definition of intellectual capital:spidi2.iimb.ac.in/~networth/ccs/2005/589 ccs... · web...
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Introduction
Definition of Intangibles Assets1:It broadly means invisible assets that include employee competence, internal
structure and external structure.
The International Accounting standards Board defines an intangible asset as “an
identifiable non-monetary asset without physical substance held for use in the
production or supply of goods or services, for rental to others, or for
administrative purposes”
According to this definition, an item can be recognized as an intangible
asset if it meets the definition and it is probable that the future economic
benefits will float to the enterprise. Otherwise, the item is to be treated as
an expense.
As a result many intangible resources cannot be recognized on the
Balance Sheet
Another common term in accounting is goodwill. Goodwill is defined as the excess of the cost of an acquired company over the sum of identifiable net assets
Nowadays the most important factors of production are the intangible assets.
These intangible assets include staff skills, strategic and process quality,
software, patents, brands, supplier and customer relationships etc. They are the
highest contributor to corporate competitiveness.
1 Daniel Andriessen, Making sense of Intellectual Capital-Designing a method for the valuation of Intangibles, Elsevier Butterworth-Heinemann, 2004
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Levels of IntangiblesBlair and Wallman (2001) have defined three levels of intangibles2:
Level 1: These intangibles can be owned and sold. For example, patents,
copyrights, brands and trademarks.
Level 2: These intangibles can be controlled but not separated out and sold. For
example R & D in process, business secrets, reputational capital, proprietary
management systems and business processes.
Level 3: These intangibles may not be wholly controlled by the firm, for example,
human resources, organizational capital and relationship capital.
2 Daniel Andriessen, Making sense of Intellectual Capital-Designing a method for the valuation of Intangibles, Elsevier Butterworth-Heinemann, 2004
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The Current Scenario3
Nowadays the most important factors of production in developed economies are
invisible. These intangible assets –
Patents Staff skills
Software Strategic and Process Quality
Brands Supplier and Customer Relationship
are delivering a fast-growing contribution to corporate competitiveness. And
massive investment is being made in these assets: in the figure below, Leonard
Nakamura from the Federal Reserve Bank of Philadelphia puts the total for the
USA in 2004 at USD one trillion, equivalent to about 9% of US GDP and fast
approaching capital expenditure on tangibles.
Source: L. Nakamura, Federal Reserve Bank of Philadelphia - 2005
As the figure below shows (Expensive Names), even in the classical
manufacturing sector, land, real property and machinery are becoming less
important relative to intangible assets. But it is with “R&D-intensive Producers”
and “Knowledge-Intensive Service Providers” where the intangibles play a really
prominent part. Together in 2006, they made up an average of one-third of
macroeconomic output in the G6 and the EU-15. Figure below shows that the
3 Deutsche Bank Research, October 19, 2005
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International trade in patents and licenses is also growing apace which provides
more scope for market-based valuation.
Sources: Interbrand, Business Week, Bloomberg 2005
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Brisk Trade in Intangibles4
a) Income from and b) Expenditure on patents and licenses
b) in international payments in % of GDP
Sources: IMF Research 2005
In short, the oft-heralded knowledge society is very much a reality. One might be
tempted to believe that this would be reflected in the valuation of companies and
their projects; that their creditworthiness and attractiveness as an investment
would rest in large and an increasing measure on the analysis of their
intangibles. Unfortunately, ground-realities are wide off this mark. At present,
intangible assets enter into company ratings – if on any notable scale at all – on
a generally unsystematic basis, accorded rather superficial treatment and
virtually impossible to compare. Inevitably, therefore, many companies’
performance is under- or overestimated. The consequence is misallocation on
the capital market and ultimately passed-up growth. Therefore in our study, we
examine methods for more intensive analysis of intangible assets, outlining
obstacles and showing how financial services providers and their clients can
secure a competitive lead.
4 Deutsche Bank Research, October 19, 2005
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Stepmotherly Treatment5
In a survey of fund managers, private equity investors, venture capitalists and
bank analysts dating from 2001, almost 90% of survey respondents considered a
company’s intellectual property an important factor in their investment
assessment. So what is the contention? In the same study 70% of respondents
felt convinced that the market lacked reliable tools to value intellectual property
effectively. 56% even stated that the value of intellectual property could not be
measured at all, leaving them no alternative but to rely on a subjective, inevitably
unrelated assessment hardly consistent with their own estimation of the
significance of intellectual property in valuing a company.
Value Intangibles!6
Intangible capital can and must be valued – Owners and Valuers alike will benefit
The reality is that we are living in the knowledge society. Yet even now intangible
capital, from employee training to brands, is scarcely valued systematically at all.
That is an unhealthy sign: The cost of capital has steadily increased to very high
levels for the knowledge-intensive companies. Investors and lenders are missing
out on potential earnings and the economy on potential growth. A lack of suitable
methods is perceived as the key obstacle to more extensive valuation. However,
on closer inspection we observe:
Promising valuation models do already exist 7
Various methods of Non-Monetary and Monetary Valuation (which by no means
is necessary) of intangible assets are already available – and some of them
tested in practice. We offer an overview to set of 25 methods from the field of
Intangible Valuation.
5 Deutsche Bank Research, October 19, 20056 Deutsche Bank Research, October 19, 20057 Deutsche Bank Research, October 19, 2005
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These methods can optimize investment and lending8
Each has its specific strong points, and each area of application have certain
requirements in particular. The methods available can, some as stand-alones
and some in combination, crucially improve the information base in many
valuation situations, from internal resource planning through lending to M&A.
Companies should (be allowed to) report more on intangibles 9
Restrictive accounting rules, fear of divulging secrets and the absence of a
common language are major impediments while reporting on intangibles.
Cautious opening-up of mandatory reporting requirements and the development
of voluntary reporting would be needed to improve the level of knowledge
presented to the capital market.
Takers and providers of capital alike can secure themselves a tangible
competitive edge with more systematic measurement of intangible capital. For
this they need experience and, most importantly, a close relationship with one
another. This can be built up only slowly – often in the course of new business
processes. Those who start capitalizing early would have an added source of
competitive advantage. The early bird catches the worm.
Still a long way to go!Bitter are the roots of knowledge, but its fruit is sweet - Marcus P. Cato, 234-149 BC
Tangible benefits from knowing about intangibles
Clearly investors and lenders stand to gain a lot from more systematic valuation
of intangible capital. But companies themselves often lack information about the
returns on investments in intangible assets. Companies are missing an important
element of the image they wish to portray -
8 Deutsche Bank Research, October 19, 20059 Deutsche Bank Research, October 19, 2005
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To investors, lenders and public sponsors - Leading to inordinately high
costs of capital for knowledge-intensive service providers and R&D-
intensive good manufacturers in particular
To Customers – To whom innovation or cost leadership should be
communicated more transparently
To Labor Market – It is often receptive to a company’s “soft values”
From a welfare point of view more systematic valuation of intangible assets
should lead to more growth:
Companies aware of the value of their IP can better trade these assets or
licences
Capital would be channeled more reliably to its most efficient uses. This
would enable a better access to equity and dept for fledgling, knowledge-
intensive companies – a pivotal innovation driver.
Improved information on intangible assets would render capital markets
less volatile, and investors and companies would have more faith in them.
This, in turn, could increase the investment in equities.
Given that more appropriate valuation requires better corporate reporting
on intangible assets, so information asymmetry between wholesale and
retail investors could be partially alleviated. From the point of view of big
investors, some of whom are already extremely well informed, this would
admittedly have less appeal, but in terms of perceived fairness on the
capital market as a whole – and hence its efficiency – it would presumably
be beneficial.
But the contribution of these assets is not reflected in the valuation of the
companies. This is due to the fact that it is very difficult to measure and value
these intangibles.
Difficulty in Measurement of Intangibles10:
10 Daniel Andriessen, Making sense of Intellectual Capital-Designing a method for the valuation of Intangibles, Elsevier Butterworth-Heinemann, 2004
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The intangibles of different companies include intangible resources that are all
very different by nature. Some are intellectual or knowledge assets and some are
not.
The unique characteristics of intangibles mean that it is impossible to fit them into
the transaction based accounting system. (Webber, 2000)
As a result they are given only a very superficial treatment. This results into a
lack of transparency of intangibles which makes it very difficult for companies
that lack tangibles assets to raise money from investors or banks as the banks
are biased against lending to companies with few tangible assets. This lack of
transparency also leads to undervaluation of companies that are intangible
intensive.
Not all Plain Sailing11
Given the advantages to all concerned, what is preventing greater recognition of
intangible capital in corporate valuation?
First, companies say too little about their intangible assets…
…because of the shackles imposed on them by accounting regulations.
Without the appropriate information from within a company, an outsider is
unable to analyze its intangible assets.
…because they do not want to divulge any competitive advantages.
…because there is still no generally received vocabulary for intangibles.
Even if companies were prepared to publish more information on
intangibles, in many cases there is still no common language.
Second, valuers and the capital market are out of their depth…
…because it is often virtually impossible to compare intangibles. The
value of a tangible good becomes apparent when it is sold. Staff skills and
11 Deutsche Bank Research, October 19, 2005
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organizational processes unfold their value only in the context of a specific
company.
…because intangibles are often particularly risky.
…because they lack knowledge of valuation methods. What is more,
varying methods are suited to different fields of application.
…because the capital market still lacks faith.
Thus the Method Knowledge is the pivotal driver for the promoting the trend of
Intangible Capital Valuation
Why Classification of Intellectual capital is difficult?12
Mouritsen et al. (2000c) have said that the classification of intellectual capital is
difficult:
Mainly because the categories are interrelated and even integral to each
other. People(human capital) work through technology (structural capital)
and customers (relational capital) get services from people (human
capital)
Also, because the same indicator can sometimes fall into two categories
at the same time. For example, employee training in technology may fall
under human capital or structural capital. It is in fact this synergy between
intangibles that creates uniqueness and wealth, not the individual
resources.
Another problem is that when the same classification scheme is used for
different companies, every company starts to look the same. While this
similarity helps in benchmarking, it is a hindrance when it comes to
making strategic management decisions on how to improve or sustain
company success.12 Daniel Andriessen, Making sense of Intellectual Capital-Designing a method for the valuation of Intangibles, Elsevier Butterworth-Heinemann, 2004
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Finally, classification does not provide any guidelines for handling issues
or solving problems.
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Valuation
Approaches to valuation13:
There are three main approaches to financial valuation:
1) Cost approach
2) Market approach
3) Income approach
1) The cost approach: It is based on the economic principles of substitution
and price equilibrium. These principles assert that an investor will pay no
more for an investment than the cost to obtain an investment of equal
utility. The problem with the cost approach is that in many cases cost is
not a good indication of value. However, this methods is appropriate to
value intangible resources when setting transfer prices, royalty rates etc
2) The Market approach: It is based on the economic principles of
competition and equilibrium. These principles assert that in a free and
unrestricted market, supply and demand factors will drive the price of any
good to a point of equilibrium. However, when the subject resources are
unique, this approach is not appropriate.
3) The Income approach: It is based on the economic principle of
anticipation. The value of intangible resources is the current value of the
expected economic income generated by these resources.
A standard critique of valuation models, in general, and discounted cash flow
models in particular is that they fail to fully account for the many intangible assets
possessed by firms. There have been attempts to value brand name, trade
13 Daniel Andriessen, Making sense of Intellectual Capital-Designing a method for the valuation of Intangibles, Elsevier Butterworth-Heinemann, 2004
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marks and copyrights and bring them on to the balance sheet. Other intangible
assets include patents and customer lists. We would expand this list to consider
the flexibility that a firm may preserve to expand its market or enter new markets.
Company Valuation - Categorizing Methods14
On critical examination, the method of estimating a company’s intangible assets
already in common use – determining goodwill, i.e. the difference between the
market and book value – does not appear very suitable, as is immediately
apparent from the often high volatility of this indicator owing to market
fluctuations. That hardly makes it an appropriate means of modeling values such
as staff skills, process knowledge and customer relations, which tend to develop
slowly over time. Intangible asset valuation models less widespread at present
than goodwill can be categorized according to various criteria:
Objective - Is a company seeking a loan? Are there plans to invest in the
company? Is it up for sale?
Granularity - Are individual intangibles (e.g. specific patents or bundles of
patents), knowledge-intensive projects, business divisions including their
intangible assets, or entire companies being valued?
Perspective - Does the company’s management value its intangible
assets itself, or are they valued by an external player (a lender, a private
equity or venture capital company, a fund manager, rating agency or
private investor)?
