Intangible Assets and Measurement


Intangible assets take many forms. A recognized brand is one of the easiest to understand: the name Coca-Cola, the McDonald’s golden arches, the Nike “swoosh.” Each represents enormous value. The “relationship value” within a network of trusted suppliers and customers is another intangible asset that is not found on the balance sheet.

In many cases a company’s greatest intangible asset relates to human capital. Human capital is the wellspring of many of the other intangibles valued by investors. Increasingly, investors see human capital as the engine of innovation in knowledge-economy companies, the source of winning strategies and business models.

Although the importance of human capital is undeniable, the calculation of its value is often a puzzle. Unlike a piece of equipment, the system of human capital practices deployed to create and manage human assets in an organization has no “purchase price” from which value can be determined. This lack of a transactional starting point led Martin Fridson and Fernando Alvarez to conclude, “Everybody acknowledges the value of a company’s ‘human capital’ . . . but no one has devised a means of valuing it precisely.”[1]

Human capital is different from tangible assets and other intangible assets in that companies can never wholly control people’s motivation and productivity in the way they control physical capital. In addition, there is little unique value to a business in its employees’ knowledge, skills, and experience since in principle they are available to all companies at prevailing market rates. It is only when they are combined with a company’s management system and/or transformed into firm-specific capability that unique and lasting advantage is created.

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Origins of the Human Capital Concept

To economists, the term human capital has a very specific meaning that appeared initially in the works of Jacob Mincer, Theodore Schultz and Gary Becker in the late 1950s and early 1960s and was developed further by Sherwin Rosen and Richard Freeman, among others.[2] Both Becker and Schultz won Nobel Prizes largely for their work in this area and made human capital a core concept in labor economics.

The original work in this area attempted to achieve a better understanding of decisions made by individuals and firms to increase the quality of labor through expenditures on education, training, and on-the-job learning. Individuals and organizations incur costs in improving labor quality in the hope of generating future returns through enhanced productivity and earnings. Therefore, their decisions are investment decisions. The analogy to capital investment has stuck despite recognized differences between human capital and physical and financial capital. Organizations invest current resources on training in the hope of generating higher productivity over time.

In 1985 Leif Edvinsson, the chief knowledge officer of Skandia Corporation, offered perhaps the first comprehensive report of human capital as a component of his firm’s annual report. To Edvinsson, human capital embodied the sum of the knowledge, skills, and practical experiences possessed by an organization’s employees and contractors.

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That management system is a major determinant of economic productivity, yet it generally is overlooked in corporate valuations. The reasons for that omission include the difficulty of measuring the management system and the fact that human capital is not a fungible asset. It cannot be traded or exchanged easily; more specifically, it is essentially indivisible and cannot be collateralized to secure other assets. Moreover, there are no markets for exchanging claims on future labor services. Also, human capital is only one of several types of intangible assets held by firms, as Figure 11-1 indicates. Despite the difficulties of measuring intangibles, many companies are making the effort.

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Figure 11-1: The intangible Asset Family

Let us say at the outset that whereas estimating an asset value for human capital is useful for investors, it is clearly less useful for managers. The dollar value of an asset, although interesting, does not tell managers much. A manager’s primary focus should be on putting in place and running the systems that create value from intangibles. Managers should know what creates value for investors and how to best manage it.

For the last 30 years attempts have been made to link human capital to shareholder value. Many approaches have been tried to proxy for a linkage or a way of measuring human capital, but all have failed to make the linkage explicit. Still, for investors (and some managers) who do not yet have access to the facts, those approaches represent a step in the right direction. Let’s consider several of the most notable approaches.

