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Intangibles: assets or overheads?

Intangibles: assets or overheads?

Traditional accountancy appears to have stopped working as a guide to the proper market valuation of a company. Until relatively recently, the price set on a firm by the value of its shares and the book value established by conventional accounting were very similar. Typically, markets would value a company at around 10% over book, and the difference was attributed to "intangibles". These were assets which seemed innate to the firm, but which could not easily be quantified or connected directly to earnings. The ability to handle scientific knowledge, or to interact with customers or with the regulatory framework are examples of such intangible assets. This situation had remained stable for decades, but valuation began to shift in favour of intangibles during the mid-1980s. By 1995, only half of the price that investors paid for the average company was attributable to identified assets with clear associated cash streams. By the turn of the century, around four-fifths of the value of companies quoted on the NYSE was associated with intangibles: that is, it could not be attributed to conventional accounting assets.

A similar development occurred in the relationship between market valuation and GNP. The Dow Jones and the US economy had maintained a 1:1 relationship since 1897, when the Dow began. However, this relationship began to change in the early 1980s, altering to favour the market. The 1:1 ratio had shifted to 2:1 by 1986. It was around 15:1 in 2000.

There are three interpretations of these developments. First, the market believes that not only will existing tangible assets be much more productive than they have been in the past, but that a huge dose of intangible factors are needed to enable this performance. The second interpretation is that markets are suffering from asset price inflation, due to a surplus of savings in the world and a paucity of viable projects in which to invest these. The third view is that markets are deluded, and that resources are being forced into a relatively tiny fraction of overall commercial activity, the few hundred major traded companies which make up almost all transactions.

This note attempts to separate these three issues. It does not set out to do so in ways that would satisfy a technical economist. The analysis does, however, it lead us to a surprising conclusion.

What do we mean by an "intangible"?

It is important to be clear on what we mean by an intangible asset. Many things which are produced by organisations are non-physical, but can nonetheless be traded in discrete lumps: in hours of a lawyers time, for example. Not all such lumps have the same value, of course, but we have exact mechanisms that value these and produce clear cash streams as a result. We can exactly measure and account for these cash streams. A brand is not an intangible if one can sell it: GSK could sell Lucosade as an entity and this is not. therefore, an intangible. It has a clear earning stream. They could not, however, easily sell their capacity to interact with the medical-biological network in the same way. This is an intangible.

'Intangibles,' therefore, are those things which a firm possesses that others want, and which are associated chiefly with the internal processes and governance of these within the firm. It is about the organisational gestalt of the organisation: its effectiveness in confronting the complexities of its operating environment and adapting itself to these. Governance and reputation, complexity management and creative enthusiasm, technical and regulatory competence, financial probity and predictability are all areas in which intangible value can be created and destroyed. It is not possible to measure their volume or effectiveness directly, and nor is it possible to assign a direct cash stream to them. It is clear, however, that if they are present, value will be added, and if they are not, then value will be destroyed.

The market is saying, in effect, that intangibles are both more present and better done in the firms of the industrial world than was proportionately the case before 1982, and - from market performance - that this is particularly true in the United States. Is this true?

Separating the threads.

This discussion will, for the moment, remain firmly in the context of traded companies. In discussing these, it is extremely difficult to separate three threads: asset price inflation, the role of intangible assets and market delusion. The current US accounting crises should not blind us to the Japanese bubble, where the Tokyo market became briefly worth a sum equivalent to nearly half of the entire world's traded securities.

Consider first asset price inflation. Savings have grown spectacularly with the industrial economies and with demographic change. Market integration has set these in an endless pursuit of the best, inflating the value of assets held strong economies. Around a trillion dollars in savings is transferred from now-becalmed Japan to the US market annually. The Euro zone has shown weak performance, and its demographics (and unfounded pensions) make long term prospects unattractive. Other markets are simply too small to absorb the sums involved, whatever their prospects. However, since the Asia emergent markets bubble burst in the late 1990s, such markets have appeared unattractive. Inflation of the more attractive asset prices is almost unavoidable in thee circumstances, whether they be properties in the major cities of traded assets in their financial markets.

The change in market-to-book ratio since 1980 has not only been huge but it has also been generic. That is, the shift is by no means confined to the allegedly intangible-rich sectors or firms, but is universal. This and other evidence points to asset price inflation as a major factor in the decoupling of market to book from its traditional values.