Measure - Does the analysis set out to deliver a monetary value? Or is a
non-monetary indicator, but one which still permits comparisons, sufficient
as a value metric (e.g. an industry benchmark)? Or are pure-play
statistical readings without a measure of value (e.g. the average number
of hours’ training per employee and year) adequate?
14 Daniel Andriessen, Making sense of Intellectual Capital-Designing a method for the valuation of Intangibles, Elsevier Butterworth-Heinemann, 2004
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The latter distinction is particularly important. Whether monetary valuation is
necessary, or an alternative value metric will suffice, depends on the valuation
objective. However, a model merely recording purely statistical measurements is
of only very limited use. Who can judge, without a standard metric to go by,
whether a certain number of hours’ training is sufficient? Yet in a recent
comparative study12 nine of the 25 methods examined delivered measurements
only without a benchmark – among them the best-known, the “Skandia
Navigator” developed by insurers.
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Method Modules for the valuation of intangible capital…15
15 Deutsche Bank Research, October 19, 2005
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Literature on the other methods for the valuation of intangibles16:
Many authors state many different methods of valuation of intangibles. We have
studied 25 methods used in the measurement or valuation of the intangibles.
These 25 methods address a wide variety of problems.
1. Problems involved in improving internal management
2. Problems involved in improving external reporting
3. Reasons to analyze the value of intangible resources-statutory or
transactional
The issue of improving internal management is a wide one and various
problem definitions fall into these categories:
a) How to measure the intangible resources as only what gets measured,
gets managed.
b) How to improve the management of intangible resources.
c) How to create resource based strategies.
d) How to monitor effects from actions
e) How to translate business strategy into action.
f) How to weigh possible courses of action
g) How to measure income in a reliable way
h) How to enhance the management of the business as a whole
The second issue is of improving external reporting. The basic premise is
that improving disclosures makes the capital allocation process more efficient
and reduces the average cost of capital. The various problem definitions
categories are:
16 Daniel Andriessen, Making sense of Intellectual Capital-Designing a method for the valuation of Intangibles, Elsevier Butterworth-Heinemann, 2004
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a) Closing the value gap between book and market value
b) Improving information to stakeholders about the real value and the future
performance of the enterprise
c) Reducing information asymmetry
d) Increasing the ability to raise capital
e) Enhancing corporate reputation and affecting stock price
The third issue is of Statutory and Transactional reasons for valuing intangible resources. Statutory provision, administrative ruling or regulatory
authority can mandate a valuation. Alternatively, valuation an be discretionary in
the case of a transaction.
Some other noteworthy points in these 25 methods are:
1) Twelve methods are financial valuation methods that use money as the
denominator of value. The other 15 do not use money
2) Nine methods do not use values, norms or other yardsticks and hence are
not considered valuation methods. They are merely measurement
methods.
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Methods used for Valuation and Measurement of Intangibles17
Exhibit 1 provides a summarized review of the following 25 methods. Exhibit 2 provides different frameworks in which a prospective firm can match its
parameters to those in framework and arrive at a suitable Intangible Valuation or
Measurement Technique that can help further its Accounting/Business
Strategy/Monetizing of intangibles.
1. Balanced Scorecard (BSC)18
This is a measurement method used to measure tangibles like skills,
competencies and motivation of employees, innovation in product and
services etc.
The use of this method helps the company to track financial results
and at the same time acquire the strategic skills necessary for the
future growth.
17 Daniel Andriessen, Making sense of Intellectual Capital-Designing a method for the valuation of Intangibles, Elsevier Butterworth-Heinemann, 200418 http://images.google.com/images?sourceid=navclient&ie=UTF-8&rls=RNWE,RNWE:2005-34,RNWE:en&q=Balance%20scorecard&sa=N&tab=wi
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Intangible assets
Intellectual capital
The BSC looks at four perspectives: the customer perspective, the
internal perspective, the innovation and learning perspective and the
financial perspective. These four perspectives are used to create a
strategy map which illustrates the path by which improvements in the
capabilities of intangibles assets are translated into tangible customer
and financial outcomes.
The BSC consists of 20 to 25 measures grouped under each
perspective. All these measure should be measurable, reflect the
outputs, must be something that can be influenced by the people
responsible and more importantly must have a specific target attached.
However, the score card does not measure the size or value of the
intangibles.
2. Calculated intangible value
It is a financial valuation method used to help new knowledge intensive
businesses acquire loans. Since the knowledge intensive companies
have few tangible assets as collateral, the method assumes that the
premium on a company’s value is a result of its intangible assets.
Publicly available accounting information is used to calculate a
premium return on assets on tangible assets. This is compared to the
industry’s average ROA. The industry ROA is multiplied by the value of
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Patents
the company’s intangibles. The present value of this premium is found
by using a discount rate.
However, the method doesn’t reflect the value of the intangibles that
contribute to normal earnings.
Also, if the intangible value for a company that performs below industry
average is calculated then it shows a negative value. This would
indicate a negative value of its intangibles which cannot be true.
Another limitation is the problem of finding the right benchmark.
The calculated Intangible value method is an elegant method that uses publicly
available accounting information to calculate a premium on tangible assets. It can
be used for benchmarking to show whether an organization is fading or whether
it has value not reflected in the balance sheet (Luthy, 1998). It can show traders
when they may be a buying opportunity (Stewart, 1997).
3. Citation-Weighted patents
The method assumes patents as a proxy for inventive output and
patent citations as a proxy for knowledge flows or knowledge impact.
The citation of a particular patent in other patent information provides
information about the size of the technological “footprint” of the cited
patents.
The method combines both these assumptions to construct a citation-
weighted patent index, in which the number of patents a firm has is
weighted by the number of citations.
According to the method citations-weighted patents are more highly
correlated with market value of the patents themselves, because of the
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high valuation placed on firms that hold highly cited patents. An
increase of one citation per patent is associated with a 3% increase in
market value.
This method is used to value the portfolio of patents. But it is limited to
patents and is meaningful only when compared with other companies.
The other limitation is that it is easy to manipulate as a company can
influence the number of self-citations. Also, the time taken to grant the
patent and the time before it is cited are both too long.
The citation-weighted patent method is not meant to improve management but to
explain market value. However, the correlation found between the index and
market value can help to improve company performance. The method can
indicate the value of a portfolio of patents. Companies can benchmark a citation-
weighted portfolio against competitors and use this information to make
investment decisions. Furthermore, Hall et al. (2001) show that patents with more
than 20 cites has a strong impact on market value. This information can help
management to identify individual patents with high values.
4. Economic Value Added
EVA is a financial evaluation method.
However, there is only an indirect link between EVA and the value of
intangible resources.
It has never been the intention of the EVA method to measure the value of
intangible resources. Yet, EVA is on many lists of intellectual capital
measurement methods (Bontis, 2001; Bontis et al., 1999; Sveiby, 2002; Van den
Berg, 2003). However, EVA is not a stock but a flow indicator. It therefore cannot
be a measure of the value of intangible resources. At the most, it indicates the
added value of a resource. But whether it measure the added value of intangible
resources is debatable.
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Intellectual Capital
HumanCapital
Relational Capital
Organizational Capital
5. Holistic Value Approach
It is a combination of Intellectual Capital Index method and Inclusive
Value Methodology.
Intellectual Capital is divided into human capital, organizational capital
and relational capital.
Measurement of intellectual capital is in two forms. Intellectual capital
stock is like a traditional balance sheet. It provides a snapshot in time
but doesn’t explain the causes of change in value. Intellectual capital
flow statement is like a profit and loss statement which provides
information on the transformation from one intellectual capital category
to another. When stock is used, value is created. However, value
created is different for each category of stakeholder.
But the major limitation of this method is that each stakeholder has a
different and a very subjective definition of value which cannot be
combined.
Roos was the first to acknowledge that there are two fundamentally different
perspectives in creating an intangible resources valuation system:
1. The logical-positivist perspective: value should be measured as
objectively as possible
2. The axiologist perspective: value is always subjective and should
be treated as such
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Human Resources
Human Assets
The HVA is based on this axiologist perspective. The approach models the
mental maps of stakeholders of a company (for example, a management team, a
group of shareholders, environmental pressure groups, or public opinion).
Information derived from these stakeholders is translated into a model about how
these stakeholders is translated into a model about how these stakeholders
believe value is created within the company.
6. Human Resource Accounting
Human Resource Accounting is based on the assumption that people
are valuable organizational resource.
Human resource value models can be monetary, non monetary or a
combination of both. A number of monetary models calculate the value
of future wages and models that allocate a portion of discounted future
earnings to human resources. Non monetary models use indicators to
measure aspects of human resource.
However, this method focuses only on human resources and not other
intangibles.
Also, it has been accused of “putting a price on people” and is not
widely acceptable.
HRA is in many respects the predecessor of the intellectual capital movement. Of
course HRA focuses on human resources only whereas intellectual capital
focuses on other intangibles as well. But their aim seems to be the same. This
aim is well phrased by Sackman et al. (1989): “Specifically, it can contribute to an
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Intellectual Capital
Market assets
Human centered
assets
Infra-structure
assets
Intellectual property
assets
organizational culture in which the belief that people (or intangible resources) are
valuable organizational resources is actually manifested in managerial decisions
and actions”
7. Intellectual Capital Audit
This method defines intellectual capital as “the combined intangible
assets, which enable the company to function” and divided IC into four
categories-market assets, human-centred assets, infrastructure assets
and intellectual property.
The method aims to put a financial value on every asset and
recommends the use of either a cost or a market or an income
approach.
The method identifies the company’s intangibles and determines the
optimal state of the set of aspects for each asset. Each aspect of each
asset is audited and the current state of each aspect is compared with
the target value and is indexed on a scale from 0 to 5, 5 being the
optimal state. The scores are plotted on a target board (similar to a
dart board) with the size of dots reflecting the importance of the assets.
The target provides a comprehensive view of the strengths and
weaknesses of all intangible resources.
24
However, the method to put a financial value on these intangibles is
very generic and not very practical.
Brooking’s (1996) intellectual capital audit is one of the very few well-
documented methods to audit various types of intangible resources. She
describes 30 ways to audit various aspects of intangibles and provides 158
questions touching on a range of issues (Van den Berg, 2003). Each aspect is in
fact an indicator of some kind. The audit is a value measurement approach
because the method includes yardsticks for the optimal state of each aspect of
each asset. The intellectual capital audit target provides a comprehensive
overview of the strengths and weaknesses of all intangible resources.
8. Intellectual Capital Index
The method breaks intellectual capital into human capital (comprising
of competence, attitude and intellectual agility) and structural capital
(comprising of relationships, organization, renewal and development).
Intellectual Capital
Human Capital Structural Capital
Competence
Intellectual agility
Attitude Relationships
Organization
Renewal and development
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Intellectual Capital
HumanCapital
Relational Capital
Organizational Capital
The method suggests a creation of a list of non financial indicators and
the identification of the key success factors which are vital for the
success of a company’s strategy. The next step is to identify the
indicators which reflect these key success factors. And then the
selected indicators by focus area are grouped together. All these
indicators are consolidated into one index using weights. This
intellectual capital index is then correlated with the market value.
The changes in the market value are reflected in the changes in the
index.
However, the method is not very useful as the company doesn’t know
what went wrong and the data is not useful for decision making.
The authors of the intellectual capital-index clearly learned from their pioneering
work on the first-generation of intellectual capital models. They try to avoid the
pitfall of coming up with long lists of meaningless indicators. Their solution is
based on a critical selection of indicators, rooted in the company’s strategy, and
the combination of indicators into one single index.
9. Inclusive Value Methodology
This method divides intellectual capital into human capital,
organizational and relational capital.
The method is based on the axiology that value is measurable with
respect to a well defined context.
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Intellectual Capital
Employee competence
External Structure
Internal Structure
A well defined objective of the stakeholder in the form of yardsticks is
used to measure value. These objectives are then translated into
attributes that can be measured. Different measurements are
combined into one measure and normalized to get a number between
zero and one.
Also, a mathematical model is used to stimulate various alternative
management actions. The simulation must provide output performance
measures as well as cost/revenue data. Then the output performance
measures are used as inputs to calculate the overall combine
intangible value. All financial data are processed separately.
The Inclusive Value Methodology has contributed to the intellectual capital field
by introducing elements of measurement theory and applying them to
multidimensional intellectual capital measurement. M’Pherson and Pike (2001ab)
have made the field aware of the many functional requirements for proper
measurement, thereby uncovering some bad practices.
10. Intangible Asset Monitor
This method is used to help manage knowledge-intensive companies.
Intangibles are divided into Employee competence, internal structure
and External structure. Measurement is a means to focus managers on
intangible assets and to allow them to monitor their assets.