The Lev Approach

Baruch Lev, an accounting professor at New York University’s Stern School of Business, has for the last 30 years been pursuing measures for the value of intangibles. He stated to an interviewer that “one of the major problems with today’s accounting systems is that they are still based on transactions, such as sales.” As he explained:

In the current, knowledge-based economy much of the value creation or destruction precedes, sometimes by years, the occurrence of transactions. The successful development of a drug creates considerable value, but actual transactions, such as sales, may take years to materialize. Until then, the accounting system does not register any value created in contrast to the investments made into R&D, which are fully expensed. This difference, between how the accounting system is handling value created and is handling investments into value creation, is the major reason for the growing disconnect between market values and financial information.[3]

Lev’s proposed solution is to capitalize residual earnings: What is left over after the expected return from a business’s financial and physical assets has been removed. These residual earnings are then attributed to intangibles. Lev’s approach makes it possible for outside investors who are not privy to accounting and management system details to determine the relative differences in intangibles across competing firms. Lev’s approach has the advantage of being less subjective than many of the following alternatives. Also, it can be implemented by using publicly available data, and the resulting valuations are not subject to the daily volatility of the stock market.

Further decomposing residual earnings to determine what proportion is attributable to different types of intangibles—people, brands, patents—would provide an additional degree of precision that would help isolate the earnings contribution of human capital per se. This would enable an investor to assess how well or poorly a company does at growing its human capital value.

Workonomics™

The Boston Consulting Group’s Workonomics™ attempts to identify workforce (intangible asset) measures that are in effect the counterparts of traditional (tangible asset) accounting measures.[4] For example, workforce utilization is seen as the counterpart to asset utilization; a workforce development plan is the counterpart of a capital investment plan. This approach is logical and appealing. However, it does not provide a means of pointing to which of the many possible measures are the few, most important indicators for a company to track. Ideally, a measure’s importance should be determined by the extent to which that measure reflects a human capital attribute or management practice that is known to drive a firm’s performance.

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Shareholder Value

Shareholder value analysis (SVA), which first was developed by Professor William Fruhan of Harvard Business School, is often a useful starting point when one is asking, What creates value? SVA rests on the assumption that a predictable relationship exists between market premiums and return on equity. Other value-based management models have followed, such as Economic Value Added (EVA), trademarked by Stern Stewart, which builds on Fruhan’s model by subtracting the cost of capital from operating profit.

These approaches are used in an attempt to identify the value drivers that influence profitability. For example, a value driver for a maker of computer chips might be error rates in chip manufacturing. The chip maker does not simply want to know that error rates and profits are linked; it wants to know what will drive down error rates most efficiently.

Human capital valuation should pick up where SVA and other value-based management approaches leave off. It must determine the specific workforce and human capital practices and policies that account for economic profit and shareholder return and then report measures that are specific to those drivers.

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The Spencer Stuart Human Capital Market Index

The Spencer Stuart Human Capital Market Index (HCMI) is unique in its melding of financial market and labor market considerations. Its goal is to establish the relative value of executive talent—one part of overall human capital—at any point in time and then track changes in that value.

The index has four components:

  • The number of executive jobs open relative to the number of unemployed executives; this is an indicator of the competitiveness of the labor market for executive talent.

  • The ratio of gross domestic product to the number of people in the workforce between the ages of 35 and 55; executive talent is located primarily in that age bracket.

  • The difference between the high and low stock prices divided by the average stock price as an indicator of company-specific volatility; the value of management is said to increase with volatility.

  • The ratio of market value to book value; this is an expression of the value of intangible human capital.

Changes in any of these components will change the overall index. For example, if there is a decline in the number of people in the workforce between the ages of 35 and 55, the value of executive talent will rise, all else being equal. The usefulness of the index would seem to lie in making statements about the changing value of a portion of a country’s human capital. Its application to individual companies, however, is unclear.

The Watson Wyatt Human Capital Index

This approach to intangibles converts the many human capital practices in an organization into a single number.[5] The resulting index does not address human capital attributes such as the number of employees in a certain age range; instead, its focus is on consolidating information about activities and programs. The data supporting the index come from a checklist-like survey that typically is completed by an individual in the human resources (HR) function.[6]

Bruce Pfau and Ira Kay have reported success in correlating responses to this survey with various financial measures of a company’s performance, including shareholder return.[7] According to those researchers, some practices, such as the use of broad-based stock options, are positive contributors to business performance. Others are destroyers of value, with developmental training (for future jobs) and 360-degree feedback being two examples. The index thus becomes a basis for making universal assertions about the right and wrong human capital practices for all companies, all workforces, and all times—a seductive approach because of its simplicity but one that all too often fails when applied to individual companies.

