How much is
your CEO worth?
Adrienne
Baker on the how and why of measuring intangibles - August
2002
In today's environment of investor skepticism and tough
market conditions, intangible drivers are influencing
shareholder value like never before. Ernst & Young's
Measures that Matter study suggests that at least 50 percent
of any company's market value can be attributed to
intangibles. 'The idea that intangibles are soft or squishy
is a misnomer and even though they are not necessarily on
the balance sheet or income statement, they can be
quantified,' notes John Low, senior research fellow at the
Cap Gemini Ernst & Young Center for Business Innovation.
Indeed, there is growing consensus among regulators,
accounting experts and IR practitioners that companies
should quantify the value of intangibles like CEO
reputation, intellectual capital and management credibility,
and that they should communicate their worth to investors.
The SEC is proposing to broaden the scope of 8K disclosures
to include intangibles such as the appointment of new
directors or the replacement of the CEO or CFO. Meanwhile
the Financial Accounting Standards Board (FASB) is working
on a project to establish quantitative and qualitative
measures of companies' intangible assets that would be
included in M&A valuations. At the same time, IR consultants
and researchers are coming up with new ways to identify and
quantify drivers of intangibles in an effort to boost
shareholder value by unlocking so-called hidden assets.
Sea change
The most compelling argument for quantifying intangibles is
in the direct link between institutional buy decisions and
intangibles drivers. 'Increasingly, investment decisions are
based on intangibles such as the quality of management and
bench strength,' notes Leslie Gaines-Ross, chief knowledge
officer at PR giant Burson-Marsteller.
According to Ernst & Young, non-financial criteria -
including management credibility, quality of corporate
strategy, human capital and innovation - make up 35 percent
of institutional buy decisions. Another study of 200
institutional portfolio managers by Rivel Research shows
that quality of management is the most important factor
influencing investors' buy and sell decisions.
These studies suggest a sea change in terms of what drives
institutional decision-making. As Brian Rivel, president of
Rivel Research, says, 'We have done this study for 23 years
and every year up until now portfolio managers said the
number one deciding factors were growth rate and earnings
per share. Now it's quality of management.'
Look no further than recent corporate failures for proof of
how intangibles like CEO credibility determine the market
value of a company. Dennis Kozlowski of Tyco, Kenneth Lay of
Enron, Bernie Ebbers of WorldCom, John Rigas of Adelphia and
Joseph Nacchio of Quest Communications all resigned once it
became clear their companies would not survive with them at
the helm. In other words, a CEO with a bad reputation is a
company's worst liability; conversely, a CEO with a good
reputation is a company's best asset. According to
Burson-Marsteller, CEO reputation accounts for close to half
of a corporation's overall reputation.
Another argument for measuring intangibles is the growing
'gap between book value and market value,' says Susan
Herman, executive vice president of Arizona-based
Christensen & Associates. While the collapse of the dot-com
market has considerably lessened the gap between book value
and market value, many stocks continue to trade at huge
multiples. As Herman notes, 'If 35-70 percent of a company's
value is attributed to intangibles - as various research
suggests - then it stands to reason that by placing a dollar
value on intangibles, the gap should close.'
When knowledge capital (or intangibles) are quantified and
then added to book value, the gap between market value and
book value is narrowed, according to CFO.com's third annual
Knowledge Capital Scorecard. Completed in April 2001, the
study shows that for companies trading at huge multiples of
book value, the ratio of market value becomes more
reasonable when you add knowledge capital.
Keeping score
Many companies informally track intangibles. 'But until you
start keeping score, you are only practicing,' claims Steve
Finkelstein, a partner at Deloitte & Touche. The consensus
among experts is that investor relations officers should be
quantifying intangibles and communicating those measures
beyond anything standard-setters like FASB are expected to
propose.
Under its new standards, FASB will likely define intangibles
as trademarks, patents, trade secrets, contracts, brands and
anything you could sell in the marketplace. That leaves a
lot of important intangibles unaccounted for. The new
regulations exclude such things as an assembled workforce
and R&D - two of the most fundamental aspects of what was
traditionally considered to be intangible assets, says John
Wood, president of the Playfair Group and advisor on the
FASB project to disclose intangibles.
FASB's final proposal for disclosing intangibles will not,
however, prevent companies from disclosing the value of a
broad scope of intangible assets. 'FASB has no teeth really;
the SEC does,' Wood summarizes. It just means companies are
left to their own devices when it comes to valuing things
like management credibility and employee talent. But in the
end, as Wood says, 'It's to the advantage of public
companies [to quantify these intangibles] because of their
effect on share price.'
Putting numbers on faces
How to quantify intangibles is the burning question. Baruch
Lev, professor of accounting and finance at New York
University's Stern School of Business, has devoted much of
his career to measuring intangibles. His model suggests that
a company's economic performance can be measured by adding
physical, financial and intangible assets. Lev uses a
mathematical equation to determine the value of intangibles.
It goes like this: normalized earnings minus return on
physical assets minus return on financial assets equals
intangibles-driven earnings.
Other new models for measuring intangibles have also cropped
up recently. The Playfair Group, for example, has come up
with software that identifies, classifies and reports
intangibles in accordance with intellectual property laws
and in compliance with current - and expected - accounting
standards. 'This provides companies with a transparent and
accurate understanding of what are their individual
intangible assets so they now turn up on the balance sheet
and are clearly defensible in a courtroom or shareholder
situation,' notes Wood.
Ernst & Young's value creation index quantifies intangibles
in relation to the company's market value. 'Through a series
of statistical exercises, we can evaluate how intangibles
influence a company's market value and then we can drill
down even further to look at how specific variables like
human capital influence both general and specific measures
like P/E,' explains Ernst & Young's Low.