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Intangible assets
Innovation-related
Intangibles
Organizational Intangibles
Human Resource
Intangibles
The method consists of a three by three matrix. For each type of
intangible assets, there should be indicators of growth and renewal,
efficiency and stability. Management should select one or two indictors
for each cell.
It is useful for both internal management and external reporting.
However, because the indicators are company specific, in most cases
the only comparison available will be previous years.
The intangible asset monitor is a comprehensive framework that allows for
customization. One of its strong points is that it focuses on risks and
sustainability, as did the work of the Konrad group. Also important is the
emphasis on comparison to make the indicators meaningful. However, because
the indicators are company specific, in most cases the only comparison available
will be previous years.
11. Intangibles Scoreboard
It is a financial valuation method to value intangibles. Intangibles are
divided into innovation related intangibles, human resource tangibles
and organizational intangibles.
The method focuses on the problem of financial reporting of these
intangibles. A complete lack of transparency in the financial statements
leads to information asymmetry between the general public and those
28
who have access to information on investments and returns regarding
intangibles.
The method is a top down approach to estimate the financial value of
the intangible capital of a firm based on publicly available data.
First the company’s annual normalized earnings are estimated. Then
using the expected rates of return on tangible and financial assets the
earnings linked to these assets are calculated. Subtracting them from
normalized earnings results in IDEs (Intangibles-driven earnings). The
series of IDEs over three future periods based a three-stage valuation
model is forecast. Then a discount rate is used that reflects the above
average risk of these earnings to calculate the present value of these
earnings: the value of intangibles).
However, this method has its limitations. It calculates a fair return on
the tangible and financial resources used. But this may not be the
same as the contribution of these resources to earnings.
Lev’s drive to create a new, meaningful measures based on publicly available
data has added tremendously to the field. He is a well-respected member of the
accounting community and his comments and findings have helped to create
awareness about the problem of traditional reporting. His analysis of the causes
and consequences of the problem are very insightful. They provide clear starting
points for improvement.
The intangibles scoreboard is based on the idea that tangible, financial, and
intangible resources produce earnings. IDEs are the residual after a fair return for
tangible and financial capital has been subtracted. This is common practice in
financial valuation literature, for example, Reilly and Schweihs (1999).
29
Intellectual Capital
HumanCapital
Relational Capital
Structural Capital
12. Intellectual Capital Benchmarking System
This method is a value assessment method. Intellectual capital is
divided into human capital, structural capital and relational capital.
The method focuses mainly on the knowing the causes that produce
the competitive gap between the company and the international market
leaders in the same business activity in order to increase the
company’s competitiveness.
For this a general model of business excellence is used to identify
factors to benchmark. From this general model specific models are
created for the specific business units of a company. These models
include criteria for excellent performance.
From these models, a set of questions is developed to measure
whether these criteria apply to the company under investigation and to
the world class competitor.
The criteria are measured on a scale from -5 to +, indicating whether
the company is doing worse or better than a competitor. An overall
reliability index of assessment is constructed. The results are
presented in the form of a balance sheet with assets including all the
factors on which the company is doing better than the competitor and
the liabilities side including where it is worse off.
30
Intellectual Capital
Structural Capital
Human Capital
Market Capital
Innovation Capital
These factors are weighted and added, creating a weighted average.
This weighted average is used for benchmarking.
However, a weakness of this method is the dependency solely on the
judgement of an assessor.
Viedma is a pioneer in the field of benchmarking intellectual capital. In addition,
he is one of the first to use the concept of core competency as a unit of analysis
for intellectual capital. He has done ground-breaking work in operationalzing
normative models of excellent performance. His methods are methods for the
value assessment of intellectual capital using the world-class competitor as a
yardstick. The competitor functions as the yardstick on a 10-point scale. A weak
point is that the method depends solely on the judgment of an assessor, as does
the weighing of the various factors.
13. Intellectual Capital Dynamic Value
This method divides intellectual capital into four components: structural
capital, human capital, market capital and innovation capital.
Four perspectives of analyzing, reporting and managing intangibles are
identified: the input perspective, the output perspective, the internal-
managerial perspective and the external perspective.
31
Knowledge
Employees Customers Processes Technology
The approach is based on indicators in three areas-performance
indicators for purposes, processes and outputs.
These are combined into an overall index of performance. This overall
index is multiplied with by the market value of the company to calculate
the dynamic value of the intangible capital of the company.
The market value is then divided into three components- structural
capital, human capital and market capital.
However, it is not clear what the indicators stand for, the interpretation
of the overall indicator and why it is multiplied with the market value.
A more detailed description of the intellectual capital dynamic value approach is
needed to determine the strengths and weaknesses of the method. However a
few weaknesses can be mentioned. From the paper (Bounfour, 2002), it is not
clear the exact problem the method tries to solve. It is unclear what the indicators
stand for, how they are combined, and whether this meets the requirements for
proper multidimensional value measurement. Bounfour (2002) does not explain
how the overall indicator should be interpreted and why it is multiplied by the
market value.
14. Intellectual Capital Statement
Intellectual capital statements do not represent the size and the value
of the knowledge of the firm. But the purpose is to track the
32
Intangible Assets
management activities that are put to work to organize the knowledge
resources of the firm.
It consists of three elements-the knowledge narrative, the management
challenge and a set of indicators called an intellectual capital
accounting system.
There are four types of resources in a firm-employees, customers,
processes and technology. The accounting system consists of
indicators for each type of resource.
The complete intellectual capital management is a combination of
narratives, indicators and sketches.
However, the method does not solve the yardstick problem.
Mouritsen et al. have taken the concept of intellectual capital measurement and
reporting a step forward. Building on the Scandinavian tradition and reporting a
step forward. Building on the Scandinavian tradition and experiences in
intellectual capital measurement, they have created focus and have produced a
very practical method for reporting intangibles. An important step forward is the
way they focus the performance of resources. This focus not only clarifies the
purpose of the intellectual capital statement but also makes the statements
action oriented. The result of creating the statement is a practical management
agenda of issues.
15. iValuing Factor
This financial valuation method uses iValuing factor to create decision
risk ranges.
33
This decision risk range establishes the potential downside risk and
upside benefit of a decision with regards to that intangible. The
iValuing factor is determined by taking the ratio of the book value to the
share price. This ratio is used to determine a market value risk
associated with a specific management decision.
However, the method has many weaknesses and doesn’t explain how
the calculation of the iValuaing factor should influence management
decisions.
The iValuing factor contains a number of weak points. It is based on comparing
the difference between book value and market value. However, from the article
( Standfield, 2001) it remains unclear why this difference is a predictor for the
impact of a management decision on share price. In addition, Stanfield does not
explain how the calculation of the iValuing factor should influence management
decisions.
16.Konrad Group
Know-how Capital
Individual Capital Structural Capital
Formal Education
Social competence
Acquired experience and skills
Personal attitude
Problem solving ability
Customer Capital
34
This is a measurement method focussing on companies selling know-
how services like Consultancy
Such a company has two types of capital – Traditional Financial
Capital and Know-How Capital. The know-how capital consists of
Individual and Structural Capital.
The Individual Capital would be linked to the education, skills,
experience and social competence. The Structural Capital would be
linked to the people’s attitude, problem-solving ability and position with
its customer
Key Concern – Lack of information on personnel and so do not know
how to report their operations to an external shareholder
Solution – A list of 35 indicators to be reported by know-how
companies in categories of HR indicator, Value-Add per employee,
Business and Financial Stability
The Swedish Konrad group was one of the first to search for other forms of
capital besides traditional financial and tangible capital, and to introduce the
concept of structural capital. Their set of distinctions is not as sophisticated as,
for example, the one used by Edvinsson and Malone (1997). Their use of the
term structural capital is much broader than Edvisson and Malone’s (1997)
definition of structural capital, but at the same time it is more ambiguous. There
seems to be an over-lap between the concept of individual and structural capital,
because experience and skills fall in the individual category whereas attitudes fall
in the structural capital category.
17.Market-to-Book Ratio
Popular literature has stated market-to-book ratio as quick, easy and
reasonable indicator of Intellectual Capital (IC)
35
Market Value
Book Value
Market Value is most probable price for the company in a competitive
market whereas Book Value is the accumulation of accounting entries and
adjustments over the lifetime of the company
Simple Calculation of Intangible Value as the difference of Market & Book
Values
The above formula has been deemed to present a false value since all
resources of company combine and interact with each other i.e., Market
Value (MV) = Book Value (BV) + Intellectual Capital (IC) does not have
separable variables. Also the residual is result of MV and BV is result of
IC, brand, reputation and competitive position.
The residual also depends on the accounting policies and suffers from
book value being at historical costs
Andriessen (2002) states that subtracting market value and book value is not a
good method to calculate the value of intangibles because it is like comparing
apples and oranges. Book value is the reported stockholder’s equity (less the
liquidating value of any preferred shares), which represents the difference
between assets and liabilities, both of which are most often valued at historical
costs. Market value is equal to the perceived present value of the future cash
flow of the company.
36
Options
18.Options Approach
A refined approach to the income approach
Option Theory uses the analogy with financial options to calculate the
value of an investment opportunity. So this may be used as an
improved version of DCF valuation
Traditional DCF involves the comparison of NPV of expected cash flow
and expenditure. With OT, the investment decision can be deferred;
opportunity cost of alternate investment needs to be included in the
irreversible investments.
Used in case of investment option or deferral scope for the investment
Option theory is an interesting method to overcome some of the shortcomings of
the traditional DCF method. It can only be used when there is a decision to be
made regarding an investment. Under these circumstances, it can help to
improve decision making about investments in intangible resources. If there is no
investment option or the investment decision can no longer be deferred, then the
conventional NPV and the option value are identical.
37
19.Skandia Navigator
The Skandia Value Scheme and the Skandia Navigator are two models for
highlighting and describing the evolution of intellectual capital within Skandia.
These models visualize the value components that make up intellectual capital
as well as the method of managing them and reporting on their development.
Customer Capital
Customer capital is the present value of customer relationships. Customer capital
is refined and transformed into financial value through interaction with human
capital and organizational capital, as illustrated in the Value Creation model
below
Customer BaseThe Skandia group’s customer base today consists of nearly 8 million customer
relationships, including life assurance relationships. A geographical breakdown of
these relationships is shown in the pie chart below.
38
Customer Relationships
For Skandia a customer is not a temporary contact, but an investment in a
mutual value-creating relationship. A customer relationship therefore can be seen
as part of the value-creating organization’s potential for earnings, success and
evolution.
Customer Potential
The mutual creation of value through the interaction of company and customer
can be described as customer success. To an increasing degree this success is
influenced by developments in information technology. This is leading to new
types of relationships, often in networks and without geographical confines.
A Measurement Method for Intellectual Capital
Human Capital + Structural Capital = IC; here instead of sum, product
could also be taken to indicate the synergies
Structural Capital is from Customer Capital and Organizational
(Innovation + Process) Capital
39
Focussing on long-term future of Company, the Skandia Navigator
provides a 3-D compass for charting a course tomorrow as well as a
map of yesterday
Probably the most cited example of IC capital measurement. But the 160
Skandia Indicators show where you are, instead of showing where you
need to go. Also these indicators are not clearly divided amongst cause or
effect sides, making diagnosis of situation quite difficult
Edvinsson’s work has been by no doubt the biggest contribution to the field of
intellectual capital measurement. The Skandia navigator is probably the most
widely cited example of an intellectual capital measurement method. The method
has added significantly to the general awareness about the importance of
intangible resources and the shortcomings of traditional reporting. Edvinsson and
Malone (1997) admit that the navigator “is but the first systematic attempt to
uncover these factors and to establish the key indicators for establishing their
metrics”. However, they claim, “the Skandia Navigator has already proven to be
so effective that it will likely to be the basis for most future (intellectual capital)
navigation tools”. Edvinsson tries to solve a broad range of problems: the internal
management of intellectual capital, the external reporting to stakeholders, and
problems concerning the wealth of nations. He has found that the concept of the
navigator can be translated from the corporate to the national environment.
40
20.Sullivan’s Work
IC = Human Capital + Intellectual Assets
Now Intellectual Assets = Structural Intangible Assets + Intangible Assets
that can be commercialized. So second term of commercialization is a
process called value extraction
Uses value measurements of intellectual capital to improve decision
making – for e.g. the decision of investing further in developing an
intangible, to continue holding it or to sell it.
Thus emphasizes on the relative nature of value – “The value of an item
depends primarily on the needs of the person or organization that will be
using it”
A method for determining a purchase price for an acquired company. This
price should reflect the value that the acquired intellectual assets of this
company will bring for the buyer
Intellectual Capital
Human Capital Intellectual Assets
Intangible assets that can be commercialized
Structural intangible assets
41
Intangible assets
CopyrightsPatents, propriety know-how and technology
Service marksTrademarks
Computer Software
Complimentary intangible assets
Assembled workforceCulture and managementCustomer listsEtc.
