INTELLECTUAL CAPITAL: Measure up or lose out

The recent experience of companies listed on the London Stock Exchange, not to mention those on Nasdaq, shows how modern investors value much more than simply bricks and mortar. We have entered – in no uncertain terms – the age of intellectual capital.

As a result, companies are now trying to analyse their intellectual capital (IC) and the role it plays in determining business performance. The big question is: could IC prove to be the key driver of future shareholder value? Moreover, could intellectual capital boost performance in companies that have traditionally looked on themselves as bricks and mortar organisations? And what impact would managing their intellectual assets proactively have on their shareholder value?

To find the answers, research organisation Policy Publications, in association with the University of Luton and Financial Director, carried out an in-depth study of how intellectual capital is managed and measured in 51 companies. The results are published in a new report entitled Managing Intellectual Capital to Grow Shareholder Value (see panel, page 48).

Companies in the study were promised anonymity in return for their cooperation and frankness, and information was collected via their finance directors. They include a leading brewery, a multinational insurer, one of the biggest names in the food industry, a respected name in the automotive industry, a large hotel chain, one of the world’s major logistics companies and one of Britain’s most famous football clubs. Most major manufacturing and service industries were represented. The companies surveyed divided into two roughly equal groups. The first group – called the intellectual capital leaders – expect the value contributed by intellectual capital to their business to grow substantially or significantly over the next five years. Among IC leaders, 56% of annual revenue is already contributed by intellectual capital. The second group – the IC laggards – expect the intellectual capital contribution to grow only slightly, stay about the same or even decline. Among IC laggards, 40% of revenue is currently contributed by intellectual capital.

Throughout, the report compares the performance of both groups in managing over 20 different kinds of intellectual capital, ranging from patents to customer information, and looks at a wide range of management and measurement issues. As a result, a series of critical success factors emerge.

In order to maximise returns from intellectual capital, its performance must be quantified. So, how did the companies in the study claim to measure the financial performance of their IC? Based on the responses of all companies, good old-fashioned profit is the most common method – 53% of all companies said they measured the performance of IC by monitoring profit (figure 1, page 46). Direct sales revenue was the second most popular method, and licence/royalty income was the third most common metric. Future cash-flow impact and return on investment were equally popular. The balanced scorecard approach is used by just 10% of the companies, and shareholder value added by just 8%.

Drilling down into the figures, the study reveals differences in approach between the IC leaders and the laggards. IC leaders are more active measurers of performance – more leaders than laggards use every option for measurement in figure 1. Direct sales revenue and profit emerged as joint favourites among the IC leaders – both metrics were named by 60% of this group as methods for measuring the financial performance of intellectual capital. However, just 23% of IC laggards said they used direct sales revenue to measure performance, and only 46% used profit. Similarly, while 44% of IC leaders said they used licence/royalty income to measure performance of IC, just 27% of laggards did so. And while 36% of IC leaders used future cash-flow impact as a performance measure, just 15% of the laggards followed suit.

These findings clearly show that the IC leaders are more active in measuring the performance of their intellectual capital assets and are, therefore, supplying themselves with appropriate management information. Without such data, decisions concerning the exploitation of intellectual capital become a matter of guesswork. Even so, it is notable that there is relatively little use of the more sophisticated measurement methodologies, such as the balanced scorecard and shareholder value added, even among IC leaders.

Simple methods, such as direct sales revenue and profit, have much more support and are far more widely used. The reasons for this are not clear. It may be that companies, even IC leaders, are unconvinced by more complex measures, or do not have the time or inclination to introduce them. However, concern over complexity should not be considered an appropriate reason for postponing their consideration. Implementing measures such as SVA need not be a complex process, as the experience of some survey respondents shows. And, once in place, the measure can have unexpected benefits.

If companies can gain advantages from measuring the performance of their intellectual capital assets, they can also benefit from valuing them. So what methods are the companies in this survey using to value intellectual capital? In fact, one-third of companies in the study use none of eight possible methods of valuing IC, and more than half make no mention of the contribution of IC to shareholder value in the balance sheet or annual report. The most popular method for valuing intellectual capital was discounted cash-flow earnings – 28% of all companies said they used this method (figure 2). IC leaders were more likely to use it – 32% of them said they used DCF earnings to value intellectual property, compared to just 19% of IC laggards.

