According to Leif Edvinsson IC belong to the left side of the balance sheet showing how the Intellectual Asset (IA and the right side of the balance sheet and therefore really is the actual asset such as the value of patent, branding etc.) is financed. The importance of this rather trivial statement is, and of course the reason why many professionals take such an interest in the subject, the need for a valuation tool in order to construct securities for bank loans or as a second aspect to find an evaluation structure that will serve as a tool to help management perform an even better corporate governance. Therefore one must use definitions very carefully and correct. (I myself violate this frequently due to the fact that for some reason people don't distinguish between the intangible asset and capital in the same manner as when it comes to tangibles.)
Anyway, this is something that I find very intriguing, based on Mr. Edvinssons definitions of the subject that every IA has its opposing value in the equity/debt section (IC). Now here is the twist Mr. Edvinsson decided that the true value of IC can be found using the daily stock quotations that is market value minus the value of company equity and there you have it, the value of Intellectual Capital.
Now my question is since when have a company controller used the stock market to evaluate the performance of his company in order to perfect the governance? If asked the controller would say that when analysing the company capital structure he would use different formulas based on return measures such as return on equity and using the income statement.
I therefore consider the definitions put forward by Leif Edvinsson to be quit good but the way to evaluate the value of IC incorrect.
To try and strengthen my position in the case I would like to point out why I disregard the market quotation as showing the true value of IC.
A couple of years ago I used the formula put forward in the book "Intellectual Capital" by Edvinsson/Malone. In the book it is stated that IC = Market value - Equity. The reason given was that why would anyone pay more than 1 euro for 1 euro in company equity unless the market includes something else? This "something else" must be the company IC. To prove this value false or at least that it under some circumstances is misleading I did a calculation on two Swedish companies quoted on the Swedish Stock exchange.
The chosen were two investment companies Ratos and Turn IT. Using the formula mentioned above I came to the conclusion Ratos a company that is financially stable, 95% solidity, existed during 135 years always given dividend to its owners did possess a negative IC value of -605 million SEK wile a company as Turn IT at the brink of going bust, 24,3% solidity, existed for only 5 years and during that time never given any dividend to its owners did have a IC value of 57 million SEK. (Used at the time were the 2001 financial reports and the 31/12-01 quotation of the stocks.)
One must ask oneself if the above mentioned IC valuation is correct, given the strange results when used.
For me it became obviously clear that the formula do not work as intended and further more, if it do work as assumed, you still wouldn't be better of than before. Yes, you would have a value but because of the way you evaluated the intellectual capital, you never can tell precisely what it is in the company that generate this value. Basically this renders the calculated value completely useless for any further investigations.
Continuing the quest for true IPR value one must ask, IC/IP what is it. Many people regard this as some sort of "tacit" value created due to the fact that people work in a certain way or possess certain knowledge. Let's take a pause and reflect on this statement.
Something that do not have a physical form or that we can observe creates value given interaction between individuals or individuals and vessels of knowledge (i.e. books, internet etc). Anyway, it involves humans. Now if something creates value it must also be able to destroy value, like the tree of Eden "knowledge for good or bad". But how will we decide which is which?
Edvinsson/Malone states that we can not do this using the financial reports because they lack the necessary information about the future to come, i.e. the figures only show historic benefits but say nothing about if this will continue. Using the analogy of a tree they claim that the roots (of knowledge) are not shown since they are hidden in the dust. If we can not se the roots (understand the potential knowledge base of the company employees and internal organisational benefits) we can not tell if the company will continue its road towards success. This knowledge base is not reported in the financial statements other than maybe as R/D and Goodwill figures that do not represent the true potential and even worse is that all knowledge is not accounted for.
This old fashion of reporting has left companies in the new (?) TIME sector lost. These companies possess very little tangible assets and very much intangible assets. Assets that is not shown in the financial statements and therefore limits there ability to raise necessary capital for expansion and so forth. Therefore we need to change the financial reports and what information they must contain.
A very noble and understandable reasoning, if you are a TIME sector company. But what if you are a creditor to a TIME sector company?
I state/claim/stress that the financial report system serves three aspects of which two is more important than the third.
1. Serve as basis for company taxation in relation to the state.
2. Give adequate information to external creditors and investors about assets retrievable in case of bankruptcy.
3. Serve as a foundation for company controlling and management.
Well, the state would naturally like the fact that value can be increased due to the fact that thereby taxation can be increased. Companies would probably benefit from increasing governance and figures that more accurately show its potential. But from an investor or even more so creditors point of view this could lead to disaster and increasing distrust towards the financial system.