It is worth noting that four-fifths of all market value is made up of a few hundred companies. These do not, however, hold an equivalent proportion of all of the assets - capital assets, employees and access to intangibles - that are deemed to be held by all commercial activities. US-based major corporations, for example, account for around a fifth of all employment in the US. The world's savings are, therefore, being poured onto the cherry on the top of the cake, and a cholesterol-rich cherry it must be expected to become. Current (end 2001) valuation of US stocks require a rate of return which is roughly double what has been achieved in the past, assuming constant risk premia.

Inflation can, therefore, explain a great deal of the apparent expansion in "intangibles" within major corporations. It may be a victory of hope over recent experience to believe that the consequences of mis-accounting and hyperbole contribute a much smaller figure. Together, however, these forces may well explain much of the change in valuation which we have experienced.

We know, however, that corporations operate in a much more complex environment than hitherto. They are exposed to more dangers, but also to more opportunities. They are immersed in distractions, exposed to a myriad of conflicting stakeholder claims, and scrutinised as never before. Plainly, there is value in handling this situation well, and danger in not doing so. Intangibles exist, and their role should be more important than hitherto, particularly in the complex wealthy nations.

We need to be extremely careful, however, in entering this field. Elsewhere, we offer an assessment of how intangibles such as security, environmental betterment and public health can be valued and entered into the national accounts. Some nations are indeed trying out such an approach as a guide to policy making. The key point about such efforts is that they try to translate something which innately has no owner and no tradable value into cash terms, where such assumptions are innate. Policy decisions literally trade increments in health for increments of security or education whenever spending decisions are made. The accounting fiction is, therefore, a more precise manner of reflecting this management of the naturally incommensurate.

Is this approximation useful when thinking about commerce? The fundamental question lies in what it is that any measure is intended to achieve. Is it intended to rank companies, sectors or national practices against each other, so as to point up the relatively weak or strong? Is it intended to go further, and assign a numerical value that can serve as the basis of trading? Is it, by contrast, to serve as the basis for management insight? We need to be clear.

Let us step back to the issue of what it is that intangibles "do", for our measurement can only reflect this underlying reality. If it were possible to assign a cash stream unambiguously to intangibles then, as we have already seen, they would no longer be intangible. It is not, however, possible to do this. A hundred scientists, managed badly, will deliver less value than will fewer of them, managed well. The nature of 'badly' and 'well', from the perspective of cash generation, is entirely tautological: what is well done is what makes money, and what makes money is well done.

In concept, notional assets - insight, scientists, relationships - are like tools. They can be deployed well or badly. Some of these tools can be counted, but all such measurements will be utterly dependent on quality parameters which it is impossible to measure, save in retrospect. One can say that a given relationship proved useful, and that another did not. If the successful relationship led to a cash stream, then it was one of a number of incommensurable variables - technical insight, physical location - which also contributed. Even knowing that this was a 'good' relationship, one could not assign it a fixed proportion of the benefit that you knew flowed from it. If you enter a cake for a show and win a prize, what part of the prize is attributable to a given egg in the recipe? The question is not meaningful. Would the egg be less valuable had you not won the prize? Once again, the question is grammatical but not meaningful.

Let us turn this on its head. Intangibles are not an asset but a cost, and they are the cost that a firm has to pay in order to be able to function. However, just as other inalienable but manageable costs - such as wages - also generate social benefits, so a major part of the value created by intangibles lies in public goods. However, a very important beneficiary of these public goods are other firms. Taken together, environments which are heavily endowed with commercially-sourced public goods are beneficial places in which to operate.

Intangibles as public goods.

A non-tradable asset is, of course, something which is valued but which cannot be sequestered and sold: for example, fresh air. Of course, governments do indeed manage many non-tradable assets, such as military or civil security, and they fund them - that is, sell them - by forcing citizens to buy the provision of these through their taxes. However, a government which lacked policing would be an unhappy sight, and the overheads which are involved in creating this non-tradable asset are not, therefore, elective.

In the same way, a tradesman cannot easily trade without a good reputation, skills and a network of contacts. The cost of setting up and maintaining these intangibles the price of entry, and is not elective. If the tradesman sold shares, then this 'permission to operate' would affect the value of these in complex ways. The cost of maintaining the required intangible assets comes out of his or her earnings. However, if maintenance is small compared to start up costs, then an established firm will have smaller costs that a start up. Equally, these costs may well be diluted by scale. Intangibles may, therefore, reward established players and large firms, and deter new entrants and penalize smaller companies. The impact on the earning stream is, however, extremely indirect. Without the investment in them, however, there will be no cash stream.

