Intangible Assets: an interview with Baruch Lev

WITH ALL THE SCRUTINY that public companies get these days, you would think there's little that isn't known about them. But that kind of knowledge may only scratch the surface of what composes corporations' true worth. Underneath all of the "hard" facts about plants and inventory and capital investment, some financial experts say, lies a mountain of soft data about such things as R&D, brands, patents and general know-how that traditional accounting methods don't capture.

The problem is that these so-called intangible assets -- which by some estimates could make up as much as 80 percent or more of a company's value -- have been so hard to measure that many companies, even if they realized their worth, have swept the matter under the rug.

They might not have that luxury much longer. Both the U.S. Securities and Exchange Commission (SEC) and Congress are looking into whether they should require companies to detail intangible assets more closely. That's needed, so the argument goes, to protect both investors and the companies. Investors are at risk because without knowing the impact of intangibles, a company might be overvalued and the stock wildly inflated. Companies are at risk from the other direction because they might otherwise be undervalued and find it more difficult than they should to attract capital.

It's an argument that Baruch Lev, a professor of accounting and finance at New York University's Stern School of Business and a true evangelist, has been making to anyone willing to listen. One of the most respected authorities on the issue, Lev has provided evidence to the SEC for its deliberations, and in July he testified before a Senate committee about the increasingly urgent need for companies to make fuller disclosure of intangibles.

Freelance Writer Heather Baukney recently spoke with Lev about the difficulties in identifying and measuring intangible assets, an issue that CIOs will increasingly have to grapple with as intangibles migrate into the IT realm.

CIO: How big is the gap between the actual value of companies and what their accounting systems show?

Lev: The market value of S&P 500 companies is more than six times what's on their books. This means that for every $6.50 or so of market value, only $1 appears on the books. It's extraordinary that the balance sheet number reflects only 15 percent or so of the value of these companies. And since this is the S&P 500, it includes about 80 percent of corporate America, a lot of financial institutions, low-tech, all the oil companies and retailers. This is not the new economy. And even if those who think that this market value is inflated are right, if you take 50 percent off the market capitalization, there is still a huge gap.

Investors have something to lose, of course, but they can protect themselves. It's really the companies themselves that are being hurt. When there are deficiencies in information, if investors don't know about intangibles, they are going to assume the worst. In capital markets, no news is bad news.

In this state of ignorance, investors assume managers are wasting money and price stock appropriately. This has a huge effect on investment and growth, not to mention on the compensation of employees who have stock and stock options. Being undervalued in the market means you'll have incredible difficulty raising money.

Intangible assets like patents, copyrights and R&D are not new contributions to the U.S. economy. Why are they now coonsidered such a large part of a company's value? In the past 15 to 20 years there's been a dramatic change in the business environment. Innovation is now a necessity because competition and globalization have [increased exponentially], and there's been widespread deregulation. Innovation was always important, but back then, you could innovate leisurely, comfortably and stay with that innovation for about 20 years.

But today, if you don't innovate and very quickly, then you are dead. And I'm not talking just about high-tech and the Internet. Intangibles are at the center of all innovation, and they come at the beginning of the process (ideas, discoveries), in the middle (patents) and, of course, at the end (distribution channels).

The life or death of corporations is now based on innovation, which has meant a huge growth in intangibles. They were always there, but they were not such a huge part of the life of business enterprises.

What's now considered an intangible asset?

I've been struggling with a definition for a long time. It's not easy because intangibles, or knowledge assets, are so different [from physical assets]. Some, such as patents and copyrights, are protected by legal rights, but many are unprotected, like general know-how.

The best that I have is a default definition that an asset, in general, is anything that promises future benefit, and that intellectual assets are not physical, like property, plant, equipment, and stocks and bonds. Intangibles are R&D, patents, trademarks, copyrights, brand names, employees and their training and, increasingly, ideas and processes.

Are there more kinds of intangibles than there used to be?

The old types, such as patents and copyrights, which have been around since the late 19th century and are still very strong, are intangibles that are associated with discovery. But the new type of intellectual assets, which are growing extremely fast, are what I call organizational capital, [which is] innovative designs and structure, and new ways of doing things that provide continuous competitive advantage.