Sullivan (1998a) made an important contribution to the intellectual capital field by
emphasizing the relative nature of value. “The value of an item depends primarily
on the needs of the person or organization that will be using it”. The value of an
intangible strongly depends on a company’s vision and strategy. Sullivan does
not provide a practical method for valuing intangibles. His approaches do not
provide a practical method for valuing intangibles. His approaches do not provide
a practical problems associated with a DCF method. The two approaches he
proposes draw heavily on the notion that Market Value = Tangible Assets +
Intellectual Capital. In the Market-to-Book ratio method we can see that this is
automatically not the case.
21.Technology Factor
Consists of two parts – first is the calculation of the NPV of the
incremental business using income approach. Second is the estimation of
a technology factor between 0 to 100% that approximates how much of
the total incremental cash flow can be attributed to the specific technology
The technology factor is based on a qualitative assessment by a
multidisciplinary team of experts which looks at the utility and competitive
advantage issues
There are number of issues listed in the above two categories and each
issue is assessed using -, 0, or + for their impact on value creation
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Market Value Replacement Costs
Technology Factor does not calculate which part of the cash flow can be
attributed to the technology
The technology factor method is a straightforward income approach to valuation.
The method separates elements of the income approach and incorporates them
into one technology factor. In theory, this factor calculates the part of the NPV
that can be attributed to the specific technology. As such, it tries to solve the
problem of income funneling and income allocation.
22.Tobin’s Q
Tobin’s Q is the ratio between the market value of an asset and its
replacement cost where the latter contemplates the cost to recreate the
utility of the subject asset
It is a measure to predict the whether capital investments would increase
or decrease. If as asset’s Q is less than one, a new investment in a similar
asset is not profitable.
Q happens to be a measure of “monopoly rent” as it manifests the power
of IC – you and your competitor presumably have similar fixed assets, but
one of you has something uniquely of its own – IC
Suffers from problems similar as Market-to-Book Ratio but it does
neutralize the depreciation policies of companies
43
CostsEconomic
IncomeMarket Value
ReproductionCosts
ReplacementCosts
The use of Tobin’s Q as a measure of intellectual capital is based on the same
assumptions as the use of the market-to-book ratio. The advantage of Q is that it
neutralizes the depreciation policies of companies because it uses replacement
costs instead of book value. However, the other problems associated with the
market-to-book ration as a measure of intellectual capital also apply to Tobin Q.
23.Valuation Approaches
Cost Approach which is based upon the economic principles of
substitution and price equilibrium. But in many cases cost is not a good
indicator of value
Market Approach is based on the economic principles of competition and
equilibrium. Applicable only when comparables are being transacted
Income Approach is based on the economic principle of anticipation. Best
approach but requires many assumptions on income projection, income
funnelling, income allocation, useful life estimation, and income
capitalization. The drawback is that it assumes non-deferrable investment
which is allowed in Options Theory
The problem with the cost approach is that in many cases cost is not a good
indication of value. Many of the important factors that drive value are not
reflected in the cost approach.
44
Capital Employed Intellectual Capital
Physical Capital
Financial Capital
Human Capital
Structural Capital
The market approach can be used only if data are available regarding the
transaction of intangible resources that are similar to the subject resources.
When the subject resources are unique, which is often the case, this approach is
not appropriate.
The income approach is often the best alternative but requires many
assumptions on income projection, income funneling, income allocation, useful
life estimation and income capitalization.
24.Value-Added Intellectual Coefficient
A financial valuation method
States two resources – Capital Employed (Physical + Financial) and
Intellectual Capital (Human + Structural Capital)
Value-Added (VA) = Op Income + Labour Exp
VAIC = Human Capital Efficiency + Structural Cap Efficiency + Capital
Employed Efficiency
Uses publicly available information but the basic assumption are very
questionable and thus poor indicator of company’s performance
45
The VAIC method is applied increasingly as an indicator of intellectual capital
performance in statistical analysis, because it uses data that are publicly
available. However, some of its basic assumptions can be seriously questioned.
The VAIC method does not properly separate expenses from assets. The
method confuses stocks and flows.
The aim of VAIC is to calculate the efficiency of capital employed, human capital
and structural capital. But it does not calculate efficiency. The assumption that
the effect of structural capital is the inverse from the effect of human capital
yields strange results. The method ignores the fact that value added is not only
produced by human capital, structural capital and capital employed individually,
but it is also the result of the synergies between these three. The solution to all
the efficiency indicators to come to one overall indicator is an interesting idea but
produces dissatisfying results.
Due to these limitations, the method produces dissatisfying results.
25.Value Chain Scoreboard
A measurement method with both top-down and a bottom-up approach
and uses same definition as the Intangible Scorecard Method (11)
46
It provides for the need of individual investors and myriad partners to
enable them to make and execute decisions at the level of professional
investors and managers
The scoreboard indicators should be quantitative, standardized for
comparison across firms and supported by empirical evidence
It is aimed at both internal and external decision makers with difference
being on the level of details provided
The strong statistical association that is required between an indicator and
a corporate value prevents the clutter in meaningless indicator. But the
framework requires additional fine-tuning
Lev’s value chain scoreboard is based on a thorough analysis of the problems of
current corporate disclosure. The value chain scoreboard incorporates the result
of research into the needs of investors and analysts for additional information.
The scoreboard focuses on innovation, which is one of the most important drivers
of growth and one of the most important variables explaining market-to-book
rations. The framework is easy to understand. It creates a logical (although not
causal) relationship between group of indicators, similar to the four perspectives
of a balanced score card.
47
Contemporary Concerns:19
Secondary InformationIt is by no means clear what the company's intellectual capital is, and even less
so if when the company's brand and intellectual capital are valued separately.
Brand valuation could, broadly, be categorized into three types. The first one is
valuation done as an academic exercise and for possible Business Strategy.
These are explained in the Notes to accounts. Ready examples are companies
such as Infosys, Satyam and Rolta. Second, brand valuation done by appointing
valuers, on the basis of which the balance sheet is adjusted for intangible assets
and capital reserve, as in the case of Sintex, Kitply and Emami. And, third,
brands actually paid for, as did Nirma and a subsidiary of Wipro.
Valuation done as an Accounting Exercise and used for Business Strategy:
Infosys
Satyam
Rolta
Valuation done by appointed Valuers for Accounting Purposes:
Sintex (done by Deloitte Haskins & Sells)
Kitply (done by Ernst & Young)
Emami (done by Ernst & Young)
19 Business Line, June 8, 2006
48
Valuation done for Brand Acquisition:
Nirma Ltd acquired the “Nirma” and other brands from Nirma Industries
Ltd through a demerger of Nirma Industries and a subsequent acquisition
of the demerged entity by Nirma Ltd.
Subsidiary of Wipro acquired a trademark/ brand named “Chandrika”
Marico buying ‘Nihar” from HLL
Dabur’s buyout of “Balsara”
IBM “Thinkpad” by Lenovo
Common Thread in Primary DataTo study these contemporary concerns we studied the secondary data available
and interviewed the industry experts (Exhibit 3 provides an indicative
questionnaire for our industry survey) from Infosys, Brain League IP Services
(Exhibit 4 provides brief overview for the this IIM Alumni’s entrepreneurial
venture), Bizworth et al. The common thread we could see from all the responses
were that:
Valuation is a very under-researched area.
Most of the companies do not have process or policies in place for the
valuation of intangibles
Companies and people in India are not used to considering Intellectual
Assets as property especially from a legal point of view.
Understanding the market and assessing the value of an asset is very
difficult as each asset is unique
Most companies don’t consider it as an investment but rather treat it as a
cost.
Not many consultant companies are working in this space due to lack of
domain expertise.
Some of the companies doing the valuation in the Indian context are
Infosys, Satyam, Rolta, Delloitte Saskin & Sells, EnY, etc.
49
Dealing with Intangibles:Valuing Brand Names, Flexibility and Patents20
It is human nature to draw a distinction between the assets that we can see and
feel and the assets that we cannot and to feel a little more secure about the
former. Included in the latter, though, are assets as diverse as goodwill, brand
name, loyal employees and technological prowess. A common critique of
valuation approaches, in general, and financial analysts, in particular, is that we
pay little attention to intangible assets and consequently under value them.
In this part, we confront this criticism by looking at intangible assets across the
spectrum. We begin by looking at intangible assets that stand by themselves and
generate cash flows– commercially developed patents, copyrights, trademarks
and licenses – and argue that conventional discounted cash flow models do a
more than adequate job in valuing them. We follow up by looking at intangible
assets such as brand name and corporate reputation that generate cash flows
collectively for the businesses that own them, but are more difficult to isolate and
value independently. Nevertheless, we will argue that conventional discounted
cash flow valuation models can capture their values and that adding a premium
for them afterwards can result in double counting. In the last part, we look at the
most elusive intangible assets, i.e., those that have the potential to generate
cash flows in the future but do not right now. Included in this group will be assets
as diverse as undeveloped patents and operating flexibility and they are the most
difficult intangible assets to value since they possess option characteristics.
20 Ashwath Damodaran, “Dealing with Intangibles: Valuing Brand Names, Flexibility and Patents”, Stern School of Business
50
Independent and Cash flow generating Intangible Assets21
The simplest intangible assets to value are those that attach to a single product
or product line and generate cash flows. These assets usually have finite lives,
over which the cash flows have to be estimated, but they are qualitatively no
different from many tangible assets that share generate cash-flows over finite
periods. In this section, we will consider a few examples of such assets.
Trademarks, Copyrights and LicensesTrademarks, copyrights and licenses all give the owner the exclusive right to
produce a product or provide a service. As a consequence, their value is derived
from the cash flows that can be generated from the exclusive right. To the extent
that there is a cost associated with production, the value comes from the excess
returns that derive from having the exclusive right.
As with other assets, we can value trademarks or copyrights in one of two ways.
We can estimate the expected cash flows from owning the asset attach a
discount rate to these cash flows that reflects their uncertainty and take the
present value, which will yield a discounted cash flow valuation of the asset.
Alternatively, we can attempt a relative valuation, where we apply a multiple to
the revenues or income that we believe can be generated from the trademark or
copyright. The multiple is usually estimated by looking at what similar products
have sold for in the past.
In making these estimates, we are likely to run into estimation issues that are
unique to these assets. First, we have to consider the fact that a copyright or
trademark provides us with exclusive rights for a finite period. Consequently, the
cash flows we will estimate will be for only this period and there will generally be
no terminal value. Second, we have to factor in the expected costs of violations
of the copyright and trademark. These costs can include at least two items. The
first is the legal and monitoring cost associated with enforcing exclusivity. The 21 Ashwath Damodaran, “Dealing with Intangibles: Valuing Brand Names, Flexibility and Patents”, Stern School of Business
51
second is the fact that no matter how careful we are with the monitoring, we
cannot ensure that there will be no violations, and the lost revenues (profits) that
arise as a consequence will lower the value of the right.
Illustration: Valuing the Copyright on “Damodaran on Valuation – 2006”
Assume that John Wiley has been approached by another publisher who is
interested in buying the copyright to the book (Damodaran on Valuation). To
estimate the value of the copyright, we will make the following assumptions:
The book is expected to generate $150,000 in after-tax cash flows for the
next three years and $100,000 a year for the following two years. These
are the cash flows after author royalties, promotional expenses and
production costs.
About 40% of these cash flows are from large organizations that make
bulk orders and are considered predictable and stable. The cost of capital
applied to these cash flows is 7%.
The remaining 60% of the cash flows are to the general public and this
segment of the cash flows is considered much more volatile. The cost of
capital applied to these cash flows is 10%.
The value of the copyright can be estimated using these cash flows and the cost
of capital that has been supplied in the following Table:
Table: Value of CopyrightYear Stable
CashflowsPresent value @
7%Volatile
CashflowsPresent value @
10%1 $60,000 $56,075 $90,000 $81,8182 $60,000 $52,406 $90,000 $74,3803 $60,000 $48,978 $90,000 $67,6184 $40,000 $30,516 $60,000 $40,9815 $40,000 $28,519 $60,000 $37,255
$216,494 $302,053
The value of the copyright, with these assumptions, is $518,547 (which is the
sum of $216,494 and $302,053).
