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Grey Matters: CFO's Third Annual Knowledge Capital Scorecard

Valuing things like patents, R&D, and human capital may not be easy. But with intangible assets now driving corporate performance, assessing the investestment in those assets has become crucial.

1Apr

A corporate balance sheet, prepared according to generally accepted accounting principles, does a reasonable job informing about the physical assets and financial capital employed by a company. But when it comes to the increasingly important intangible assets of corporate enterprises, it provides next to no insight.


Under GAAP, expenditures made to increase brand awareness, to foster innovation, or to improve the productivity of employees cannot be capitalized. Instead, the logic goes, they must be expensed through the income statement, because the future benefits of such investments are so uncertain. The problem with that, says Baruch Lev, an accounting and finance professor at New York University, is that corporate investment in tangible assets has stagnated. "It's the investments in R&D, Internet applications, human resources, and customer acquisition that drive the performance of companies now. And there is no indication of the value of those investments in financial reports," he says.


The aim of CFO's third annual Knowledge Capital Scorecard, developed by Lev with the help of Marc Bothwell, a vice president and portfolio manager at Credit Suisse Asset Management, is to quantify those intangible values. On a more itemized basis, knowledge capital is intellectual and human capital, customer and supplier capital. It is the sum of all the intangible factors and qualities that enable a company to earn a better-than-average return on its GAAP-valued asset base. Thus, a company with a strong brand name gets better prices than its competitors. Those with effective R&D programs are better able to defend their markets and create new ones. And those with superior employee training garner a variety of productivity benefits.


This year's Scorecard, which ran the numbers for the leading companies ranked by knowledge capital in 22 nonfinancial industries, confirms the importance of such intangible assets. As was the case last year, companies with high levels of investment in R&D and advertising continued to show higher levels of knowledge earnings and far better stock performance than companies with lower levels of spending in those areas. Intel topped the list in 1999, with knowledge earnings of $9.5 billion. The semiconductor giant also came in with the highest level of knowledge capital--the present discounted value of all future knowledge earnings--at $209 billion, surpassing last year's leader, Microsoft, which saw its knowledge capital drop 10 percent, to $189 billion. Pharmaceuticals giant Pfizer posted the largest increase in knowledge earnings ($3 billion) for the year, due in large part to its acquisition of Warner-Lambert.


As the Scorecard shows, however, knowledge earnings and capital are relevant to more than just New Economy and pharmaceutical companies. Consider Ford Motor and General Motors. The book value of Ford as of its September 30, 2000, 10Q filing was $18.3 billion, compared with $31.5 billion for GM. Ford posted knowledge earnings of $6.7 billion, more than 50 percent higher than GM's $4.3 billion. This comparison suggests that Ford is doing a much better job managing the intangible drivers of value in the motor vehicles business. "Knowledge capital is not just a New Economy metric," says Lev. "It indicates a company's profitability, both historical and anticipated, above an expected rate of return on physical and financial assets."


This year's results also indicate the value of incorporating knowledge capital into investment analysis. For example, the Scorecard shows that the market valuations of such New Economy stars as Dell Computer, Microsoft, and Intel, as well as knowledge-intensive companies in the pharmaceutical and biotech industries, have very little to do with the assets reflected on their balance sheets. Their stocks trade at huge multiples of book value (examples: Dell, 17.5; Pfizer, 18.2). But when knowledge capital is added to book value (a sum deemed comprehensive value by Lev), the ratio of market value to that comprehensive value becomes far more reasonable: Dell, 1.26; Pfizer, 1.90.


Companies with a ratio of market value to comprehensive value significantly above 1 can be viewed as overvalued. Those with a ratio below 1 are probably undervalued. The negative correlation between this ratio and the subsequent stock returns of the 105 companies evaluated in the Scorecard was remarkably strong. Between the August 31, 2000, cutoff date for the Scorecard analysis and the end of last year, the average weighted return of 53 companies with a ratio of market value to comprehensive value below the median of 1.08 was 7 percent. For the 52 companies with a ratio above the median, the average return was -15.5 percent.


Companies with some of the highest ratios, such as Broadcom (8.5) and Siebel Systems (5.8), have since experienced some of the most severe slides in the stock market. Broadcom is down 80 percent since last August, and Siebel is down 60 percent. In contrast, companies trading at low multiples of comprehensive value fared far better. The shares of Rockwell International, for example, with a ratio of 0.62, and Georgia Pacific (0.35) were both up 15 percent over the same period.


"We compared it with other metrics, and this was a particularly strong result," says Bothwell. "If a stock looked overvalued according to our metric, the market realigned it." Giving further credence to the argument that intangible assets and knowledge capital are the real drivers of value in corporate enterprises.



BUILDING A BETTER SCORECARD


WHAT ARE KNOWLEDGE EARNINGS and knowledge capital? New York University accounting and finance professor Baruch Lev's methodology for computing these values begins with an estimate of a company's "normalized earnings." That figure is derived from the average of three years of historical core earnings, and three years of consensus analyst estimates as compiled by IBES International. Thus, knowledge earnings reflect both past performance and future growth potential.