Think about Wal-Mart's now-famous system in which its suppliers have direct access to its inventory. When you buy something there, the bar code is read, [and that purchase information] goes directly to Procter & Gamble, which is in charge of maintaining the inventory.

Wal-Mart got rid of inventory maintenance completely. And it has a market value which is substantially larger than its book value, yet it doesn't have any patents or trademarks. So where is this value added coming from? What is this huge asset that is there in addition to the stores and the inventory? It's these new types of intangibles, this new way of doing things and [the sustaining of] that advantage.

Another example is The Home Depot. I can still remember the first store I went into in Berkeley [Calif.]. It was dark and seemed dirty. It looked like a huge warehouse, a really shabby operation. I said to myself, "This will never fly." People don't want to shop in a place like this. But I wish I had bought stock at the time. Like Wal-Mart, Home Depot had an idea about how to do things differently, and it has maintained that advantage.

How well can intangibles be measured?

It's very difficult to value these assets. In contrast to financial and physical assets, intangibles are usually associated with a much higher level of uncertainty and risk. Organizational designs, for instance, can be wiped out in a matter of a week or two when someone comes up with a better idea, unlike commercial property, which cannot be wiped out even if the market is bad.

For example, a pharmaceutical company can invest hundreds of millions of dollars in a new drug and, if it fails clinical tests or doesn't get FDA approval and someone else comes along and develops it correctly, then it's sunk. But it's extremely rrare that if you invest in airplanes, you'll be completely wiped out. [This makes] any valuation, which is based on an estimate of future benefits, very difficult.

How, then, can companies begin to put a price on their intangibles?

While valuation in many cases is impossible to determine, providing data on lots of important things is possible. Take human capital. I'm not asking you to value it outright, but I would like to know what your retention rates and investment in employee training are, particularly compared to other companies. What's the big secret?

I don't expect companies to provide extensive information about the future, because I don't think they know. But some things they definitely know, like investment in training. I don't think revealing that would have any damaging effect. To the contrary, it could ultimately benefit the company for outsiders to know what investment is being made in employees. This ensures investors that the company understands the enormous value of human capital and is investing wisely in its own future.

Is any company disclosing the value of their intangibles in this way?

No one is doing this right now. But I just started working with two major companies, one a pharmaceutical company and the other a chemical company. I'm specifically tracing their knowledge capital and knowledge earnings to the drivers, which are investments in intangibles like R&D, advertising and information technology. The main thing these companies are interested in is how tracking and disclosing more information on their intangibles can benefit their business strategy.

How does information technology -- its management and a company's investment in it -- factor into valuing intangibles?

There is a story about a Buddhist monk who is sitting and clapping his hands and, looking at them, he asks, "Which one of the two is making the noise?" This is to say that valuation of information systems is particularly difficult because information technology is really intertwined with all other intangible and physical assets. It's almost impossible to determine their value specifically. But short of all-out valuation, you can come up with whole processes of continuous valuation that are doable.

CIOs in particular can contribute to designing systems that will track features of, for example, an intranet. How do you assess its value, its usefulness? IT, in particular, is well equipped to measure such things as extent of use, potential use and use patterns over time of this type of system.

If CIOs saw, for example, a decline in the number of people [using the intranet] or in the amount of time spent using it, this is something they can take to management. This is proof that investing in a certain intangible is either valuable or not. CIOs should develop tracking systems like this themselves or suggest these measures to other executives. It takes some imagination [to value these intangibles] and usually some time to talk to people, but it's definitely doable.

How soon can we expect to see changes in the disclosure of information about intangibles?

I've been pessimistic for the past three or four years, but in the past few months, I see signs of change from the Senate hearing and the SEC debate. I've seen signs from capital markets, and these are the most promising because when they start requiring more information, managers have no alternative than to start providing it.

I see clear signs from capital markets that people are realizing that these are, by far, the most important assets and that they need more information. I now have an alliance with a large money management fund whose mantra is investment in knowledge. So, clearly, they are going to require more information about intangibles and are very interested in knowledge capital management. While I hope I'm not too optimistic, I have seen concrete signs of change.

This story, "Intangible Assets: an interview with Baruch Lev" was originally published by CIO.

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