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FranchisesA franchise gives its owner the right to market or sell a product or service of a
brand-name company. Examples of franchises would include the thousands of
McDonald’s around the world, dealerships for the automobile companies and,
loosely defined, even a New York City cab medallion. In each case, the
franchisee (the person who buys the franchise) pays the franchisor (McDonald’s
or Ford) either an up-front fee or an annual fee for running the franchise. In
return, he or she gets the power of the brand name, corporate support and
advertising backing.
Franchise value and Excess Returns
The acquisition of a franchise provides the franchisee with the opportunity to earn
above-market returns for the life of the franchise. While the sources of these
above market returns vary from case to case, they can arise from a number of
different factors.
Brand Name Value: The franchise might have a brand name value that
enables the franchisee to charge higher prices and attract more customers
than an otherwise similar business. Thus, an investor may be willing to
pay a significant up-front fee to acquire a McDonald’s franchise, in order to
take advantage of the brand name value associated with the company.
This brand name value is augmented by the fact that the franchisor often
provides the advertising for the product.
Product/Service Expertise: In some cases, a franchise has value because
the franchisor provides expertise on the product or service that is being
sold. For instance, a McDonald’s franchisee will have access to the
standard equipment that McDonald’s uses as well as the product
ingredients (the special sauce on the Big Mac).
Legal Monopolies: Sometimes, a franchise may have value because the
franchisee is given the exclusive right to provide a service. For instance, a
company may pay a large fee for the right to operate concession stands in
53
a baseball stadium, knowing that they will face no competition within the
stadium. In a milder variant of this, multiple franchises are sometimes sold
but the number of franchises is kept limited to insure that the franchisees
earn excess returns. New York City, for example, sells cab medallions that
are a pre-requisite for operating a yellow cab in the city. They also have
tight restrictions on non-medallion owners offering the same service.
Consequently, a market where cab medallions are bought and sold exists.
In essence, the value of a franchise is directly tied to the capacity to generate
excess returns. Any action or event that affects these excess returns will affect
the value of the franchise.
Special Issues in Valuing Franchises
Buying a franchise is often a mixed blessing. While the franchisee gets the
backing of a well-known firm with significant resources to back up his or her
efforts, there are some costs that may affect the value of the franchise. Among
these costs are the following.
The problems of the franchisor can spill over into the franchisee. For
instance, when Daewoo, the Korean automaker, borrowed too much and
got into financial trouble, their dealers around the world felt the
repercussions. Similarly, McDonald’s franchisees around the world were
picketed by anti-globalization activists. Thus, an efficient and well-run
franchise’s value can be affected by actions that it has little or no control
over.
Since franchisors tend to be large corporations and franchisees tend to be
small business people, the former often have much more bargaining
power and sometimes take advantage of it to change the terms of
franchise agreements in their favor. Franchisees can increase their power
by banding together and bargaining as a collective unit.
The value of a franchise derives from the exclusive rights it grants the
franchisor to sell the products of a firm. This value can be diluted if a
54
franchise is granted to a competitor. For instance, the value of a Burger
King franchise may be diluted if another Burger King is allowed to open
five miles down the highway.
Final Thoughts on Franchise Valuation
It is not difficult to value franchises using either discounted cash-flow or relative
valuation models. With discounted cash-flow valuation models, the key challenge
is estimating the incremental cash flows associated with owning the franchise as
opposed to operating the same business without a franchise. When valuing a
Burger King franchise, for instance, this would require estimating the cash flows
from operating a Burger King as opposed to a restaurant with the same menu but
no franchise name attached to it. These incremental cash flows will be
discounted back to the present at a risk-adjusted discount rate, reflecting the risk
of the business the franchise is in, to arrive at a value for the franchise.
With relative valuation, we would draw on the transactions prices at which
franchises are bought and sold. With widely held franchises such as McDonald’s,
we should be able to replicate what we did with stocks, which is to compute a
valuation multiple (franchise value/sales) based upon recent transactions and
use it to value a particular franchise.
55
Firm-wide Cash flow generating Intangible Assets22
The intangible assets that attract the most attention and have the greatest value
tend to be difficult to isolate and value. They do not generate cash flows on their
own but they allow a company to charge higher prices for its products and
generate more in cash flows. As a consequence, valuing these intangible assets
is more difficult to do, but there are three different ways we can go about
estimating their value.
Capital Invested : We can estimate the book value of an asset by looking
at what a firm has invested in that asset over time. With brand name, for
instance, this would require looking at advertising expenditures over time,
capitalizing these expenses and looking at the balance that remains
unamortized of these expenses today. While this approach is the least
subjective, it may not match or even be close to the market value of the
asset. It is, however, consistent with how accountants measure the value
of other tangible assets on the books.
Discounted Cash Flow Valuation : We can discount the expected
incremental cash flows generated by the intangible asset in question to
the firm. This will require separating out the portion of the aggregate cash
flows of a firm that can be attributed to brand name or technological
expertise and discounting back these cash flows at a reasonable discount
rate.
Relative Valuation : One way to isolate the effect of an intangible asset
such as brand name is compare how the market values the firm (with the
brand name) with how it values otherwise similar companies without a
brand name. The difference can be attributed to the intangible asset.
In the following section that follows, we will take a detailed look at brand name
value and a more cursory look at human capital.
22 Ashwath Damodaran, “Dealing with Intangibles: Valuing Brand Names, Flexibility and Patents”, Stern School of Business
56
Brand Name23
Brand name is the asset that comes to mind most often when there is talk about
intangible assets. After all, brand name accounts for a large proportion of the
value of many consumer product companies and accounting standards in many
countries have required companies to value brand name and show it on the
books. In this section, we will explore the choices that we face when trying to
value brand name and why they might give us different answers.
Historical Cost Approach
In the historical cost approach, we adopt a solution rooted in conventional
accrual accounting to value the brand name. We begin by making an assumption
about what expenses that a firm incurs are most likely to impact its brand name.
It stands to reason, for instance, that a portion of every firm’s advertising
expenses is spent to build or augment the company’s brand name. We then use
a process very similar to the one we used to capitalize R&D expenses to
compute brand name value.
1. We determine an amortizable life for the brand name expenditures, based
upon how long we think the benefits from the expenditure will accrue. For
consumer product firms, this may extend out to 20 years or longer since brand
names long lives.
2. We collect the data on brand name expenditures each year, going back
historically, for the amortizable life of brand name. Thus, if we choose 20 years
as our amortizable life, we will collect the brand name expenditures (or at least
the portion of it that we attribute to brand name) each year for the last 20 years.
3. Using a straight-line amortization schedule, we write off a portion (5%, for
instance, with a 20-year life) of the brand name expenditure from each year’s
expenditure in the subsequent years. As a result, we should be able to estimate 23 Ashwath Damodaran, “Dealing with Intangibles: Valuing Brand Names, Flexibility and Patents”, Stern School of Business
57
the total amortization of brand name expenditures in the current year (to be
treated like depreciation) and the unamortized portion of the previous year’s
expenditures, which will now be treated as an asset (brand name value).
While this approach has the benefit of simplicity and reduces discretionary
choices by firms, it does not really measure the value of the brand name. What it
does measure is the capital that has been invested in the brand name, which
may bear little or no resemblance to the actual market value today. After all,
there are firms that have spent billions of dollars in advertising and have no
brand name value to show for it, whereas there are other firms that seem to
establish brand name value with little or no advertising expenditure, often
because they happen to be in the right place at the right time.
Discounted Cashflow Approach
In a discounted cash flow approach, we try to isolate the effect of the brand name
on the cash flows of the firm. That is easier said than done because the effects of
brand name are felt through a firm and it is also difficult to separate out brand
name effects from other factors that may also impact the cash flows such as the
firm’s reputation for quality or service and market power.
1. Comparison to Generic Company
Perhaps the simplest measure of brand name value is obtained by comparing the
cash flows of a brand name company with an otherwise similar company (in
terms of product and scale) without a brand name. The difference in cash flows
then can be attributed to the brand name and the present value of these cash
flows should generate a value for the brand name.
While the approach is intuitive, the key constraint is finding a generic version of a
brand name firm. All too often, brand name companies dominate their sectors
and have different product mixes and much larger revenues than generic
companies in the same sector. Finding a generic twin to Procter and Gamble or
58
Gillette will be impossible to do. To simplify the process, we would recommend
one of the following approximations:
a. Generic operating margin approach : In this approach, we replace the
operating margin of the brand name firm with the operating margin of
generic companies in the same business. The implicit assumption that we
make is that the power of a brand name lies in pricing products and that
brand name companies will be able to charge higher prices for identical
products (produced by generic companies). Revaluing the brand name
company with a generic margin will have ripple effects, since lower
margins beget lower returns on capital and lower returns on capital result
in lower growth rates. As a consequence, even a small change in
operating margin can translate into a large change in value, which can
then be attributed to the brand name.
b. Generic return on capital approach : A close substitute for the first
approach involves replacing the return on capital of the brand name
company by the return on capital of a generic substitute. Here, we are
assuming that the power of a brand name ultimately will show up in higher
returns on capital. The resulting changes in operating income and growth
will reduce the value of the company, and the change in value is the brand
name value. Implicitly, we are assuming that the costs of capital are the
same for both the generic and the brand name company.
c. Generic excess return approach : In this approach, we replace the excess
returns (return on capital minus cost of capital) earned by the brand name
company by the excess returns earned by the generic company. In
addition to capturing all of the effects that changing the return on capital
has on value, this approach allows us to set the costs of capital at different
levels for the brand name and the generic company. A legitimate
59
argument can be made that brand name companies have less market risk
(unlevered betas), more debt capacity and lower costs of capital.
In all of these approaches, we are making two key assumptions. The first is that
a generic company exists and that we have access to its financial statements,
though neither the brand name company nor its generic counterpart need to be
publicly traded. The second is that the brand name is the only reason for
differences in margins, returns on capital and excess return across these
companies. To the extent that brand name is intermingled with other intangible
assets, what we will get is a consolidated measure of value for all of these
assets. This makes it more appropriate for products where the only reason for
pricing differences is the brand name and not product quality or service. Thus,
this approach is more appropriate in valuing brand name at Coca Cola or Mars
Candy but less so in valuing brand name at Sony or Goldman Sachs.
2. Excess Return Models
When a generic company does not exist, there is an alternative approach that we
can use to value brand names, though it makes its own set of heroic
assumptions. If we assume that all of the excess returns (returns over and above
the cost of capital) earned by a firm can be attributed to its brand name, the
valuation of a brand name becomes simple. In chapter 6, we introduced the
excess return model for valuing firms and showed the in the absence of excess
returns, a firm will trade at the book value of capital invested. If we assume that
the excess returns are entirely attributable to brand name, the value of the brand
name can be computed as the difference between the estimated value of the firm
and the book value of capital invested in that firm.
Value of brand name = Estimated DCF value of firm – Capital Invested in firm
This approach will yield the same value as the generic firm approach, if generic
firms earn zero excess returns. The limitation of the approach is that excess
60
returns come from all of a firm’s competitive advantages and not just brand
name. In addition, accounting choices and manipulation can affect capital
invested estimates, and thus affect the brand name value estimates.
Relative Valuation ModelsIn relative valuation models, we try to extract the value of a brand name by
looking at how the market prices companies with and without brand name. The
first relative valuation approach draws from the generic firm computation we used
earlier with discounted cash flow valuation. The second approach grows out of
the multiple regressions where we regress the multiples that firms trade at
against the fundamentals that determine that value.
1. Comparing Valuation to Generic Firm
This approach is built on the premise that both the brand name company and a
generic company that resembles it are both publicly traded. Since we can
observe how the market values both firms, we can draw conclusions about the
value it attaches to brand name by looking at the difference between the two
valuations. The aggregate market values will be difficult to compare because the
generic firm may be smaller (or bigger) than the brand name company. Instead,
we compute enterprise value multiples for firms, using revenues, operating
income or book capital as a base. If brand name has value and is the only
difference between the two firms, the enterprise value multiple should be much
higher for the brand name company than it is for the generic company.
