Business Valuations and the Intangible Information Gap

I was recently sent a copy of a new Statement on Management Accounting about Business Valuation (free but registration required) from the Institute of Management Accountants.

It’s a great overview of the process used to value businesses. None of the information in the paper was a surprise to me. I learned the basics of this process years ago when I was a high-risk lender.

But when I read the paper with my intangible capital hat on, I was struck by how much the accounting challenges of intangibles are limiting and, perhaps, distorting the work of valuation professionals. Here are a few thoughts:

Valuation Analysis

In the paper, company analysis is a first step in the valuation and includes SWOT, Historical financial analysis and normalization of financials. The paper does not mention the goodwill/intangible information gap that exists in just about every company’s financials today. But those of us in the intangibles community know that financials today hide a big problem. Corporate value is today, on average, roughly 70% intangible. That means that the net book value shown on the balance sheet only explains 30% of the value of a company. Data from E&Y for 2007 shows that 23% of the average corporate purchase price in an M&A situation is booked to identified intangibles like customer lists and technologies. That leaves 47% as goodwill. To me, this shows that accountants are creating a dangerous information gap because this goodwill represents real value and investment. This gap exists in all companies; it only becomes visible in M&A because of accounting norms.

Valuation professionals will be quick to counter that their work captures the essence of intangibles through their projection of the income statement. That, while the balance sheet may not describe intangibles, their effect is taken into account on the income statement. This is true to an extent, except that it ignores:

1. Because intangibles are not capitalized, they are expensed. So, for example, a lot of the money spent on implementing a new computer system along with the training of people to use it is shown as an operating expense. Macro level data from the Conference Board shows that the intangible/tangible split in U.S. corporate investments is 60/40 ($1.6 trillion intangible, $1.2 trillion tangible). Heavy investments in future intangibles capacity means that the income statement does not actually represent a true operating picture of the organization because it is mixing investments with operating revenues and costs.
2. Many of the intangible costs of an organization are embedded in SG&A rather than CoGS. This lack of clarity limits a user of the financial statement’s ability to understand what is really going on in the operations. So the projections of the financials may not represent an accurate representation of the future.
3. Lack of information about the intangible side of business (human capital readiness, health of key business relationships, quality of core processes, to name a few) limits the ability of an analyst to use past financials to project the future. Problems on the intangible side are often at the core of reputational crises that can drastically change the future earning capacity of a company.

Capital Asset Pricing Model (CAPM)

Once a set of projections are developed, the valuation process discounts that value of future cash flows using a discount rate. The theoretical foundation of the discount rate calculation is the CAPM. Basically, this approach enables the calculation of a weighted average cost of capital based on the relative use of different capital sources as a percentage of the balance sheet.

Although I have never seen an analysis of this, I cannot help wondering how the CAPM is distorted by the fact that the total value of the balance sheet may include up to 50% unbooked goodwill.  So if debt is $7 and equity is $3, equity would be 30% of the capitalization. But if there is unbooked goodwill, equity is $13 ($10 goodwill plus $3 equity) which is 65% of a $20 capitalization ($13 plus the $7 in debt). What would this do to the average valuation?
Finished Valuation

Of course, the ultimate value of a valuation is limited as a management tool if it ends up with a large goodwill component. This was very clear in a recent survey by the Hay Group on intangibles in M&A. In it, they found that executive typically value intangibles at about 30% (when the data tell us that intangibles make up 70%). To me, this means that the lack of accounting and valuation information about intangibles is coloring the ability of the executives to “see” the true value of their own and other companies.

What’s the answer here?

Well, this is one of the reasons we have written Intangible Capital and why we are expanding the IC Knowledge Center community. The answer involves developing a new understanding of intangibles across the business community. Two of the best places to start are in creating inventories of intangibles and then measurement systems for them (tracking intangibles investment is an important first step here). This will go a long way to filling in that enormous information gap. Hope you will join in the conversation about how to bridge this gap.