There was less disparity between the two groups in their use of return on investment – just under 24% of companies said they used this method, divided almost equally between IC leaders and laggards. Given the accepted importance of brands, it was surprising that just 18% of all companies said they used brand contribution to value their intellectual capital. Again, more IC leaders than laggards did so – 20% compared to 15.4%.

In general – and not surprisingly – IC laggards turned out to be poor measurers of intellectual capital value. IC leaders, although more consistent measurers, could also improve their performance. Establishing and monitoring the value of intellectual capital assets is likely to become an increasingly important activity for all companies because those figures provide the only way to assess the impact of management decisions.

In addition, a thorough knowledge of the value of these assets can provide a valuable addition to the corporate armoury when fending off a takeover. A management team that can prove to its owners where the drivers of its growth lie – and show how intellectual capital contributes to its market valuation – stands a much improved chance of defeating a hostile bid. Alternatively, the knowledgeable management team stands a good chance of driving up the acquisition price if it can justify why the business should be more highly valued because of assets that aren’t traditionally pulled onto the balance sheet.

Given that monitoring and valuing intellectual capital assets ought to be a more significant activity for companies, it is worth looking at some of the methods available:

The balanced scorecard: first described by Kaplan and Norton in 1992, this is a tool for providing balanced information about corporate performance. Its theoretical basis is that financial data alone cannot provide the information needed by management to take appropriate business decisions. The balanced scorecard therefore includes measures that monitor performance in at least four areas – financial, customer, internal business processes, and learning and growth, which can be tailored to meet individual business needs. By using a balanced scorecard, an organisation can seek to align strategic objectives with targets, track performance and compare the performance of different business units.

Economic value added: the EVA concept was developed by global consulting firm Stern Stewart as a framework that organisations can use in a number of ways to provide a consistent approach to setting goals and measuring performance, to communicate with investors, evaluate strategies, allocate capital, value acquisitions and determine incentive bonuses. EVA aims to provide an estimate of economic profit, which is essentially net operating profit less a charge for the opportunity cost of capital invested in the business. It provides an estimate of the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders or lenders could get by investing, at a similar risk level, elsewhere.

The Skandia navigator: a form of balanced scorecard developed in 1993 and based on a theory of knowledge capital created by Karl Erik Sveiby in 1988. It identifies customer capital, structural capital and human capital. Key indicators used include, for instance, numbers of lost customers, administrative costs per employee, personnel turnover and an employee satisfaction index.

The intangible assets monitor: developed by Karl Erik Sveiby in 1994, the intangible assets monitor has some similarities to Kaplan and Norton’s balanced scorecard, although the two were developed independently. Sveiby considers intellectual capital and knowledge management as twin concepts – defining knowledge management as the art of creating value from an organisation’s intangible assets. The intangible assets monitor offers both a method for measuring intangible assets and a format for displaying relevant performance indicators.

The intellectual capital index: The IC index was developed by industrial professor Goran Roos of Monash Mt. Eliza Business School and Helsinki School of Economics; and professor Johan Roos of IMD. Goran Roos is chairman of Intellectual Capital Services, which applies the approach with client companies. The index provides companies with a way to monitor whether they are using their physical and intellectual assets to create value. It also provides a framework for assessing the trade-offs between usages of different assets and the flows between them.

Irrespective of which method a company uses to measure its intellectual capital, there are a number of actions that FDs ought to be taking to make sure their business is up to speed. First, they should review current performance measures and consider whether they are the most appropriate. Next, they should assess current valuation techniques.

If the management team does not understand the true value of its intellectual assets, it should initiate plans to provide this information. It should also look for quick wins, and do the obvious before launching into advanced techniques. Whatever measurements of performance or value are selected, it should be ensured they are appropriate to the business in question and really do provide useful information. Then, the management team should consider what gaps there are in management information. If it is not already doing so, it should consider whether any of the approaches listed above could provide enhanced management information.

Finally, the team should review the nature and strategic purpose of the business. Stepping back from day-to-day detail to take a strategic review of the fundamentals – in order to discover how their company creates value – can throw up insights on how to improve performance. But, through all of this, the management shouldn’t overlook the company’s traditional assets. It is the interplay of intellectual and physical assets that ultimately creates value in an organisation.

Next month, Sarah Perrin moves on to look at how, once you can measure it, you can get the most of out what your organisation knows.Return to the Financial Director website