The brand name value can be backed out as follows:
Brand name value = [(EV/Variable)Brand name - (EV/Variable)Generic]* VariableBrand name
Thus, if we are using EV/Sales ratios as our multiples for comparison, this would
be modified as follows:
Brand name value = [(EV/Sales)Brand name - (EV/Sales)Generic]* SalesBrand name
This approach requires less work that the discounted cash flow approach, since
we are taking the market valuation as given and not trying to estimate value
ourselves. On the other hand, market mistakes will find their way into our
61
valuations and we are still assuming that the only reason for the differences
across firms is that one has a brand name and the other does not.
b. Comparing Market Valuations of different firms
What if we cannot find a generic company that is publicly traded? In multiple
regressions, we regress the multiples that firms trade against the fundamentals
that determine value. The resulting output allowed isolating the effect of each of
the fundamentals; for instance, we could estimate the effect of higher growth on
EV/Sales ratios of retail firms. By introducing a direct or an indirect measure of
brand name into the regression, we can estimate its effect on value.
a. Direct Measure of brand name: Assume that we are analyzing 30
consumer product companies, ten with strong brand names and twenty
with weaker brand names. We could introduce a brand name dummy
variable into the regression and capture its effect on value. For instance,
using EV/Sales ratio as the multiple, we would run the following
regression:
EV/Sales = a + b (Risk Measure) + c (Expected Growth) + d (Brand Dummy)
The brand dummy is set to one for the strong brand name firms and to
zero for the weak brand name companies. The coefficient ‘d’ on the brand
dummy will capture the value effect of having a brand name.
b. Proxy Measure of brand name: Earlier, we argued that the value of a
brand name was most likely to show up in higher operating margins.
Introducing the operating margin into the regression will capture this
effect.
EV/Sales = a + b (Risk Measure) + c (Expected Growth) + d (Operating Margin)
Presumably, companies with higher operating margins trade at higher
multiples of sales and the coefficient “d” on operating margin will capture
the effect. Using a generic or even an industry average operating margin
in this regression will yield an estimate of the EV/Sales ratio for a generic
62
firm. Comparing the actual EV/Sales ratio of a brand name company to
this predicted value will generate the brand name value:
Brand name value = [(EV/Sales)Brand name - (Predicted EV/Sales)Generic Margin]*SalesBrand name
Human Capital24
Rather than repeat what was said about brand name, we can map out how we can apply the approaches developed to value brand name to value other intangible assets that also generate value for the entire firm. One such asset is human capital. A firm with an well trained, loyal and intelligent workforce should be worth more than an otherwise similar firm with a less expert workforce. This is especially true for consulting firms, investment banks and other entities that derive most of their value from human capital.
Historic Cost Approach : With brand name, we considered advertising expenses to be the determining expense. With human capital, we would consider recruiting, training and employee benefit expenses as the determining force. As with brand name, firms may need to invest for years in human capital before the investment pays off, but we can attach an accounting value to human capital by assuming an amortizable life and collecting information on employee expenses for that period.
Discounted Cash flow Model : We can value the human capital invested in a company by comparing the value of the company with the investment with a generic company in the same business. Finding a generic company with regards to human capital can be more difficult than finding one with regards to
24 Ashwath Damodaran, “Dealing with Intangibles: Valuing Brand Names, Flexibility and Patents”, Stern School of Business
63
brand name. After all, every consulting firm believes that its consultants have special qualities; the difference is relative.
Excess Return Models : We can attribute all of the excess returns earned by a firm to its human capital, in which case the difference between estimated value and capital invested becomes a measure of the value of human capital.
Relative valuation models : We can compare the market multiples at which companies with superior human capital investments trade at, relative to firms with more average workforces.
With all of these approaches, we would add a note of caution. Unlike brand name, which is owned by a company, human capital is available only for rent. In other words, it will be very difficult to keep our skilled consultants or traders from moving to a competing firm at the right price; consider how often skilled traders on Wall Street move from one investment bank to another. Put in excess returns terms, it is conceivable that the entire excess returns from human capital may accrue to
the person or person possessing it rather than to the firm that hires them.
Goodwill: The non-assetIt may seem surprising that we have paid little attention to the most commonly
reported intangible asset on balance sheets, which is goodwill. Goodwill is not an
asset but a plug variable. Note that it shows up only after acquisitions and is
designed to capture the difference between what is paid for a target company
and the book value of its assets, thus allowing the balance sheet to still balance
after the acquisition.
The most charitable interpretation of goodwill is that it measures the estimated
value of growth assets in the target company; growth assets are investments that
64
the target company is expected to make in the future. This is true only if a fair
price is paid on the acquisition and the book value of the target company
measures the market value of assets in place, both of which are daunting
assumptions. In reality, the value of goodwill will be affected by
Mis-measurement of book value: If the book value of assets is understated
(overstated), because of accounting choices, the value of goodwill will be
overstated (understated).
Overpayment or underpayment on acquisition: If the acquiring company
overpays on an acquisition, its goodwill will increase by the overpayment.
If it underpays, the reverse will occur.
Though this may be asking for too much, our job in valuation would be made far
simpler if the goodwill item on balance sheets were broken down into smart and
stupid components, with the former being for growth assets (and thus justifiable)
and the latter capturing the overpayment on acquisitions. When computing the
return on invested capital, where we are often called upon to estimate the return
on assets in place, we would treat the stupid goodwill as part of the capital
invested (thus lowering return on capital) but not smart goodwill, since it is unfair
to expect companies to generate operating income on investments that they
have not taken yet.
65
Intangible Assets with Potential Future Cash Flows25
The most difficult intangible assets to value are those that have the potential to
create cash flows in the future but do not right now. While these assets are
difficult to value on a discounted cash flow valuation basis and often impossible
to evaluate on a relative basis, they do have option characteristics and are best
valued using option pricing models. In this section, we will begin by looking at
undeveloped patents and natural resource reserves as options and then move on
to consider two less clearly defined intangible assets – the option to expand into
new markets and products or to abandon investments.
Undeveloped PatentsA patent provides a firm with the right to develop and market a product or service
and thus can be viewed as an option. While an undeveloped patent my not be
financially viable today and generate cash flows, it can still have considerable
value to the firm owning it because it can be developed in the future. In this
section, we will consider first the mechanics of estimating the value of a patent as
an option and then expand the discussion to consider how best to value a firm
with both developed products and undeveloped patents.
Valuing a patent as an option
Using Standard Option Pricing Models with the parameters as input
Valuing a firm with patents
If the patents owned by a firm can be valued as options, how can this estimate
be incorporated into firm value? The value of a firm that derives its value
primarily from commercial products that emerge from its patents can be written
as a function of three variables.
The cash flows it derives from patents that it has already converted into
commercial products,
25 Ashwath Damodaran, “Dealing with Intangibles: Valuing Brand Names, Flexibility and Patents”, Stern School of Business
66
The value of the patents that it already possesses that have not been
commercially developed and
The expected value of any patents that the firm can be expected to
generate in future periods from new patents that it might obtain as a result
of its research.
Natural Resource Options
Natural resource companies, such as oil and mining companies, generate cash
flows from their existing reserves but also have undeveloped reserves that they
can develop if they choose to do so. They will be much more likely to develop
these reserves if the price of the resource (oil, gold, copper) increases and these
undeveloped reserves can be viewed as call options. In this section, we will
begin by looking at the value of an undeveloped reserve and then consider how
we can extend this to look at natural resource companies that have both
developed and undeveloped reserves.
Undeveloped Reserves as Options
Using Standard Option Pricing Models with the parameters as input
The Option to Expand into New Markets and Products
Firms sometimes invest in projects because the investments allow them either to
make further investments or to enter other markets in the future. In such cases,
we can view the initial projects as options allowing the firm to invest in other
projects and we should therefore be willing to pay a price for such options. Put
another way, a firm may accept a negative net present value on the initial project
because of the possibility of high positive net present values on future projects.
67
Case Studies
In the following section, We are going to take a number of case studies in the
following section. We take the Human and Brand Valuation done by Infosys
(Exhibit 5 provides a detailed overview of Infosys, the premier IT company with a
very reputed and clean corporate image) and compare it across the companies
and Last 7 years interval to understand any significance of the accounting
numbers provided by Infosys.
Brand ValuationValuation of Brand Infosys by Brand Earnings Multiplier Method
Method of Calculation of Infosys Brand Earnings Multiplier 26
Determine brand profits by eliminating the non-brand profits from the total
profits of the company
Restate the historical profits at present-day values
Provide for the remuneration of capital to be used for purposes other than
promotion of the brand
Adjust for taxes
Brand strength or Brand earnings multiplier Brand-strength multiple is a function of a multitude of factors
Leadership
Stability
Market
Internationality
Trend
Support and
Protection.
26 Infosys Annual Report 2006
68
These factors have been evaluated on a scale of 1 to 100 internally, based on
the information available within.
Interbrand, a leading branding company, uses a similar methodology to work out
the annual ranking of the world's most valuable brands. Exhibit 6 provides an
overview of their methodology.
69
Reconciliation of Brand Valuation of Infosys
Brand valuation (in Rs. Crore)2006 2005 2004
Profit before interest and tax 2,654 2,048 1,357 Less: Non brand income 124 112 111Adjusted profit before tax 2,530 1,936 1,246Inflation compound factor 1.000 1.053 1.108Present value of brand profits 2,530 2,039 1,381Weightage factor 3 2 1Three-year weighted average profits 2,175Remuneration of capital (5% of average capital employed)
309
Brand-related profits 1,866Tax 628Brand earnings 1,238 Multiple applied 18.51Brand value 22915
2006 2005 2004Brand value 22,915 14,153 8,185Market capitalization 82,154 61,073 32,909Brand value as a percentage of Market Capitalization 27.9
%23.20% 24.90%
Key Assumptions
Total revenue excluding other income after adjusting for cost of earning
such income is brand revenue, since this is an exercise to determine our
brand value as a company and not for any of our products or services
Inflation is assumed at 5% per annum
5% of the average capital employed is used for purposes other than
promotion of the brand
Tax rate is at 33.66% (Base rate of 30.0%, surcharge of 10% on base rate
and cess of 2.0%)
70
The earnings multiple is based on our ranking against the industry
average based on certain parameters (exercise undertaken internally and
based on available information)
The figures above are based on consolidated Indian GAAP financial
statements.
Net Profit before tax and interest 2724Provision for Taxation 303PAT 2,421P/E 33.93
ReconciliationBrand Earnings is a fraction of PAT 51% Tax 13% Weightage factor 15% Non Brand Income 8% Opportunity Cost 13%Total 100%
Brand Earning Multiplier is a fraction of P/E 55%
Brand Earning Multiplier is a fraction of P/E
Brand Earning Multiplier is a multiple for premium brand earnings which are significantly less robust than the company's ability to produce PAT without the Infosys brand
Given: Provision for taxation = Income tax – Deferred Tax = 325 – 22 = 303
Income taxes:
The provision for taxation includes tax liabilities in India on the company’s global
income as reduced by exempt incomes and any tax liabilities arising overseas on
income sourced from those countries. Most of Infosys’ operations are conducted
through Software Technology Parks (“STPs”). Income from STPs is tax exempt
for the earlier of 10 years commencing from the fiscal year in which the unit
71
commences software development, or March 31, 2009. Infosys now also has
operations in a Special Economic Zone (“SEZ”). Income from SEZs is fully tax
exempt for the first five years, 50% exempt for the next five years and 50%
exempt for another five years subject to fulfilling certain conditions. During the
year ended March 31, 2006, the tax authorities in an overseas tax jurisdiction
completed the assessment of income up to fiscal year 2004. Based on the
assessment order, management has re-estimated its tax liabilities and written
back an amount of Rs. 20 crore. The tax provision for the year is net of the write-
back.
Inferences
We can see from the above reconciliation that even though Non-Branded Income
is significantly less, the Brand Value is only one-fourth of the Market
Capitalization. Clearly market sees Infosys as just more than a brand. The
reasons are:
Its ability to save taxes with operations in STPs and SEZs
Brand is a signaling instrument. The resources put in signaling could and
is utilized by Infosys in productive activities
The brand earnings are less than branded profits since the growth in these
profits are not only attributable to brand but also to the organic growth
Most importantly Brand Earning Multiplier is a multiple for premium brand
earnings which are significantly less robust than the company's ability to
produce PAT without the Infosys brand. This itself leads to significant
difference of Brand Valuation and Market Capitalization.
72
Comparative valuation of Infosys, Rolta and Satyam
Brand Valuation of Rolta
Brand valuation (Rs. In million) 2004-05 2003-04 2002-03
Profit before interest and tax 1226 1014 1504Less: Non brand income 103 88 57Adjusted profit before tax 1123 926 1447Profit for the brand and associated intangibles 1123 926 1447Average capital employed 5723 6200 5410Remuneration of capital (5% of average capital employed) 5%Remuneration of capital 289Profit attributable to brand and associated intangibles 834Tax 305Profit after tax attributable to brand and associated intangibles
529
Multiple applied 15.15Brand value 8011Market Capitalization 7662Brand value as a percentage of market capitalization 104.5%
Key Assumptions
Total revenue excluding other income after adjusting for cost of earning
such income is brand revenue, since this is an exercise to determine the
brand value as a company and not for specific products or services
5% of the average capital employed is estimated to be used for purpose
other than promotion other than the brand.
