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The importance of leadership intangibles for valuation

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This post is excerpted with permission of the publisher, Berrett-Koehler, from “The Leadership Capital Index: Realizing the Market Value of Leadership” by Dave Ulrich. Copyright (c) 2015 by Dave Ulrich. This book is available at all bookstores and online booksellers.

Dave Ulrich is the Rensis Likert Professor of Business at the Ross School, University of Michigan, and a partner at the RBL Group.

In recent years, due to changes and uncertainty in markets, information, and globalization — and despite the constant attention reported in the preceding section — the financial data publicly reported by firms has not reflected their value accurately. Earnings reported in a variety of forms (net income, operating earnings, core earnings, and more) have become ever more suspect. As a result, efforts at firm valuation have turned from financial results toward a deeper understanding of the intangibles that influence these results.

Baruch Lev, an accounting professor who is a thought leader of the intangibles movement, has shown the importance of intangibles as indicated through market to book value — suggesting that for every $6 of market value, only $1 occurs on the balance sheet.This means that the balance-sheet number — which is what traditional accounting measures — represents only 10% to 15% of the value of these companies. This data shows that the value of many firms comes as much from perceived value as from hard assets. Firms like Coca-Cola and Gilead have high market value from brands and patents. Technology-based firms like Amazon and Google have high market value with relatively little in the way of cash flow, earnings, hard assets, or patents. And even traditional companies like 3M and IBM are increasing market value by focusing on brands, leveraging the Web, and restructuring. Professor Lev further recommends that managers learn to win investors over by finding ways to more clearly communicate intangibles with them.

Harvard professor Robert Eccles and his colleagues at Pricewaterhouse Coopers (PwC) call for a “value reporting revolution” by changing financial reports to include more intangible information. They find that only 19% of investors and 27% of analysts “found financial reports very useful in communicating the true value of companies.” They argue for changing the performance measurement game to better allocate capital and assess the true value of firms. In identifying better measures of firm performance, they focus on “key performance measures — both financial and non-financial, and how they relate to each other, that they are measured and reported on, and that they create real value.”

They propose a model they call “Value Reporting Disclosure” with enhanced business reporting where firms report information on business landscape (industry, technology trends, the political and regulatory environment, social, and environmental trends), strategy (mission, vision, goals, objectives, portfolio, governance), resources and processes (physical, social, organizational capital and key processes), as well as GAAP-based performance. By reporting these more intangible factors, they give investors better information for determining a firm’s true value. Analysts perceive the benefits of better disclosure when they help long-term investors have greater confidence in future earnings.

Accenture’s finance and performance management group also reports that intangibles are an increasingly important part of a firm’s value. Its classification of assets still includes monetary and financial assets, but also intangible assets of relationships, organization process, and human resources, and it proposes measures to track these intangible assets.

Ernst & Young’s Center for Business Innovation has also attempted to find out how investors use non-financial information in valuing firms. It concludes that non-financial criteria constitute, on average, 35% of an investor’s decision. Sell-side analysts use non-financial data, and the more non-financial measures analysts use, the more accurate their earnings forecasts prove to be.

Because of studies like those just cited,in recent years intangibles have received more attention as a source of value.Generally intangibles have been listed as intellectual capital or knowledge as evidenced in patents, trademarks, customer information, software codes, databases, business or strategy models, home-grown processes, and employee expertise.Investors have worked to classify lists of intangibles that include intellectual capital but are more expansive. Baruch Lev categorizes intangibles into R&D efforts (such as trademarks, patents, copyrights), brand value (such as image, reputation), structural assets (such as business systems, processes, and executive compensation, human resources), and monopoly position.

In our earlier work, Norm Smallwood and I synthesized the work on intangible value into four domains called the architecture for intangibles. We found that intangibles could be clustered into fourbroad categories — making and keeping promises, having a clear strategy for growth, managing core competencies, and building organization capabilities — all of which depend heavily on the behavior of leaders.

To elaborate:

  • Keeping promises comes when leaders build relationships of trust by doing what they say to employees inside and customers and investors outside, often measured as risk.
  • Creating a clear, compelling strategy comes when leaders have strategic capital to define the future and work with customers to deliver value through brand identity and reputation.
  • Aligning core competencies increases when leaders invest in R&D and the intellectual capital that comes from patents, copyrights, trademarks, and the like. Creating core competencies also comes when leaders access functional expertise in technology, manufacturing, and operations.
  • Building organization capabilities comes when leaders have the ability to create a corporate culture consistent with its mission, which could mean a culture of innovation, collaboration, efficiency, risk management, or information asymmetry.