SEEING IS BELIEVING
A better approach to estimating market capital
Knowledge-capital methodology by Baruch Lev
Text by S.L. Mintz

The 18th-century philosopher Immanuel Kant spent much of his life pondering experience beyond the physical realm. Although a stranger to modern finance, he might feel right at home in the current debate about measuring and reporting knowledge assets. Just as Kant concluded that metaphysical reality exercises more influence on human behavior than objects we can see and touch, some observers today recognize that intangible knowledge assets increasingly drive financial performance.

Where knowledge assets are concerned, accounting practice has not changed much since Kant's day. After several hundred years of double-entry bookkeeping, account-ants still do not treat knowledge assets as assets. CFOs can keep close tabs on spending tied to patents, brands, trade-marks, and research and development, but unlike routine accounting for tangible assets, there are no rules for estimating or reporting the cumulative consequences of these investments.

Meanwhile, the industrial revolution has given way to an age of computers, information and global competition. Decisions are made more quickly, and superior knowledge of products, markets, methods and cultures often determines who prevails. The desire for mobility favors assets that can move over those assets rooted to the ground. This spurs additional investment in assets that may affect the balance sheet, but are not recorded there.

Despite increasing awareness that the value of knowledge assets now approaches or even exceeds the value of reported book assets, rulemakers in the United States have largely dodged the issue. Since hosting an exploratory seminar on intangible assets in 1996, the Securities and Exchange Commission has been silent on the subject. At the Financial Accounting Standards Board, which often leads the way on such matters, knowledge assets are "not on the horizon," says an FASB spokesperson.

Whether or not regulators choose to deal with it, a gap exists between a knowledge-based economy and accounting measures geared to an era when most corporate assets resided on factory floors and shelves. Debate centers on the merits of measuring knowledge assets, not on whether they exist.

Skeptics, including many CFOs, insist that knowledge assets cannot be measured in a meaningful way, chiefly because nothing actually changes hands. Barring calamity, tangible assets won't vanish overnight, but the value of a knowledge asset can. A high-tech patent can be improved upon or superseded by a new technology; an unfounded rumor can diminish the reputation of a brand name; promising R&D can come a cropper; a top executive can go elsewhere.

"The closest you'll come," says David Shedlarz, CFO of pharmaceuticals giant Pfizer, "is by determining the quality of existing and future product pipelines, as well as the capacity to develop, manufacture and market new pharmaceutical products, taking risk factors into consideration. None of that is on the balance sheet." Until a mechanism for evaluating knowledge assets wins wide acceptance, says Shedlarz, they won't belong on the balance sheet.

Skeptics predict unintended and unwelcome results if knowledge assets find their way onto financial reports. Far from clarifying performance, in their view, knowledge assets will instead mislead investors, distract managers and foster uncertainty.

These fears are overblown. There are more serious deficiencies in an accounting system anchored to physical assets. The value of a single knowledge asset may indeed rise or fall unexpectedly, but successful long-term corporate performance demands optimal control over the levers of value creation. This cannot be accomplished fully without the means to assess how well companies manage knowledge capital.

Companies need to answer such questions as: Are returns on R&D satisfactory? Are patents worth renewing? Are brands worth defending? Failure to address these deficiencies already undercuts prospects for optimal decision making. Companies failing to address these deficiencies will ultimately lose out to competit ors that learn to measure, manage and leverage their knowledge assets.

The momentum for change is growing. "We are just at the stage of forming a consensus," says Steven M.H. Wallman, co-chair of a Brookings Institution task force charged with advancing the visibility of knowledge capital. During his tenure as an SEC commissioner, Wallman helped initiate the move toward consensus. "Once the intellectual foundation is laid for the need for change," he declares, "and once world-class academic research shows the importance of this evolution, we will see a serious discussion about how to make the system more reflective of the economy as it is today and as it is likely to be in the future."

Absent a secure handle on knowledge assets, companies address the knowledge-capital gap either in a piecemeal fashion or by resorting to shortcuts with obvious flaws. Attempts to assess knowledge capital one product at a time stumble on such questions as how to allocate overlapping benefits from companion products and services.

Developing a Knowledge Index

A broad proxy for knowledge capital is the subtraction of book value from market value. This proxy assumes, however, that book assets have no value above reported cost - an assumption that is plainly suspicious, if not dead wrong. The resulting figure overstates knowledge assets and ignores the market value of book assets. Moreover, because the proxy is stock-market based, knowledge capital appears to fluctuate with every tick in the stock price. Such behavior makes it even more elusive and hinders the ability to manage it.

Calls for companies and regulators to start measuring knowledge capital caught the attention of CFO Asia's sister publication CFO in 1996 when it published "Getting a Grip on Intangibles" (September).

Response to the story prompted the question of whether intangibles, or knowledge assets, can indeed be measured. We turned for guidance to Baruch Lev, the Philip Bardes Professor of Accounting and Finance at New York University's Leonard Stern School of Business. Lev, an outspoken advocate of greater recognition for knowledge assets, embraced the challenge by formulating the first Knowledge Capital Scoreboard.

With critical assistance from portfolio manager Marc Bothwell of BEA-Credit Suisse Asset Management, Lev developed this performance-based calculation of knowledge capital as a tool for measuring the economic consequences of investment in knowledge assets.

CFO asked Lev to analyze two industries using the Scoreboard. Lev and Bothwell computed levels of knowledge capital at ten chemical companies with sales in excess of $1 billion, and ten pharmaceutical companies with sales over $250 million.

