The Invisible Advantage: Owning and Counting Intangible Assets In the Post-Enron Era

Jonathan Low, Cap Gemini Ernst & Young Center on Business Innovation and co-author of Invisible Advantage: How Intangibles are Driving Business Performance

The Project on America and the Global Economy (PAGE) cosponsored a meeting on intangible assets with the Athena Alliance. Jonathan Low from the Cap Gemini Ernst & Young Center on Business Innovation and co-author of Invisible Advantage: How Intangibles are Driving Business Performance discussed how dramatically non-financial performance measures have grown in significance. In part, interest in the subject has grown as the markets have put more and more emphasis on intangibles. Older, established manufacturing firms generally have substantial tangible assets – factories, heavy equipment, and inventory. Companies such as Microsoft, however, hold relatively few tangible assets beyond scattered office buildings and a host of personal computers. Yet the market capitalization, the value the market puts on Microsoft is usually much higher than the value given to established manufacturers. Their value, along with many other technology companies, lies in intangibles – meaning everything from an effective research department to well-respected leadership to strong brand management.

Not surprisingly then, intangibles have attracted the attention of leaders in the financial world. Low pointed to a recent statement by Alan Greenspan, “An ever increasing share of GDP has reflected the value of ideas more than material substance or manual labor input.” The growing importance of intangibles has captured the attention of the domestic and international financial markets, regulatory agencies, and the academic community.

In many instances, investments in R&D, workforce education, brand development and other intangibles now exceed investments in tangible assets. Valuing intangibles is becoming ever more important for corporate investment committees who must decide between investment in new structures and maintaining a research initiative but also individual investors who are interested in future as well as current investment returns. Institutional investors (pension funds, university endowments) indicate that 35% of their portfolio allocation decisions are based on nonfinancial, or intangible, factors. For sell-side analysts (working for investment banks or brokerage houses) the more they incorporated intangibles into their forecasts the better they were.

Intangibles are now the most significant differentiator between successful and unsuccessful new stock offerings. Successful IPOs (initial public offering marking when a private company first sells its stock to the public) consistently exhibit:
 A realignment of internal systems and employees’ interests with corporate strategy early in the IPO process;
 Superior strategy execution compared to its competitors; and
 Communication of both the company’s non-financial strengths and its financial position to stakeholders and to the market.

Current measurement systems of corporate performance are inadequate for effective management of intangibles. A poll conducted by Ernst & Young showed that 81% of respondents thought their performance measurement systems were poorly aligned with their corporate strategies. Gaps in intangibles measurement have been correlated with financial performance measures such as one and three-year stock returns and five-year sales growth.

It is not easy to always easy to measure intangibles. For instance, Low cited studies finding that investments in technology (say new software systems) did not distinguish one firm from another. In terms of market valuation, the technology investments were viewed as necessary to be in commercial competition. What separates one firm from another are the organizational factors needed to make effective use of the technology. There is also an increasing global demand for greater transparency. Even for large, mature companies, a significant part of the valuation is attributable to non-financial information. With this becoming more common, companies are experimenting with alternative performance measures. "As intangible assets grow in size and scope, more and more people are questioning whether the true value--and the drivers of that value--are being reflected in a timely manner in publicly available disclosure." Arthur Levitt, Chairman 1993-2001, U.S. Securities and Exchange Commission.

The international business community and regulatory agencies are somewhat ahead of their US counterparts in defining and accounting for intangible assets. Preliminary definitions put forth by the International Accounting Standards Board (IAS 38) May give European corporations an advantage over their American counterparts. The IAS defines an intangible asset as “an identifiable non-monetary asset without physical substance held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.” Its “fair value is the amount for which that asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction.”
We can expect a greater effort on the part of the American Financial Accounting Standards Board and the Securities and Exchange Commission.

American companies who want to be or remain competitive need to determine their critical intangibles, decide on metrics for these key intangibles, create a baseline for measuring them and benchmark them against their competitors. Corporations need to undertake initiatives to improve the performance of their key intangibles, and disclose and communicate these strategies and philosophies to Wall Street and the public.

Lynn Sha, Project on America and the Global Economy. 202-691-4206

The Project is Directed by Kent Hughes, 202-691-4136