In Sweden the real obstacle for not including the IP/IC in the financial statements is the law (Bankrörelselagen 1987:617 kap.2 § 13) regulating how a bank should lend out money to a company only in relation to its assets retrievable. To put it in plainly, only the assets a company truly can own can be used as security for bank loans. (Because of the -32 depression with banks going bust it was necessary to restore peoples trust in banks i.e. banks do not lend their own money but other peoples money, something that is often forgotten). In other words the financial reports are made for the purpose of creditors to understand to what and how much they will/can lend money. The reason is of course that companies do go bust and management is not responsible for a company's debt (normally that is). Therefore it is considered "best practice" from the legislator/society that the values retrievable are kept reasonably correct.
Following the statement above the company must own its personnel in order to use it as collateral, but this would then constitute slavery and something that we in the west abolished some 100 years ago (if we do not count the era of WWII) Secondly, one could also argue that if we include knowledge in the statements what are we to do with company boards like Enron's. Should we include behaviour that we do not like as an asset, the fact that the board seems to have financed the company in a very imaginative way may constitute for some sort of value creation and therefore an asset and did they in that case do anything criminal? The examples above are extreme possibilities but still have to be answered and dealt with in some way.
Still this does not render the subject of IC/IP as an anomaly in the history books but if we leave it outside the normal financial reports it can still be of interests for the company's own understanding to be used for controlling and governance.
I therefore state that we should not create a more confusing report system were even more misunderstandings can be made about the value of companies. But this does not make the subject uninteresting. On the contrary it can be used to create tangible values by using and understanding what this is and how we normally deal with and create tangible and accepted values (even in the reports today) from what is normally intangible.
If positive IC creates value how should we view a negative IC i.e. value destruction?
To some extent you could probably view negative IC as something "good" if you play the market, cause it show that there is room for improvements in company performance. Then if you correct the faults the value of the company stock would rise and you would let the market "eat" up the value hidden or "unleashed". This is a valid view from an investor's side.
But from an IC-managers view, if my company show negative numbers it ought to alarm you that you are doing something wrong. IC-managers goals are to in every way possible highlight and manage the true value of IC for the continuing success of the company. A correct IC value is essential for the companies understanding of them selves in order to perform correctly.
As earlier described Edvinsson believes that market value is the correct way of showing the potential of IC, I disagree. But still according to him IC = Market Value - Equity.
We all heard about the balance sheet left hand asset post "Goodwill". "Goodwill" can emerge when a company buys another company for more then its amassed Equity. If one was to buy a company for less than its Equity a "Badwill" is created. If you are a believer in that market value holds the answer to the value of IC, here you have it in full bloom. "Goodwill" is actually IC cause it represent a the part of the market value that is greater then the Equity.
Positive value means that there were hidden gold, negative value means disaster company and zero is zero, i.e. that the company does not use its potential but doesn't misuse it either.
But is this true? Is reality this simple? I say not! Why?
Dagens Industri 2002-09-13 (The Swedish FT) had the following article (translated poorly by me) "Sandvik buy's Japanese machine company". The article states that Sandvik bought a company called Toyo from MET (Mazda Earth Technologies). The interesting is that the buy would not result in any "Goodwill" for Sandvik since they paid a sum equal to the Equity. Basically Sandvik did not acknowledge any IC in Toyo worth mentioning. Toyo had delivered zero in profits within the MET organisation, and still Sandvik claimed that Toyo should contribute positively to the 2003 statement but not as high as the corporate demands.
What happened here? A company buys another company showing via the pricing mechanism that it has no exceptional benefits to contribute with and that has a low earning potential. Why? The reason is that trough this transaction Sandvik became the third largest seller within the Mining & Construction in Japan, a market renowned for its difficulties of letting foreign actors into its markets. In Japan Japanese trademarks are a must.
The seller MET did they loose anything over this deal? They actually sold an important trademark not realising its full potential or value. Well, no! Toyo didn't contribute to MET due to its bottom line zero. MET had a large capital investment that didn't generate any returns on investment, the money would therefore be better placed at the bank earning them at least interest.
Funny, two companies that were better of then before by a single transaction that did not generate any Intellectual Capital. How should we interpret that?
Now, if the balance sheet is not the proper way to locate IC, where do you look? There is only one place to go, the income statement.
To conclude my discussion on the valuation of IC and my view upon it and to make short ending statement;
A company is a virtual entity that does not exist. Still it is bound by different laws of conduct. These conducts are subject to our own imagination or the sum of beliefs as we as individuals and collective groups hold as true. Therefore everything connected in regulating the entity as we know as a company is changeable. It all depends on the mass of power that you can bring in to the negotiations of what is to be in the future and you will probably be more likely to force your version of the truth if you can continue the attack on the acknowledged reality from as many different directions as possible. Basically most aspects of life are politics and positions of power.