Isolating intangibles
Some companies have a tough time quantifying intangibles
because they don't know which drivers move the stock. 'Most
organizations don't know what their intangibles are because
they may have grouped them under goodwill and now they are a
big black hole,' notes Wood. This 'big black hole' may be
contributing more to shareholder value than the tangible
assets a company sells. Indeed, 91 percent of Coca-Cola's
market capitalization of US$112.5 bn is intangible assets,
according to Interbrand's World's Most Valuable Brands
study.
The process of isolating a company's intangible drivers
begins with asking investors, analysts, customers and
employees what they think drives the bottom line. Some
companies have no problem coming up with a long list of
intangibles - 300 in some cases. 'You have to do
quantitative research among your shareholders,' notes Rivel.
'It's much more then a perception study because a perception
study gives you perceptions, but not the ability to
benchmark against your peers and measure progress.'
Companies need to isolate what is most important to
communicate and what is shaping their reputation, says
Gaines-Ross. Cisco's IR department, for example, has
isolated five key differentiators that drive shareholder
value. 'A good portion of these are intangibles like
intellectual property, strong management and IP [internet
protocol] expertise,' notes Roberta DeTata, senior manager
of investor relations at Cisco.
'You need to sit down with management and come up with a
list of four or five [drivers] and then constantly reference
them in your investor communications,' adds DeTata. Cisco
refers to those intangible drivers in all its communications
including conference calls, investor presentations, analysts
meetings and one-on-ones.
Having identified a list of intangible drivers, it's
important to set tangible goals that investors and analysts
can follow. 'From an IR point of view, the single most
important activity that a company can engage in to build
credibility is to develop a guidance policy through which it
communicates its vision for the future and makes that
tangible in terms of goals,' suggests Ed Owens, managing
director of Burson-Marsteller's US investor relations and
financial services unit. GE, for example, recently announced
it would have the best quality standards with the fewest
errors per million parts, and then the company delivered on
that promise. As Gaines-Ross says, 'Intangibles are built by
delivering on tangibles.'
Promoting intangibles
Playfair's Wood estimates that less than 10 percent of
companies in the S&P 500 currently quantify and communicate
the value of their intangibles. These companies have
incredible assets but they don't always disclose them. He
says many companies focus strongly on one intangible that is
intrinsic to its business but neglect other key areas.
'You'll find organizations like pharmaceutical companies
that focus on patents all day long but have not looked at
other areas like their domain name.'
There are, of course, companies that do an excellent job of
promoting and disclosing the value of their intangibles. BP
is a great case study of a company that understood early on
that being in the global business of oil and gas meant it
was also in the business of having to convince customers,
potential employees and voters in countries where it wanted
to explore that the company was honorable and would live up
to its commitments, Low notes. 'They were one of the first
companies to produce a sustainability report and their stock
price has performed consistently above average,' he adds.
BP, Shell, Nike and Timberland are already producing
supplements to their annual reports that focus solely on
intangibles. Other companies highlight messages about
intangible drivers like employee talent, management
credibility and branding in annual reports. GE's 2001 annual
report, for example, featured 84 pictures of people (not
products), many of them employees.
The Limited is a good example of a retail company that has
built its core strategy around communicating the value of
intangibles. 'Brands, talent and developing operating
capabilities have been our strategies for the last four
years,' says Tom Katzenmeyer, vice president of investor
relations for The Limited. He says he spends a lot of time
educating the company's investment base about the
three-to-five-year plans for each of the company's brands
including its most popular ones: Victoria's Secret, Bath &
Body Works and Express.
'The best way to communicate [the value of the brand] is to
bring investors into the store, show them how it looks, and
let them try the product with a sales associate,' says
Katzenmeyer. That's what Katzenmeyer did with investors for
the launch of Bath & Body Works' spa and aromatherapy
products. To demonstrate the tangible side of his company's
talent, Katzenmeyer introduces investors to employees. 'We
show them we have functional expertise at the center of our
company and low turnover.'
Intangible assets like management credibility, talent,
culture, brands and CEO reputation now play a critical role
in a company's success. In 1970, intangibles made up only
15-20 percent of a company's market cap; now that figure is
85 percent, notes Wood: 'For investors, these are the crown
jewels.' For companies to succeed, it's essential to
isolate, measure and promote the value of these immaterial
assets in all investor communications.
Communicating intangibles is also part of restoring investor
confidence in capital markets. With so few companies
communicating the value of intangible drivers, it's 'no
wonder there is such volatility in the marketplace', says
Wood.
'If investors understand and respect the decision-making
that goes into the way a company makes managerial choices,
that will reduce uncertainty and have a positive influence
over stock price performance,' adds Low.
In coming months, with FASB expected to deliver its proposal
for intangibles disclosure, there will undoubtedly be more
discussion about how companies should quantify such assets.
In the meantime, any investor relations officer who hasn't
yet done so should begin to identify their company's key
intangible drivers. As Low says, by isolating and measuring
intangibles internally, they will gain the confidence to
disclose them.
Tangible texts
A summer reading list on intangibles:
Invisible Advantage: How intangibles are driving business
performance, by Jonathan Low and Pam Cohen Kalafut
Intangibles, by Baruch Lev
Strategy-Focused Organization: How balanced scorecard
companies thrive in the new business environment, by Robert
Kaplan and David Norton
The HR Scorecard: Linking people, strategy and performance,
by Mark Huselid, David Ulrich, and Brian Becker