Tax rate is 36.5925% (Base rate of 35%, surcharge of 2.5% on base rate
and cess of 2%)
The earnings multiple is based on a brand strength model where Rolta is
ranked on various parameters such as leadership, stability, market,
geographic spread, trend, support and protection.
Brand Valuation of Infosys
73
Brand valuation (in Rs. Crore) 2006 2005 2004Profit before interest and tax 2,654 2,048 1,357 Less: Non brand income 124 112 111Adjusted profit before tax 2,530 1,936 1,246Inflation compound factor 1.000 1.053 1.108Present value of brand profits 2,530 2,039 1,381Weightage factor 3 2 1Three-year weighted average profits 2,175Remuneration of capital (5% of average capital employed)
309
Brand-related profits 1,866Tax 628Brand earnings 1,238 Multiple applied 18.51Brand value 22915
2006 2005 2004Brand value 22,915 14,153 8,185Market capitalization 82,154 61,073 32,909Brand value as a percentage of Market Capitalization 27.90% 23.20% 24.90%
Key Assumptions
Total revenue excluding other income after adjusting for cost of earning
such income is brand revenue, since this is an exercise to determine our
brand value as a company and not for any of our products or services.
Inflation is assumed at 5% per annum.
5% of the average capital employed is used for purposes other than
promotion of the brand.
Tax rate is at 33.66% (Base rate of 30.0%, surcharge of 10% on base rate
and cess of 2.0%).
74
The earnings multiple is based on our ranking against the industry
average based on certain parameters (exercise undertaken internally and
based on available information).
The figures above are based on consolidated Indian GAAP financial
statements.
Brand Valuation of Satyam
Rs. in CroresParticulars 31-Mar-06 31-Mar-05 31-Mar-04Profit Before Taxation 1,445.89 661.94 867Add: Financial Charges 2.72 0.75 0.76
1,448.61 662.69 867.76Less: Other Non-Branded Income 342.08 84.52 91.64Adjusted Profit for Brand Valuation 1,106.53 578.17 776.12Inflation compound factor @ 5% (assumed) 1 1.1025 1.05Present value of profits for the Brand 1,106.53 637.43 814.93Weightage factor 3 1 2Weighted profit 3,319.59 637.43 1,629.86Three year weighted average profit 931.15Less: Remuneration of capital (5% of avg capital employed)
188.77
Brand-related profits 742.38Less: Income Tax @ 33.66% 249.89Brand earnings 492.49Multiple applied 15.61Brand Value 7,688 4,662 3,462Market Capitalization 28,366 13,406 9,796Brand value as a percentage of Market Capitalization 27.1% 34.8% 35.3%
Key Assumptions
As on March 31, 2006, the Brand value of the Company was Rs. 7,687.77 crores (US$ 1,728.37 mn.), as computed below:
75
PBIT reduced by non-branded income was taken as profit for brand
valuation.
Previous two years profits were considered at present value and
weightage factor was applied to arrive at weighted profit.
5% of average capital employed was provided for non brand purposes.
Income Tax at current rate was provided.
Brand multiple was estimated based on certain parameters and internal
evaluation.
Inferences
While the three companies are not comparable, Infosys uses a higher
multiplier for the calculation of its brand value, leading to the highest value
for its brand among the three companies.
Rolta’s Brand Valuation is higher than its Market Capitalization indicating
negative stub problem or futile brand valuation excercise. Negative Stub
situation arise when there is implied negative price for the tangible fixed
assets. Alternatively the brand valuation exercise might be futile since
their brand premiums might be low and their Brand Earnings Mulitple be
too high (15.15 compared to 7.51 of P/E)
Satyam’s Brand Valuation is closer to that of Infosys in terms of
percentage of Market Capitalization. It would indicate either aggressive
Brand Earnings Multiplier in previous years or Market correcting its implied
value of the “Satyam” brand.
76
Infosys Brand Valuation over Time
Brand valuation (in Rs. Crore)
Particulars 2006 2005 2004 2003 2002 2001 2000 1999Market capitalization 82,154 61,073
32,909 26,847 24,654 26,926 59,338
9,673
Brand value 22,915 14,153 8,185 7,488 7,257 5,376 5,2461,72
7Brand Value as a % of Market Capitalization 28% 23% 25% 28% 29% 20% 9% 18%
Brand Valuation Vs Market Capitalization
010,00020,00030,00040,00050,00060,00070,00080,00090,000
2006 2005 2004 2003 2002 2001 2000 1999
Year
Rs. C
rore
0
5,000
10,000
15,000
20,000
25,000
Rs. C
rore
Market capitalization
Brand value
77
0%
5%
10%
15%
20%
25%
30%
2006 2005 2004 2003 2002 2001 2000 1999
Year
Brand Value as a Percentage of Market Capitalization
Inferences
Due to the boom time in the year 2000, the market capitalization of the
company was very high, leading to a lower brand value as a % of market
capitalization
However, the crash in the year 2001 led to decrease in the market cap. As
a result Brand value as a % of market capitalization increased.
Over the last five years Infosys has increased its market cap and at the
same time increased its brand value.
The consistency reinforces the strong reputation for clean Financial
Statements by Infosys and strong Market Forces to correctly value the
premium Indian Software Firm
78
Brand Valuation for Sintex using Brand Earnings MultiplierAs in above cases, we’ll use the Estimated Brand Multiplier to estimate the Brand Value of Sintex.
Brand Strength ModelBrand valuation (in Rs. lacs) 2005 2004 2003Profit before interest and tax 9,546 7,545 6,293 Less Non Branded Income 1,053 876 692Adjusted PBIT 8,493 6,670 5,601Profit for the brand and the associated intangibles
8,493 6,670 5,601
Inflation compound factor 1.000 1.053 1.108Present value of brand profits 8,493 7,023 6,206Weightage factor 3 2 1Three-year weighted average profits 7,622Average capital employed 80562 65944 59708Remuneration of capital (5% of average capital employed)
3,827
Brand Related Profits 3,795Less: Income Tax @ 33.66% 1,278Brand earnings 2,518Multiple Appllied 15.00Brand value 37,767
2005 2004 2003Brand value 37,767Market capitalization 73907Brand value as a percentage of market capitalization 51%
Key Assumptions
Total revenue excluding other income after adjusting for cost of earning
such income is brand revenue, since this is an exercise to determine our
brand value as a company and not for any of our products or services.
Inflation is assumed at 5% per annum.
79
5% of the average capital employed is used for purposes other than
promotion of the brand.
Tax rate is at 33.66% (Base rate of 30.0%, surcharge of 10% on base rate
and cess of 2.0%).
The earnings multiple is based on a brand strength model where Rolta is
ranked on various parameters
The figures above are based on consolidated Indian GAAP financial
statements.
Brand valuation (in Rs. lacs) Sintex GenericDealer 133 100Dealer Margin per unit 25 20Sales 108 80RM (45%) 48.6 40OpExp (35%) 37.8 30PBIT 21.6 10
Neglecting InterestPre-Tax Operating Margin 20.00% 12.50%After-Tax Operating Margin 13.33% 8.33%Sales/BV of Capital 1.19 1.19Return on Capital 15.87% 9.92%Reinvestment Rate 85% 85%Expected Growth 13.49% 8.43%Length 5 years 5 yearsCost of Equity 14% 14%E/(D+E) 64% 64%AT Cost of Debt 6% 6%D/(D+E) 36% 36%Cost of Capital 11.12% 11.12%Value/Sales Ratio 1.9468751
40.97385
Value of Sintex's Brand Name = (3.122-1.257)*68798 66942.17Value of Sintex as a Company = 3.122*68798 133941.1 49.98%
Brand Valuation – Value to Sales Method
80
Key Assumptions: Using the balance sheet the payout ratio was calculated as 14.8148% and
growth has been assumed at 6%. The growth period is five years.
The above expression has been used to calculate the value of a company.
Exhibit 7 provides similar working for the brand valuation of Coca Cola
and Kellog’s.
Inference
In the case of Brand Earning Multiplier, an indicative multiplier of 15 is
used but P/E is 11. So without the Brand Strength analysis, it is very
difficult to reach a brand valuation figure through this method.
The second valuation methodology assumes crucial forecast values of
growth rate, growth period, payout rate and so is debatable
81
Both methodologies estimate Brand Valuation to be 50% which could be
true only to a limited extent even with given strong “Sintex” brand
Human Valuation
In India, Infosys has been prime mover in valuing its Human Resources. It has
made the Lev and Schwartz Human Accounting model (Exhibit 8 provides the
overview of Lev and Schwartz) as a default model for Human Valuation. Other
companies like Rolta have chose to take a similar model that of Economic
Approach model (Exhibit 9 provides the overview of Economic Approach Model)
Comparative Human Valuation of Infosys, Satyam and Rolta
Human Resource Valuation at Infosys
Human Resource ValueInfosys has used the Lev & Schwartz model for computing the HR value.
As on March 31, 2006 As on March 31, 2005Particulars Number of HR Value Number of HR Value
Employees Rs. In crores Associates Rs. In croresSoftware delivery
49,495 43,336 34,747 26,550
Support 3,220 3,301 2,003 1,784Total 52,715 46,637 36,750 28,334Market Cap 82,154 61,073
Key Assumptions: Employee compensation includes all direct and indirect benefits earned
both in India and abroad
The incremental earnings based on group / age have been considered
The future earnings have been discounted at 12.96% (previous year –
13.63%) the cost of capital for the company.
Beta has been assumed at 0.78, the beta for the company in India
82
Human Resource Valuation at Satyam
Human Resource ValueAs on March 31, 2006 As on March 31, 2005
Particulars Number of HR Value US$ % Number of HR Value US$ %Associates Rs. In
croresmillion Associates Rs. In
croresmillion
Development 24,801 22,203.06 4,991.70 95.03 17,859 15,886.31 3,631.16 95.78Support 1,710 1,161.49 261.12 4.97 1,305 700.1 160.02 4.22Total 26,511 23,365 5252.82 100 19,164.41 16,586 3,791.18 100
Market Cap 28,366 13,406
Key assumptions:
HR value is the present value of future earnings upto retirement age and
in this model earnings are dependent on age alone.
The future earnings have been discounted at 17.01%, being the weighted
average cost of capital (WACC) for the past five years
Human Valuation at Rolta
Economic Approach model(Rs. In millions except numbers and ratios)Particulars 2004-05Total value of human resources 31,404Market Cap 7,662Revenues per employee 2.17Net Profit per employee 0.46Value of human resources per employee 16.01
83
Total Revenues/Total value of human resources (ratio)
0.14
Key Assumptions:
Employee compensation includes all direct and indirect benefits earnings
both in India and abroad
The average annual increment is based on the increment paid during the
last three years
Retirement age is as per company policy
Inference
While all the three companies are not comparable, Infosys has the highest
HR Valuation. But Satyam feels that its entire market capitalization is
equal to its HR valuation. multiplier for the calculation of its brand value,
leading to the highest value for its brand among the three companies.
Also Rolta’s HR Valuation is much higher than its Market Capitalization
indicating negative stub problem or futile brand valuation excercise.
Negative Stub situation arise when there is implied negative price for the
tangible fixed assets. Alternatively the HR Valuation exercise might be
futile since their HR skill-set might be low and market correctly recognizes
that.
84
Human Resource Value
Infosys has used the Lev & Schwartz model for computing the HR value.
Summary of Human resources value
(in Rs. crore, unless stated otherwise)
Particulars 2006 2005 2004 2003 2002 2001 2000 1999No. of Employees 52,715 36,750 25,634 15,356 10,738 9,831 5,389 3,766Value of Human Resources 46,637 28,334 21,140 10,417 9,539 5,123 2,237 946Market Capitalization 82,154 61,073 32,909 26,847 24,654 26,926 59,338 9,673Software revenue 9,521 7,130 4,853 3,623 2,604 1,901 882 509Total Employee Cost 4,801 3,539 2,451 1,677 1,118 718 335 166Value added excluding exceptional items 8,027 6,053 4,185 3,043 2,239 1,563 723 374Net profits excluding exceptional items 2,479 1,846 1,244 958 808 623 286 133Key ratiosHR Valuation/Market Capitalization 57% 46% 64% 39% 39% 19% 4% 10%Total software revenue / human resources value (ratio)
0.2 0.25 0.23 0.35 0.27 0.37 0.39 0.54
Value added / human resources value (ratio) 0.17 0.21 0.2 0.29 0.23 0.31 0.32 0.4Value of human resources per employee 0.88 0.77 0.82 0.68 0.89 0.52 0.42 0.2511Employee cost / human resources (%) 10% 12% 12% 16% 12% 14% 15% 18%Return on human resources value (%) 5% 7% 6% 9% 8% 12% 13% 14%
Human Resource Valuation of Infosys over time
Inferences
The numbers of employees have steadily grown and there is inverted
parabolic shape for value added per employee over the years. Similarly for
the Revenue per employee
The HR Valuation/Market Capitalization shows similar trend as the Brand
Valuation/Market Cap but has a much higher steady state value, that of
50% compared to 27%
While employee cost has come down, the returns has also come down
indicating mass recruitment and dilution of elite Human Resources.
