Chapter 11: The Investor s Perspective

Overview

Investors’ confidence has been shaken, and calls for transparent and complete corporate accounting are growing louder. In this atmosphere is it not borderline irresponsible for a corporation to fail to disclose information about the performance of what is usually its largest annual investment, its expenditures on human capital? That is exactly what most corporations do today.

The performance of a firm’s investments in human capital must surely affect that firm’s value. Investments in tangible assets such as equipment, land, buildings, inventory, and cash have always played a role in firm valuations. Rules and standards guide the calculation of tangible asset values at any point in time. As Accounting 101 teaches, calculating the value of tangible assets begins with historical cost: the price at which each asset was acquired. That value then is adjusted through depreciation to reflect loss of value through use or obsolescence. The firm’s balance sheet rolls up the value of all its assets and, after reducing it by liabilities, provides us a proxy of its worth: its book value. Information on the firm’s income statement provides a basis for assessing how well the company has used its tangible assets to produce revenues and profits.

However, something remains unexplained by this accounting. What an acquirer pays for a corporation almost always exceeds that corporation’s book value, as does the market value of its shares. What explains this disparity?

The gap between book value and marketplace price is substantial and has grown over the years. Is this value expansion simply a function of “irrational exuberance” on the part of investors? One way to check is to determine whether the market-to-book gap closed in the wake of the American stock market collapse. Our assessment, based on valuations at year-end 2002, indicated that S&P500 companies still command a market-to-book premium of over three times book value. Although this is below the four to six times book value seen at the end of the 1990s, the gap between tangible asset value and market value remains appreciable.

What is the source of this discrepancy? Why do accounting measures fail to reflect the ways investors appraise corporate value? What is missing? The answer is intangible assets. Although their values are not reflected in corporate balance sheets, investors recognize and are willing to pay for those assets.