really the firm’s job to reveal as much as it can, but it is our job, as investors, analysts, and scholars, to learnas much as we can.
Portfolio of Intangible Economic Benefits (PIE-B) 71
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CHAPTER 6
Income Approach and Intangibles
S
o far we have explored the terminology of intangible assets, some eco- nomic characteristics, some evidence of their value, the most important accounting rules for dealing with intangibles, and even a conceptual frame- work to prepare intangible assets for measurement. Now it is time to explore the first of three valuation techniques. Again, before embarking on our exploration of the different approaches, we should endeavor to remem- ber that the best valuation attempts to reconcile all approaches.This chapter presents the basic steps of calculating present value. Then it extends the example into a hypothetical intangible that we are going to value with the income approach. This analysis moves from the tangible to the intangible assets reflected in Test Company’s proverbial soda pop machine. At the end, we arrive at a value of the intangible proto-asset that can be tallied in Test Company’s portfolio of intangible economic benefits, or PIE-B. It will require valuing three different streams of income:
1.The income from soda pop sales to employees
2.The inefficiency (lost income) currently caused by the machine’s presence
3.Income that could result from the machine’s intangible asset
After we work through this theoretical example, this chapter goes on to discuss some particular issues when applying the income approach to intan- gibles. We also discuss how the entertainment industry provides some guid- ance and how options pricing can be a helpful alternative. At the end of the chapter is an appendix that goes into more detail about calculating the dis- count rate. But first let us tackle some basics.