The Balanced Scorecard

The Balanced Scorecard developed by David Norton and Robert Kaplan has been an especially popular approach for discerning the leading activities, along with their respective measures, responsible for financial and customer outcomes. There have been many views of strategy over the years. Remember SWOT (strengths, weaknesses, opportunities, threats) in the 1960s, portfolio approaches in the 1970s, Porter’s model in the 1980s, and core competencies and strategic intent in the 1990s? The Balanced Scorecard does not contest those approaches but tries to focus on a few of their shortcomings and implementation practicalities.

Based on research conducted in the 1980s with a small group of companies, the Balanced Scorecard proposes that accounting measures are too narrow, too backward-looking, and too inclined to measure aggregated results. Norton and Kaplan suggest that other factors, ones that speak to the effectiveness and sustainability of systems, processes, and activities, should be included in any measurement system.[8]

Despite the popularity of this approach to measuring and managing, many attempts to implement the Balanced Scorecard have been unsuccessful. A key reason for those failures is the inability to determine which processes and innovation activities truly are linked to customer and financial outcomes. In the absence of clear linkages, Balanced Scorecard implementations often default to applying templates of “best practices,” a “bad practice” if there ever was one.

[1]Martin Fridson and Fernando Alvarez, Financial Statement Analysis, 3rd ed. New York: John Wiley & Sons, Inc., 2002, 29.

[2]The original thinking about human capital is captured in the following article and books:
• Jacob Mincer, “Investment in Human Capital and Personal Income Distribution,” Journal of Political Economy, 1958, 66(4): 281–301.
• Theodore Shultz, The Economic Value of Education. New York: Columbia University Press, 1963.
• Gary Becker, Human Capital: A Theoretical and Empirical Analysis with Special Reference to Education. New York: National Bureau of Economic Research, 1964.

[3]Interview with Baruch Lev by Juergen Daum. Posted at www.juergendaum. com/news/03_06_2002.htm. The full text of that interview can also be found in Juergen H. Daum, Intangible Assets and Value Creations. New York: John Wiley & Sons, 2002.

[4]Felix Barber, Jeff Kotzen, Eric Olsen, and Rainer Strack, “Quantifying Employee Contribution,” Shareholder Value Magazine, May–June 2002.

[5]Bruce Pfau and Ira Kay, The Human Capital Edge. New York: McGraw-Hill, 2002.

[6]The Watson Wyatt approach is consistent with a body of academic research in the 1990s that sought to link HR practices to various measures of economic productivity (e.g., sales per employee) and shareholder value. Some representative studies of this kind are:
• Ann P. Bartel, “Productivity Gains from the Implementation of Employee Training Programs,” Industrial Relations, 1994, 33: 411–425.
• Mark A. Huselid, “The Impact of Human Resource Management Practices on Turnover, Productivity, and Corporate Financial Performance,” Academy of Management Journal, 1995, 38: 635–672.
• Casey Ichniowski, K. Shaw, and G. Prennushi, “The Effect of Human Resource Management Practices on Productivity,” American Economic Review, 1997, 87: 291–313.

[7]Bruce Pfau and Ira Kay, The Human Capital Edge. New York: McGraw-Hill, 2002, xvii.

[8]Robert S. Kaplan and David P. Norton, “The Balanced Scorecard: Measures That Drive Performance,” Harvard Business Review, January–February 1992.




Play to Your Strengths(c) Managing Your Internal Labor Markets for Lasting Compe[.  .. ]ntage
Play to Your Strengths(c) Managing Your Internal Labor Markets for Lasting Compe[. .. ]ntage
ISBN: N/A
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Year: 2003
Pages: 134

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