Now as for the company I just stated that anything is possible to create in the virtual world and a company is a virtual entity. IC tries to deal with putting an economic number on how much the company's intellectual capital is worth. The problem is a very intriguing one to say the least. Following the reasoning above the value must be close to infinity. Its like trying to find the physical singularity point of the Big Bang using the mathematics of today, it all breaks down. We can not approach the value and understand it fully without getting some very strange results.
Still the concept of value existing in a company that is not reported must exist because companies do not report the same bottom line figure. There are differences and these differences are highlighted in the economic reports of the company. My argument is that you can not use the stock markets valuation of a company to flush this value out as proposed by some theorists.
Why? Because even though I can subscribe to the EMT (efficient market theory) in the long run it is to uncertain in the short and as Keynes once remarked "In the long run we are all dead". Another difficulty is that the stock market does an outsiders guess/estimation of the reality and therefore bring in their own IC value to the process that is the result of their own knowledge regarding the selected company. To put it short, if you are a good evaluator of the company it is more likely that the value you conclude is correct then if you are a bad, trouble being that we do not know what kind of analyst has done the evaluation. The counter argument is as always that in the long run all this will even out, but as Keynes so brilliant put it we don't know when, only that it is going to happen.
So should one not investigate this subject then? No, it is of vital importance to the companies because it makes it possible to understand the internal value creation processes in the company and the best person to do it is as always the company. The best starting point to understand the company is the economic reports and the value created at the bottom line. The return is the sum of value created divided by the capital used. The value created is the result of the work done utilizing the limited resources at hand. Using simple mathematics known as a residual formula would give a more accurate starting point of the proposed value.
Vic = EBT / Rea - E
Vic (Value of Intellectual Capital)
EBT (Earnings before Tax)
Rea (Return on Equity at Average for the investor to expect)
E (Equity)
Great, we have a value but actually this is no good, cause it just tells us the value and not when, what and why it has been created and this is more important then having a value, only by knowing how the value is created is really helpful to an industrialist as opposed to a investor.
One of the cornerstones in the calculation is to determent the Return on Equity at an appropriate level because the return must represent the return an investor can expect on the capital invested. If one can determine this you will get the value of the Intellectual Capital or the way that we do things that is our company.
Combining different economic formulas like the du-Pont method and leverage formula you end up with the following
Re = VM * KomH + (Rt - Rs) * S / E
Re (Return on Equity)
VM (Profit margin)
KomH (Asset Turnover)
Rt (Return on Assets)
Rs (Average interest on Debt)
S (Debt)
E (Equity)
Not knowing exactly how the IC really is constructed one could at least assume that the contribution from the different aspects of the formula above, by an educated guess, is that the IC is roughly deployed in the same manner. If it is, it means that you can split the value of Vic to the different aspects
Profit margin is closely linked to external interests such as sales Asset Turnover relates to internal company structures The leverage relates to how efficient management are in financing the company
Knowing the capital distribution and comparing it to other similar companies working in the same field led to an increased understanding of the ups and downs in the Intellectual Capital. Remember the calculations made also means that the IC value can take negative form and actually be IC destruction.
Anyway knowing the capital deployment gives room to further investigation in the different contracts regulating the actual events taking place within the company. Managing the Contracts of the company and increasing the knowledge of what makes them tick is the first step towards the true understanding and increasing the true economic value of a company. Contracts are the matrix of the company and temporarily set the rules in the environment that the company must navigate through. Nevertheless it is important to remember that it is possible to alter the rules "as times goes by", and that they are not carved in stone forever.
The tools that can be created will guide how to interpret the economic results from the aspects of the law regulating the behaviour of the company i.e. the current contracts and how to improve them. Creating real value through the only possible mean a virtual reality can get real, the Contract that is a temporary creation of reality by law or as I like to call it through the discipline of Lawnomics!!!
For compnies with a Lawnomic approach the IPR game with its different legl protection systems therefore almost can be compered to a game of chess where, space, power accumulation i.e. multiple piece interaction, sacrifice, threats, promotion to any piece (that is, to compare the promotion of the pawn with patent pending to patent), time and flexible rule interpretation are the foundations of our perceptions of value ceation i.e. profit. A value which at an ever greater speed abandons the physical realm in order to transform into knowledge or intellectual performance will ultimatly lead to an increased activity in our courts. The result beeing that a company's market value will depend on how well it handled the recent court proceedings and if it managed to defend its non-physical assets from being exploited by competitors.
So welcome to the futures most exciting game of all, where there are no restrictions and only SWOT exist.
Any problems with this approach? Lots but this will hopefully be further investigated by future scholars, at least to my beliefs.
Fredrik Andersson
