Valuation Evolution: From Financial to Intangible to Leadership

The definition of an organization’s value has changed over the years, and I believe it is still changing. Once it was mainly the physical stuff that could be removed and sold; then it expanded to include the intangible assets that made it a going concern. Leadership looks like the next step.

It’s worth tracing the development in more detail. Historically, the accounting profession received a major challenge after the stock market crash of 1929. Many argued that stock prices misrepresented firm value because the public information available to investors did not accurately reflect the extent of a firm’s assets. In 1934 the Securities and Exchange Commission was formed to create standards and regulate how public companies report their financial performance to investors. The large accounting and audit firms at the time (called the "Big Eight”: Price Waterhouse & Co.; Haskins & Sells; Ernst & Ernst; Peat, Marwick, Mitchell & Co.; Arthur Young & Co.; Lybrand, Ross Bros. & Montgomery; Touche, Niven & Co.; and Arthur Andersen & Co.) established a set of standards and principles through the Financial Accounting Standards Board (FASB). The rules define uniform standards in an effort to communicate accurate information to investors so they can better measure firm value (generally accepted accounting principles—GAAP—in the United States, or international accounting standards—IAS—outside the United States).

The intent of these accounting standards is to offer investors comparable, public, and transparent data that will enable them to make accurate valuation decisions. The ingredients, or financial data, from the accounting standards can then be combined to define a firm’s value. An entire industry has been created and evolved to define approaches to the increasingly complex task of measuring a firm’s value. Income approaches to valuation focus on capitalization of current net income or cash flows and discounting of future cash flows. Cost approaches to valuation emphasize the cost of replacement of an asset to determine its value. Market approaches value assets because of their current value based on competitive pricing. Again, each of these broad approaches to valuation combines the ingredients from the accounting standards data to determine a value of the firm.

IMPORTANCE OF INTANGIBLES FOR VALUATION

In recent years, due to changes and uncertainty in markets, information, and globalization—and despite the constant attention reported in the preceding section—the financial data publicly reported by firms has not reflected their value accurately. Earnings reported in a variety of forms (net income, operating earnings, core earnings, and more) have become ever more suspect. As a result, efforts at firm valuation have turned from financial results toward a deeper understanding of the intangibles that influence these results.

Baruch Lev, an accounting professor who is a thought leader of the intangibles movement, has shown the importance of intangibles as indicated through market to book value—suggesting that for every $6 of market value, only $1 occurs on the balance sheet. This means that the balance-sheet number—which is what traditional accounting measures—represents only 10% to 15% of the value of these companies. This data shows that the value of many firms comes as much from perceived value as from hard assets. Firms like Coca-Cola and Gilead have high market value from brands and patents. Technology-based firms like Amazon and Google have high market value with relatively little in the way of cash flow, earnings, hard assets, or patents. And even traditional companies like 3M and IBM are increasing market value by focusing on brands, leveraging the Web, and restructuring. Professor Lev further recommends that managers learn to win investors over by finding ways to more clearly communicate intangibles with them.

Harvard professor Robert Eccles and his colleagues at Pricewaterhouse Coopers (PwC) call for a "value reporting revolution” by changing financial reports to include more intangible information. They find that only 19% of investors and 27% of analysts "found financial reports very useful in communicating the true value of companies.” They argue for changing the performance measurement game to better allocate capital and assess the true value of firms. In identifying better measures of firm performance, they focus on "key performance measures—both financial and non-financial, and how they relate to each other, that they are measured and reported on, and that they create real value.” They propose a model they call "Value Reporting Disclosure” with enhanced business reporting where firms report information on business landscape (industry, technology trends, the political and regulatory environment, social, and environmental trends), strategy (mission, vision, goals, objectives, portfolio, governance), resources and processes (physical, social, organizational capital and key processes), as well as GAAP-based performance. By reporting these more intangible factors, they give investors better information for determining a firm’s true value. Analysts perceive the benefits of better disclosure when they help long-term investors have greater confidence in future earnings.

Accenture’s finance and performance management group also reports that intangibles are an increasingly important part of a firm’s value. Its classification of assets still includes monetary and financial assets, but also intangible assets of relationships, organization process, and human resources, and it proposes measures to track these intangible assets.