These normalized earnings are then compared with the expected rates of return on the company's physical and financial assets as recorded on its balance sheet. In the competitive global marketplace, physical and financial assets have largely become commodities. The expected aftertax returns used in the broad cross-sectional Scorecard are 7 percent for physical assets and 4.5 percent for financial assets. In company- specific measurements, physical and financial assets are adjusted to fair values, and their expected returns are adjusted to company circumstances.


The portion of normalized earnings for any given year that exceeds the expected returns on book assets represents knowledge earnings--the performance contribution attributable to the intangible assets of a company. Knowledge capital is then computed as the present discounted value of all future knowledge earnings. Without a widely accepted expected rate of return for knowledge assets, the average 10.5 percent historical aftertax return of three knowledge-rich industries (software, biotechnology, and pharmaceuticals) is used as the discount rate.







ACROSS THE BOARDS



From aerospace & defense to telecom equipment, industry rankings of median knowledge-capital earnings.

IndustryKnowl. Capital ($ millions)Knowl Earnings '99 ($ millions)Change in Knowl. Earnings '98-'99 ($ millions)Knowl. Capital / Book ValueMarket Value / Book ValueMarket Value / Compre- hensive ValueMarket Value 8/31/00 ($ millions)
Aerospace & Defense23,4471,417653.581.8.5011,407
Airlines7,949399222.121.00.555,496
Biotech4,393171405.1816.33.0713,940
Chemicals9,948632423.082.20.757,746
Computer Hardware49,8572,4903896.6917.51.85202,719
Computer Software38,9081,7822795.6815.22.4048,465
Electrical7,690450293.703.60.756,081
Electric Utilities10,3516911771.112.10.9919,418
Food / Beverages18,5651,306677.489.11.0827,007
Forest Products8,8848542850.871.580.8110,322
Home Products19,2961,0971098.106.61.1129,257
Industrial23,1321,1661133.653.30.8116,922
Media16,7596461190.942.71.4082,396
Motor Vehicles13,413962973.501.90.469,205
Newspapers5,619336443.773.20.676,594
Oil24,5592,2105851.713.41.2755,150
Pharmaceuticals75,2244,2956218.4412.21.34116,073
Retail15,4068851152.893.81.5218,486
Semiconductors42,0291,8591,0516.2312.62.0889,911
Specialty Retail10,320512842.628.01.7717,154
Telecom81,2214,8516603.263.51.00118,288
Telecom Equip.26,9471,6846153.257.71.7896,184


THE SCOPE OF KNOWLEDGE

How knowledge capital compares at the top companies.






