Facing the Facts: You are already spending a lot of money on intangibles

November 19, 2010 by  

We can say with great confidence that you are already spending a lot of money on intangibles. How do we know? Academics have been looking at the question for quite awhile. Here are places they have looked:

Macroeconomic Data

Leonard Nakamura at the Philadelphia Federal Reserve used a number of approaches to arrive at some basic estimates of our national investment in intangibles. He actually made three calculations based on different sets of data to zero in on his estimates: expenditures, labor inputs, and corporate operating margins. The expenditure data focused on three types of investments for which data is available: research and development (R&D), advertising and software. For labor inputs, he looked at the “proportion of labor income going to workers whose occupations are creative—engineers, scientists, writers, artists, etc.” Nakamura then looked at the change in the proportion of cost of goods sold versus operating margins.

In Lev and Hand’s book Intangible Assets, he used these three numbers to triangulate an estimate that in the year 2000, investment in intangibles by American corporations was roughly $1 trillion. Assuming a useful life of intangibles of five to six years, he concluded that the equilibrium value of intangibles was roughly $5 – 6 trillion, roughly one third of the total valuation of U.S. corporations. This is a conservative estimate; Nakamura is quick to point out that there are many kinds of expenditures that were not included in his calculations due to lack of data.  Papers by Corrado, Hulten, and Sichel also came up with a $1 trillion number for 1999 which, they pointed out was about the same amount as investment in tangible assets. BusinessWeek recently reported on an update of the Corrado study still in process that will show $1.6 trillion in intangible investment in 2007, well in exces of the $1.2 trillion invested in tangibles that year.

The Stock Market

Another kind of data that gets used a lot to “quantify” intangibles is the valuation of public companies. The reason is the curious phenomenon that started in the late 1970s when the total stock market valuation of American corporations began to diverge in a big way from their tangible book value. Until the 1970’s, these two numbers (total corporate value and tangible book value) tracked each other pretty closely. This was logical because, as we have stated before, that industrial era business was dependent on what a company owned, which would be capitalized on its balance sheet. As computers and information technology enjoyed greater use, companies were able to create value for their customers that wasn’t associated with physical assets. This fact is the whole point of the knowledge factory discussion in the first section of this book.

In recent years, this intangible or off-balance sheet amount (the difference between total corporate value and tangible book value) ranged from roughly half to three quarters of the total stock market valuation of public companies. That means that up to 75% of the value of a company can not be associated with tangible productive assets. This is a very graphic way of illustrating the extent of the intangibles information gap. However, it can get confusing if you use this gap as a market “valuation” of intangibles. What does it mean when the market goes down—that all the loss in value is attributable to intangibles?

So comparing net book value of the company on the balance sheet value to total corporate value in the stock market does not give you any kind of hard data that you want to hang your hat on. But the fact remains that there is a big amount of corporate value that cannot be linked to underlying tangible assets. Businesspeople for the most part just ignore this gap.

Data from Mergers and Acquisitions

But no one can ignore the gap when there is a merger or an acquisition. This is the moment when traditional accounting and the reality of the knowledge economy come head to head. A good illustration of the extent of this gap was an Ernst & Young survey of 709 transactions in 2007 showed that on average, only 30% of the purchase price could be allocated to tangible assets. Another 23% of the price could be allocated to identifiable intangible assets such as brands, customer contracts, and technology. That left a whopping 47% in goodwill. Bottom line, this means that 70% of the average deal was intangible.

The huge goodwill is an indicator of the failure of the accounting system to provide helpful information on intangibles. Many would submit that it is, rather, just an indication that companies are overpaying. There is no data to refute this directly. However, the stock market still leaves a large intangible value. And we have seen that there has also been significant investment in intangibles. So there is some level of intangible value that is justified. We just cannot say exactly how much.

Given the information gap in the average company, it is not really that surprising that when two companies combine, the average merger fails to deliver the results expected at the closing of the deal. If you cannot even identify what you are buying going into the deal, how can you do a good job managing it after the deal closes? No one asks this question because the dilemma faced by merging companies is exactly like that faced by all companies—they have absolutely no idea what they have for intangibles….

Which begs the question, if organizations are spending so much money to build their intangible infrastructure, why don’t they even know what they have and what the total cost was? The information is there for the taking. Current accounting standards are confusing people to the point that they are ignoring their most important resource: their knowledge. Knowledge is a different kind of asset than a “tangible” asset. But it is an asset nevertheless. And one not to be ignored.

Adapted from Intangible Capital: Putting Knowledge to Work in the 21st Century Organization by Mary Adams and Michael Oleksak.

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