Ernst & Young’s Center for Business Innovation has also attempted to find out how investors use non-financial information in valuing firms. It concludes that non-financial criteria constitute, on average, 35% of an investor’s decision. Sell-side analysts use non-financial data, and the more non-financial measures analysts use, the more accurate their earnings forecasts prove to be.

Because of studies like those just cited, in recent years intangibles have received more attention as a source of value. Generally intangibles have been listed as intellectual capital or knowledge as evidenced in patents, trademarks, customer information, software codes, databases, business or strategy models, home-grown processes, and employee expertise. Investors have worked to classify lists of intangibles that include intellectual capital but are more expansive. Baruch Lev categorizes intangibles into R&D efforts (such as trademarks, patents, copyrights), brand value (such as image, reputation), structural assets (such as business systems, processes, and executive compensation, human resources), and monopoly position.

In our earlier work, Norm Smallwood and I synthesized the work on intangible value into four domains called the architecture for intangibles (see Figure 1.1). We found that intangibles could be clustered into four broad categories—making and keeping promises, having a clear strategy for growth, managing core competencies, and building organization capabilities—all of which depend heavily on the behavior of leaders. To elaborate:

Keeping promises comes when leaders build relationships of trust by doing what they say to employees inside and customers and investors outside, often measured as risk.

Creating a clear, compelling strategy comes when leaders have strategic capital to define the future and work with customers to deliver value through brand identity and reputation.

Aligning core competencies increases when leaders invest in R&D and the intellectual capital that comes from patents, copyrights, trademarks, and the like. Creating core competencies also comes when leaders access functional expertise in technology, manufacturing, and operations.

Building organization capabilities comes when leaders have the ability to create a corporate culture consistent with its mission, which could mean a culture of innovation, collaboration, efficiency, risk management, or information asymmetry.

In this current work, I emphasize the point that leadership is a key underlying factor in an organization’s ability to keep promises, set clear and compelling strategies, align core competencies, and build organization capabilities. When leaders at all levels of a firm guide these four domains, they create sustainable intangible value. Therefore investors who assess leadership will be more able to fully value a firm’s intangible assets and overall market value.

As I’ve said, this is the right time for this book. Nearly every interested investor has access to publicly reported data, so essentially, each investor knows what every other investor knows about a firm’s financial position and, increasingly, about its intangibles. Investors need to dig deeper to find new insights, and this is not easy to do. For example, the New York State Attorney General recently required BlackRock (the world’s largest asset management company) to stop surveying Wall Street analysts to find out their collective views on a company’s financial performance and likelihood of being taken over. The argument was that financial data should be public, transparent, standardized, and shared so all investors have the same access to it. When financial data is widely shared, however, investors have to find other information, such as leadership, to inform and differentiate their investment choices.

LEADERSHIP: THE NEXT STEP

When New York University researchers administered a questionnaire to a hundred venture capitalists, exploring the criteria for fundability of new ventures, they found that the most important factor is the quality of the entrepreneur or management. Similarly, when Boris Groysberg and his colleagues at Harvard surveyed analysts to find out what they valued in making their investment decisions, they found that quality of management was among the top factors. However, they also found that analysts lack consistency in rating this dimension.

Research among joint ventures and venture capital firms has also found that information that has not traditionally been incorporated in the due diligence process, such as the quality of management and culture, can be critical to the future success or failure of the acquisition. The success of many companies can be traced to a few prominent managers who provided the required leadership. Without auditing intangible assets such as management, it is not possible to conduct a correct valuation of a potential investment.

These studies show that work on valuation is moving toward an assessment of the quality of leadership—the leadership capital—that underlies and creates intangibles and leads to financial results. Figure 1.2 traces the s-curves in the history of valuation, showing how intangibles move beyond financial information and proceed almost inevitably to the inclusion of leadership.

These days investors are creating metrics for intangibles (like brand recognition, strategic clarity, innovation index). Investors who do a better job of assessing leadership will create information asymmetry for themselves and make better investment decisions. However, management practices and leadership vary enormously across firms and countries. Financial valuation sets the accepted baseline that levels the playing field, but leadership valuation differentiates how investors can determine long-term firm value.