Lev's novel interpretation of intangible-asset values chiefly reflects the assumptions underlying conventional appraisals of tangible assets. Standard aftertax return expectations for tangible and financial assets drive two-thirds of the analysis. The other third of the analysis rests on an estimate of long-term expected returns on knowledge assets. Since no such historical calculation yet exists, the Scoreboard substituted a proxy: average aftertax expected return (Ibbotsen & Associates' cost of equity) for three industries that consist almost entirely of knowledge assets - computer software, bio-technology and pharmaceuticals.

The Formula for Knowledge Capital

Calculating knowledge capital starts with an estimate of each company's annual normalized earnings. For the Scoreboard's purposes, the estimates encompass three years of historical data through year-end 1997 plus earnings forecasts for one, two and three years taken from IBES International consensus estimates. To accommodate bus-iness changes that are likely to affect future results, averages give slightly greater weight to earnings forecasts. Performance improvements expected beyond three years out do not affect the Scoreboard, Lev warns.

Once normalized earnings are established, a figure for knowledge-based earnings, the Scoreboard's primary building block, is determined based on a residual calculation. Expected rates of return for each broad asset class are applied to tangible book assets and financial assets.

The Scoreboard multiplies the recorded assets by their respective aftertax expected returns - 7 percent for tangible assets and 4.5 percent for financial assets. The rates of return apply to all companies in both industries equally, irrespective of each company's risk profile or cost of capital. With more time and resources, companies can adjust these rates to reflect their specific track records. This limitation notwithstanding, the process computes credible measures of earnings linked to tangible and financial assets.

Subtracting tangible and financial earnings from normalized earnings leaves a portion of normal earnings unaccounted for. This residual, says Lev, represents earnings generated by knowledge assets, or knowledge capital earnings (KCE). This calculation by itself suggests a range of new financial metrics, including a knowledge capital margin (KCE/Sales) and a knowledge capital operating margin (KCE/Operating Income), to name just two.

With these measures, companies can, for the first time, estimate the contribution of knowledge assets to their profitability and performance. The formula solves for knowledge capital by reversing the steps for calculating earnings that tangible and financial assets generate. Instead of multiplying assets by their expected returns, knowledge-based earnings are divided by an expected rate of return for knowledge assets. It's a familiar process, with one hitch: no one has ever computed an historical expected rate of return for knowledge assets.

This is where the proxy comes in handy. Absent an acceptable alternative, the average aftertax expected rate of return for three knowledge-rich industries (software, biotechnology and pharmaceuticals) supplies the aftertax knowledge capital discount rate of 10.5 percent.

To take an example, normalized earnings at pharmaceuticals company Merck & Co. are $5.5 billion, according to our estimate. Average tangible assets of $4.9 billion (net of long-term liabilities and reserves) can be expected to generate earnings of $343million, while financial assets of $624 million can be expected to generate $28 million. The residual, $5.1 billion, represents Merck's knowledge earnings.

Applying the 10.5 percent as a proxy for the knowledge capital discount rate to knowledge earnings yields the Scoreboard's figure for knowledge capital as of year-end 1997: $48 billion.

As expected, company size affects results. The amount of knowledge capital at large companies will often exceed that at smaller companies in the same business. There is much more to the story, however, as comparing Merck with chemical company DuPont suggests. DuPont rang up sales of $40 billion in 1997, versus $24 billion at Merck. But when it comes to generating knowledge capital, Merck's knowledge-intensive portfolio of existing medications and drug pipelines enjoys a nearly two-to-one advantage over DuPont's capital-intensive portfolio of commodity-chemical and plastics-processing capabilities. The bottom line: Merck has accumulated $48 billion in knowledge capital compared with $26 billion at DuPont.

With figures in hand for knowledge capital and related earnings, new metrics can cast conventional financial statements in a fresh light. Calculating the ratio of knowledge capital to book capital, for instance, suggests the degree to which a company is knowledge-based. For every dollar of book capital at DuPont, there is $2.34 worth of knowledge capital, among the highest for chemical companies. A ratio of knowledge capital to sales adds another dimension, the knowledge-capital margin. A downward change in this ratio hints at lower contributions to overall performance by knowledge-capital assets; a shift upward suggests greater contributions can be expected. Warner Lambert and Bristol-Myers Squibb, with the highest ratios of knowledge capital to book value, 4.27 and 4.22, respectively, are also amply rewarded by investors, as indicated by their highest and third-highest rank in the traditional market-to-book ratios.

A More Robust Appraisal

Merging a new metric with a familiar one, the Scoreboard introduces the concept of "comprehensive value," arrived at by adding knowledge capital to book value. Comprehensive value yields an appraisal of the balance sheet that takes all corporate assets into account, from machine tools to patents. Analysts frustrated by widely divergent ratios of market value to book value might welcome a more complete picture of total assets.

Gone are whopping multiples of book value, replaced by more modest multiples of comprehensive assets. While Warner Lambert has the highest market-to-book ratio, pipeline-rich Pfizer enjoys the highest market-to-comprehensive-value ratio.

"A one-to-one ratio," says Lev, "would indicate that market value is mostly derived from past performance and short-term earnings forecasts." Or, to put it another way, a 1:1 ratio indicates that near-term earnings expectations are embedded in the stock price, and not much growth is expected beyond that in the absence of new developments.

As a systematic model for evaluating knowledge assets, the Knowledge Capital Scoreboard attempts to capture a critical dimension of value that conventional accounting has failed to grasp. Reliance on public information and broad assumptions make it available to everyone, but these steps also impose obvious limitations. Access to proprietary information about expected returns and itemized expenses can refine the methodology and, in all likelihood, enhance the results. If any single conclusion stands out, it is the shortsightedness of ignoring knowledge assets. They exist, they can be estimated and they deserve recognition.

S.L. Mintz is New York bureau chief of CFO.