The implication is that many intangibles (regulatory compliance, effectiveness, knowledge) generate non-tradable public goods, not benefits arrogated to the shareholders alone. This is a Good Thing, in that it makes the host society a fine place to be. Firms gain considerable advantage from operating in an intangible-rich environment, both because it offers a stable situation and also because it offers a tool kit of options which they can exercise. Amongst these is are an entire service industry of specialists, which constitute 'external' intangibles that the firm can access. Outsourcing to these offers effective cost management. The generation of public goods is, therefore, a two-way street.

All public goods are vulnerable to misuse, and regulation tends to evolve to prevent this. Many intangible public goods which firms have to generate are mandated by regulatory authorities. Others, where firms have acheived self-regulation are, however, plagued by free riders. That is, by firms which do not themselves comply, but which rely on a general background of compliance to provide what they need. The provision of training to staff is a clear example where the reciprocal benefits of training a mobile workforce is abused by some - many - firms. Coping with these issues tends to geenrate more and more thickets of regulation and law.

Intangibles affect economics in three ways. First, differential effectiveness impacts on differential performance amongst companies. Second, absolute performance in each firm has a consequence on overall economic growth, and on the quality of other, less tangible benefits. Third, perhaps as a sub-set of the second point, the existence of many firms and other agents collectively generating intangible benefits greatly assists all firms.

Firms which operate effectively are those which are well-situated with respect to physical and less tangible access to these benefits, and which also handle their intangibles better than their peers. Crucially, this is much more than cost control: it is concerned with effectiveness and renewal. It would save money to fire all senior staff, but - pace Dilbert - it would not increase effectiveness or adaptability. If over half of all business output in the industrial world now consists of patterns of information - according to the OECD - then improvement in the processes by which this happens must convey advantage. It is relatively easy to reduce the overheads associated with intangibles - with uncertain long term consequences, of course - but it is much harder to increase the productivity, or to know that you have done so.

On knowing whether you are doing a good job

Objective studies have shown that the long term economic performance of large, international samples of companies is dependent on getting many things right. This reality is becoming recognised in the use of tools such as the balanced score card, where performance is assessed against many criteria, not one or more financial targets alone. It is not hard to see how such governance tools can be turned to the management of intangibles.

It is clear that firms which ignore intangibles will fail. Firms which do not innovate will sink. Firms which do not couple sensibly to their operating environment - in collaboration and exploring options, in regulatory and financial affairs, in brand management and risk control - will be starved of knowledge, viewed with suspicion and ultimately shunned by their customers and potential partners. These are, however, the minimum overheads that are needed to stay in the game.

One approach to estimating the 'right' level of delivery - and thus the gap between currently-deployed resource and this target level of delivery - is to ask what would happen if a given intangible was to be reduced or terminated. One can pose "negative scenarios" and, rather in the manner of risk assessment, ask informed respondents what would happen to tangible performance if a firm did not deliver what was expected of it in the realms of the intangible. For example, if past levels of new product development, of the management of consumer confidence or regulatory compliance were to be halved at delivery, then what would happen to economic performance? What if delivery of the relevant intangible was reduced or increased in different ways? Equally, one can ask about the consequence of improvement: if we were to realise this or that positive story, then what level of improvement in tangible outcomes might we see? .

Naturally, this deals in intangible issues. Halving "regulatory compliance" is halving an intangible, for which there is no measurement. However, there are methodologies by which this can be addressed. Informed and sensible people are presented with a number of realistic situations in respct of the delivery of intangibles. They are asked to position the situation on a scale, in the middle of which sits the current level of delivery. A number of inteactions will, therefore, generate a distribution of views. Objective, or equivalent subjective calibrations of the outcome generate a continuum, in which raising of lowering the game has explicit consequences. The figure whows these as fuzzy blobs.

Each red blur in the figure is a case, with the range of its individual subjective uncertainty shown. However, the continuum across the cases is reasonably indicative. It shows that there are major consequences of lowering the game, and less obvious ones to raising it. This can be challenged, debated, rendered more objective. Second, it is possible to cost the various cases, at least in fairly general terms, and so arrive at a measure of cost-benefit.

Tracking such curves over time delivers more information. For example, the second figure reproduces the continuum shown earlier as a single red curve. After a period of time, this is transformed into the brown curve. This transformation says that the room to manoeuvre on the up and down side has been lessened: that no benefits will accrue on the upside to further increments in the effectiveness with which this intangible is delivered. It aslo shows that great penalties will be paid for minor weaknesses on the downside. Other shapes are meaningful. A horizontal line tells you that the organisation is highly exposed to risk from this variable, but has no control over it. A vertical line says that there is no exposure and that the variable is irrelevant to the firm.