IndustryKnowl. Capital ($ millions)Knowl Earnings '99 ($ millions)Change in Knowl. Earnings '98-'99 ($ millions)Knowl. Capital / Book ValueMarket Value / Book ValueMarket Value / Compre- hensive ValueMarket Value 8/31/00 ($ millions)
AEROSPACE & DEFENSE
Honeywell Int'l33,8392,1572353.603.30.7130,891
Lockheed Martin27,3581,417-3334.201.80.3411,407
Boeing23,4471,5906141.903.81.3046,270
Northrop Grumman15,901894654.501.50.285,440
Raytheon8,356800-5950.800.90.509,457
AIRLINES
Delta Airlines10,792709-152.101.20.386,071
AMR9,230425-1741.400.7.314,920
Southwest Airlines6,668374682.203.71.1711,280
U.S. Airways3,42025160NMNM0.722,280
BIOTECH
Amgen20,7861,0411366.022.43.2077,958
Medimmune4,409124366.124.33.4417,651
Biogen4,377219444.410.21.9010,229
Chiron1,50880170.85.42.959,863
CHEMICALS
DuPont49,0852,543233.73.50.7546,779
Dow Chemical29,0911,8447483.22.00.4717,761
PPG Industries9,948632633.12.20.537,045
Air Prods & Chems6,245379422.42.90.877,746
Rohm & Haas4,656280-291.31.80.776,356
COMPUTER HARDWARE
IBM128,1866,5972126.712.11.58232,413
Dell Computer83,5192,49054712.917.51.26113,251
Hewlett - Packard49,8572,598-3403.48.21.85119,385
EMC45,9581,5693896.932.24.06213,677
Sun Microsystems44,5601,8494706.127.73.91202,719
COMPUTER SOFTWARE
Microsoft188,7878,5262,4064.68.91.60368,819
Oracle54,3042,3149048.439.44.19254,509
Computer Associates39,9081,7822795.72.70.4118,763
Veritas Software16,9881761435.315.12.4048,465
Siebel Systems6,180176536.945.65.7640,715
ELECTRIC UTILITIES
AES28,4866911977.17.30.9029,119
Duke Energy15,3809342111.62.91.1027,531
Southern10,3518471771.12.10.9919,418
FPL Group5,385391670.91.70.859,488
Dominion Res3,358418770.51.81.2212,604
ELECTRICAL
Emerson Elec.24,7171,4261303.94.50.9128,273
Rockwell Int'l.9,431536163.52.80.627,534
Cooper Industries5,950363273.31.80.433,292
American Pwr Conversion4,311199324.34.60.874,629
FOOD/ BEVERAGES
Coca-Cola67,1653,4843947.314.21.71130,326
PepsiCo50,4802,334677.59.11.0861,593
H.J. Heinz18,5651,0648511.48.10.6513,223
Unilever18,3901,306363.04.41.1027,007
Campbell Soup13,0228354795.181.30.8511,140
FOREST PRODUCTS
Kimberly- Clark25,3081,5792014.55.61.0231,514
International Paper11,3691,1038410.91.20.6315,361
Georgia Pacific8,8848543692.21.10.354,568
Weyerhaeuser5,7625722850.81.50.8110,322
Williamette Industries1,044221690.51.51.013,331
HOME PRODUCTS
Procter & Gamble63,4503,8821435.26.61.0780,719
Gillette26,1451,34312411.013.31.1131,590
Colgate- Palmolive19,2961,09710911.817.81.4029,257
Clorox8,151502964.54.70.868,517
Avon Products7,67545524NMNM1.279,304
INDUSTRIAL
Tyco International56,1842,9706403.76.31.3496,177
United Technologies25,8561,5644383.43.90.8729,231
Caterpillar23,1321,166544.22.30.4412,705
Illinois Tool Works15,8009571133.13.30.8116,922
Ingersoll- Rand14,453819774.52.30.427,340
MEDIA
Walt Disney53,0122,126592.23.51.0782,396
Viacom16,7596461880.32.11.55102,113
Clear Channel Comm.9,5364471190.92.71.4027,518
MOTOR VEHICLES
Ford Motor90,3386,6851,6803.72.10.4450,951
General Motors55,0264,2572821.91.30.4638,758
Delphi Automotive Sys13,413962973.82.60.549,205
Johnson Controls8,573480743.51.90.424,589
Paccar4,159306-41.91.50.513,246
NEWSPAPERS
Gannett17,7331,0871373.83.20.6714,928
Tribune10,3885021401.71.70.6610,999
New York Times5,619336444.24.90.956,594
Knight Ridder4,921329123.02.50.634,127
Dow Jones3,562210106.610.11.335,467
OIL
Exxon Mobil114,3478,5448781.74.21.57284,382
Royal Dutch Petroleum27,2583,8185850.83.72.10131,204
Chevron24,5592,2101,0261.32.91.2755,150
Phillips Petroleum8,6978771981.73.11.1415,756
Unocal8,453376423.43.30.748,106
PHARMACEUTICALS
Pfizer128,6105,7963,0178.618.21.90273,069
Merck109,2176,5839028.612.61.32160,694
Johnson & Johnson76,4464,3366994.37.11.35127,891
Bristol Myers Squibb74,0024,2544248.311.71.26104,255
Pharmacia55,3732,1935434.76.51.1375,998
Eli Lilly48,1632,6413288.715.01.5482,453
RETAIL
Wal-Mart Stores81,2394,8671,1672.97.51.94211,872
Sears Roebuck23,4571,4211153.61.70.3610,697
Target15,4068851282.63.50.9820,999
Costco6,006349401.53.81.5215,404
Kohls5,504250502.99.82.5018,486
SEMICONDUCTORS
Intel208,6419,5022,7495.713.72.05502,711
Applied Materials44,6671,8561,0907.311.41.3870,011
Texas Instruments39,3901,8601,0123.18.72.11109,810
Broadcam5,704137386.865.88.4855,509
SPECIALTY RETAIL
Home Depot48,8492,2306213.58.01.77111,287
Lowes10,9625671712.13.31.0617,154
CVS10,320512842.63.71.0214,504
Walgreen9,243510732.38.22.5033,231
Radioshack4,552271606.315.22.0810,962
TELECOM
Verizon Communications114,4646,4621,2773.33.50.80118,573
SBC Communications113,6186,9032,7304.05.01.00141,514
AT&T81,2214,851-2220.71.10.62118,288
Bellsouth53,8123,5686603.34.31.0070,185
Worldcom23,2771,772300.41.91.35104,734
TELECOM EQUIPMENT
Cisco Systems162,2184,9102,4346.118.52.60489,845
Lucent Technologies62,8243,2203152.45.31.57139,633
Motorola26,9471,6841,0161.33.71.6278,639
Owens Corning24,7868672103.312.62.9796,184
Qualcomm19,3176721923.37.71.7844,610


NM = Not meaningful
The various measures of knowledge earnings included in this survey were designed by Prof. Baruch Lev, who retains the exclusive rights to the measures. These knowledge-based measures should not be used in any form without the written permission of Professor Lev. Marc Bothwell, vice president and portfolio manager at Credit Suisse Asset Management, contributed to the development of the measures and performed the required programming and computations. Professor Lev has a patent pending on these measures. For more information, see http://www.baruch-lev.com/.

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