One must, of course, recall that this measures intangibles through the only sensory equipment that is available, which is collective and subjective judgement. The curves mean "we all think that", and they do not point to objective fact. Huge sums are, however, spent in consequence of just such collective judgements in virtually all spheres of commerce: in market assessment, in research, in new product development, in mergers and acquistion. Ultimately, virtually all decision support tools cede control to subjective judgement. An analysis of the exposure of a firm to its intangible performance, coupled to analysis of the cost-benefit of mitigation, offers a powerful tool to manage these factors more effectively. It could, stretching the term 'accounting' to its limits, allow one to account for the overheads which the firm must bear in order to support its production of intangibles.

Analysis of intangibles will not tell you whether an industry or an economy faces unusual growth prospects. It will allow you to say whether the firm in question is likely to do relatively well only if you have access to similar data for all competitive firms. Access to this synopsis might be a useful exercise for benchmarking agencies to undertake, but it is unlikely to be the stuff of annual reports.

A counter-intuitive conclusion

We began by asking whether "intangibles" could justify the extraordinary shift in valuation that we have seen in capital markets, whereby conventional accounting measures have been superseded by subjective appeal to 'potential'. If this sentiment was justified, of course, such potential would need to be actualised as flows of tradable added value coming from the assets being so valued.

Our assessment has shown us that there is a great deal of room for such valuations to be pure fantasy, driven by a paucity of projects and a surplus of mobile capital. However, we have also noted that intangibles do exist, and that their effective use is of increasing importance to differential performance.

There are factors which suggest that economic potential is greater than ever before. There is a vast pool of knowledge and many more able heads to make use of it. There is an equally vast tool kit of potential partners, sub-contractors and suppliers. There is far better connectivity. These factors enhance flexibility and open up a myriad of options. The competent, complex industrial societies offer fine environments in which to operate. Set against this are, of course, negative factors. Some of these oppose growth. Others divert the wealth which firms generate away from the grasp of the shareholder. The erosive power of employees, regulators, tax gatherers and rent-erasing competition present considerable challenges in this regard.

The one thing of which we can be absolutely certain is that the future will be more complex than the present. Coping with complexity is, itself, a source of added value. The economic potential that we have just discussed is heavily bound up with the most complex of the operating environments, which is also where the erosive forces are also strongest. Navigation through this multi-dimensional maze requires finesse, and much more finesse than hitherto, It follows that the intangible capabilities through which this finesse is exercised are also of greater importance than hitherto.

Operating milieux can be assessed for the absolute mass of useful intangibles which they deploy: how many educated people, how safe a living environment, how stable an economy. It is conceivable that creative measurement schemes could arrive at a total of these assets. Military strength assessments undertake a very similar task. By contrast, companies cannot and never will be able to arrive at equivalent figures, and neither would it be useful for them to do so.

Their measure of excellence is distinct. It is the degree to which they deliver what is needed along a number of dimensions of well-being. As we have seen, there are good ways of assessing such performance. Set against this is the cost of maintaining these overheads. As ever, firms must strive to deliver the right level of excellence at the right cost. There are, of course, many tools which can be deployed on step down from this: the tools of knowledge exchange, strategic alignment, governance assessment and the like. We have also seen that there are ways of measuring whether these tools are delivering the changes that are needed.

This offers some conclusions to our enquiry. Markets can have no idea whether additional potential will be realised or not. Tobin's measure "Q" - market to book, less the value of land and property - shows decade long swings that amount to subjective sentiment. Markets are the alleged collective wisdom of all scrutineers, but are in fact the product of herd behaviour as much as they are of assessment.

There is a huge upside to the knowledge economy. This potential will, however, be realised for shareholders in very indirect ways. Firms and other stakeholders have to create an environment in which this economic potential can be realised, and shareholders will continue to press for their slice of it. Firms can increase their effectiveness by understanding and managing their relations with these complex processes. To do this, however, far more cerebral and gradual processes will be needed than are in common use at present. The design of these processes, and the considerable thought which is involved in making sense of the changing environment is highly subjective. It is not open to delegation to spread-sheet jockies, consultants or the finance department: you, senior managers, need to spend more time on it, for it must embody your highly remunerated judgement.

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