Conclusions
85
We can conclude that most of the companies are not doing a good job of
assessing the value of the intangible assets. For instance, Sintex Brand
Valuation was estimated at 165 crores in 2000-01 but they haven’t gone for any
new rounds of re-valuation even though the Brand Assets is sizeable 30% of
their Fixed Capital.
To encourage better valuation and measurement of intangibles we believe the
following measures are crucial:
1. Opening up Accounting Standards . Indian GAAP should permit the step
by step capitalization of intangibles. Further, efficient voluntary reporting
standards should be set up and companies should be given incentives for
better transparency in their accounting reports. Companies should go
beyond the existing voluntary reporting. Also, a set of standards should be
developed for the wide spectrum of intangibles in different industries.
2. Increased awareness of benefits of sharing the information : The
companies do a cost benefit analysis whenever they want to report the
measurement or valuation of intangibles done by them. But many
companies are not sufficiently aware of the benefits that may arise from
sharing this information. Hence, an increased awareness about the range
of benefits – from attracting talent to brand building and easier entry in
overseas market - will lead to an increase in voluntary sharing by the
companies.
3. Silent Zone Agreement : Publication of Information should not be made
mandatory regarding certain crucial areas. If an agreement can be
reached regarding a silent zone then the companies will have less to fear
and hence will have less reason to hold back.
86
4. Higher rating for companies that value intangibles : The rating
agencies should consider measurement and valuation of intangibles as an
important factor while rating the companies. This would also encourage
the companies to make further progress in this direction.
Hence, the road ahead must be paved by a combination of compulsory and
voluntary measures to encourage valuation and measurement of intangibles.
Exhibits 1 and 2 provide a company with frameworks so as to enable them to
identify an intangible valuation/measurement technique that suit their purpose
and parameters.
Learnings from Case Studies
1. The HR Valuation/Market Capitalization for Infosys shows similar trend as
the Brand Valuation/Market Cap but has a much higher steady state
value, that of 50% compared to 27%.
2. The consistency of Infosys reinforces the strong reputation for clean
Financial Statements by Infosys and strong Market Forces to correctly
value the premium Indian Software Firm
3. In case of Infosys, Brand Earning Multiplier is a multiple for premium
brand earnings which are significantly less robust than the company's
ability to produce PAT without the Infosys brand. This itself leads to
significant difference of Brand Valuation and Market Capitalization.
4. While employee cost has come down at Infosys, the returns have also
come down indicating mass recruitment and dilution of elite Human
Resources.
87
5. Rolta’s HR and Brand Valuation are quite high in comparison to its Market
Capitalization indicating negative stub problem or futile brand valuation
excercise. Negative Stub situation arise when there is implied negative
price for the tangible fixed assets. Alternatively the HR/Brand Valuation
exercise might be futile since their HR skill-set and Brand Premiums might
be low and market is correctly recognizing that.
6. For Sintex, In the case of Brand Earning Multiplier, an indicative multiplier
of 15 is used but P/E is 11. Thus, without the Brand Strength analysis, it is
very difficult to reach a brand valuation figure. The second valuation
methodology assumes crucial forecast values of growth rate, growth
period, payout rate and so is debatable
88
1. References
1) Jan Hofman, October 19, 2005, “Value Intangibles!”, Deutsche Bank
Research, Germany.
2) Andriessen, D. (2004). Making Sense of Intellectual Capital. Elsevier
Publications, Burlington, USA.
3) Annual Reports
4) Websites
5) Analyst Reports
6) Valuation by Aswath Damodaran
7) Best Global Brands – A Ranking by Brand Value, Interbrand Report
8) Aswath Damodaran, January 2006, “Dealing with Intangibles: Valuing
Brand Names, Flexibility and Patents”, Stern School of Business
89
Exhibit 1 - The Review of the 25 methods of Valuation and Measurement27
Review of 25 Methods for the Valuation or Measurement of Intangible
Sr. No. Method Purpose Means Methodological
ly sound?Measuring
Intangibles?Yardsticks or benchmarks?
Wide Range of
intangibles?Prospective?
Overall Apprai
sal
1 Balanced Scorecard
Internal Management Measurement + - + n/a n/a -
3Citation-weighted patents
External Reporting Measurement + + - - n/a -
5 Holistic Value approach
Internal Management and external
reporting
Measurement + + + + n/a +
6Human
Resource accounting
Internal Management and external
reporting
Measurement + + (-/+) - n/a -
7 intellectual capital audit
Internal Management Measurement + + + + n/a +
8 Intellectual capital-index
Internal Management and external
reporting
Measurement - + - + n/a -
9 Inclusive value MethodologyTM
Internal Management and external
reporting
Measurement + + + + n/a +
10 Intangible asset Monitor
Internal Management and external
reporting
Measurement + + - + n/a -
12
Intellectual Capital
Benchmarking System
Internal Management Measurement + + + + n/a +
13Intellectual
Capital Dynamic value
Internal Management Measurement - + - + n/a -
14
Intellectual Capital
Statement Reporting
Internal Management and external
reporting
Measurement + + - - n/a -
16 Konrad Group External Reporting Measurement + + - - n/a -
19 Skandia Navigator
Internal Management and external
reporting
Measurement + + - + n/a -
27 Daniel Andriessen, Making sense of Intellectual Capital-Designing a method for the valuation of Intangibles, Elsevier Butterworth-Heinemann, 2004
90
25 Value Chain Scoreboard
External Reporting Measurement + + - - n/a -
2 Calculated Intangible value
Statutory and transactional Valuation + - n/a n/a - -
4Economic
Value AddedTM
reporting
Internal Management and external
Valuation + - n/a n/a - -
6Human
Resource accounting
Internal Management and external
reporting
Valuation + + n/a - (-/+) -
11 Intangibles scorecard
Internal Management and external
reporting
Valuation + + n/a + + +
15 iValuing factor Internal Management Valuation - - n/a n/a - -
17 Market-to-book value
Internal Management and external
reporting
Valuation + - n/a n/a - -
18 Options Approach All three Valuation + + n/a + + +
20 Sullivan's Work
Internal Management and external
reporting
Valuation + + n/a - + -
21 Technology factor
Internal Management Valuation - + n/a - + -
22 Tobin's Q
Internal Management and external
reporting
Valuation + - n/a n/a - -
23 Valuation Approaches All three Valuation + + n/a + (-/+) +
24Value-Added Intellectual
CoefficientTM
Internal Management and external
reporting
Valuation - + n/a + - -
91
Exhibit 2 – Classification of 25 Methods
Financial Valuation, Value measurement, Value Assessment, and Measurement
Is there a value scale we can use that reflects usefulness or desirability?
Is money the unit used on the value scale?
Can the value be translated into observable criteria?
Is there a variable whose state can be observed?
No
No
No
No
Yes
Yes
Yes
Yes
Measurement
92
Financial Valuation
ValueMeasurement
Value Assessment
Exit
Blair and Wallman (2001) have defined three levels of intangibles:
Level 1: These intangibles can be owned and sold. For example, patents,
copyrights, brands and trademarks.
Level 2: These intangibles can be controlled but not separated out and sold. For
example R & D in process, business secrets, reputational capital, proprietary
management systems and business processes.
Level 3: These intangibles may not be wholly controlled by the firm, for example,
human resources, organizational capital and relationship capital.
Level 3
Level 2
Level 1
93
Classification of 25 Methods for the Valuation or Measurement of Intangible
Sr. No. Method Level
(Exhibit )Type of Method
(Exhibit) Community Problem Definition Scope Approach Time Span No. of
Indicators
1 Balanced Scorecard Level 2 Value
MeasurementPerformance Measurement
Internal Management
No Intangibles >1
3Citation-weighted patents
Level 1 Measurement Accounting External Reporting
Subset-Patents 1
5 Holistic Value approach Level 3 Value
MeasurementIntellectual
Capital
Internal Management &
External Reporting
All Intangibles 1
6Human
Resource accounting
Level 3 Value Measurement
Human Resource
Internal Management &
External Reporting
Subset-Human
ResourcesDiverse
7 Intellectual capital audit Level 2 Value
MeasurementIntellectual
CapitalInternal
ManagementAll
Intangibles >1
8 Intellectual capital-index Level 3 Measurement Intellectual
Capital
Internal Management &
External Reporting
All Intangibles 1
9 Inclusive value MethodologyTM Level 3 Value
MeasurementIntellectual
Capital
Internal Management &
External Reporting
All Intangibles 1
10 Intangible asset Monitor Level 3 Measurement Intellectual
Capital
Internal Management &
External Reporting
All Intangibles >1
12
Intellectual Capital
Benchmarking System
Level 2 Value Assessment
13Intellectual
Capital Dynamic value
Level 2 Measurement Intellectual Capital
Internal Management
All Intangibles 1
14
Intellectual Capital
Statement Reporting
Level 2 Measurement Intellectual Capital
Internal Management &
External Reporting
Subset- Knowledge
Management>1
16 Konrad Group Level 3 Measurement Intellectual Capital
External Reporting
Subset-Human
Resources>1
19 Skandia Navigator Level 2 Measurement Intellectual
Capital
Internal Management &
External Reporting
All Intangibles >1
25 Value Chain Scoreboard Level 2 Measurement Accounting External
ReportingSubset-
Innovation >1
94
2 Calculated Intangible value Level 2 Financial
Valuation Accounting Statutory & Transactional
All Intangibles Income Retrospective
4Economic
Value AddedTM
reportingLevel 2 Financial
Valuation
6Human
Resource accounting
Level 3 Financial Valuation
Human Resource
Internal Management &
External Reporting
Subset-Human
ResourceAll Prospective &
Retrospective
11 Intangibles scorecard Level 3 Financial
Valuation Accounting
Internal Management &
External Reporting
All Intangibles Income Prospective
15 iValuing factor Level 3 Financial Valuation Accounting Internal
Management n/aMarket-to-Book
RatioRetrospective
17 Market-to-book value Level 1 Financial
Valuation Accounting
Internal Management &
External Reporting
All Intangibles
Market-to-Book
RatioRetrospective
18 Options Approach Level 1 Financial
Valuation Valuation Internal Management All or subset Income Prospective
20 Sullivan's Work Level 1 Financial Valuation
Intellectual Capital
Internal Management &
External Reporting
Subset- Intellectual
PropertyIncome Prospective &
Retrospective
21 Technology factor Level 1 Financial
Valuation Valuation Internal Management
Subset-Technology Income Prospective
22 Tobin's Q Level 1 Financial Valuation Accounting
Internal Management &
External Reporting
All Intangibles
Market-to-Book
RatioRetrospective
23 Valuation Approaches Level 1 Financial
Valuation Valuation All three All or subset All Prospective & Retrospective
24Value-Added Intellectual
CoefficientTMLevel 1 Financial
ValuationIntellectual
Capital
Internal Management &
External Reporting
All Intangibles
Income and Cost Retrospective
95
Method Modules for the valuation of intangible capital…
96
Exhibit 3 - Questionnaire designed by us for the interaction with the industry experts
1. What are some of the Intellectual Property (IP) or Intangibles in your company that
could or need to be measured or valued?
2. Are you currently involved in measurement or valuation of any of the above IP or
Intangibles?
3. If yes, which ones and which Method/Consulting Company you utilize for this
regard?
4. For above methods/Consulting Company, what are parameters do you consider
during the measurement/valuation of the IP/Intangibles? Could you provide a brief
indicative process of the measurement/valuation process?
5. What Limitations/Difficulties/Challenges have you faced in the Measurement or
Valuation of IP/Intangibles? How have you tried to overcome them?
6. We have created a detailed background and write-up on 26 methods suggested by
researchers for the use in various fields/scenarios. On Based of Different
Characteristics, we have summarized the methods in a table for ease of
comparison.
Would you like to look at this table of Methods and tell us which all have you heard
and which all could be useful for you company?
7. Do you have plans for doing valuation/measurement in future? If yes, which
IP/intangible would you value/measure and how?
Company Name -
Position of Responsibility -
97
Exhibit 4 – Brain League IP Services
History of Brain league28
Brain League was founded by Arun and Kalyan in July, 2004, with an aim of
providing IP Management and strategy services for knowledge driven
companies. They undertook this endeavor to provide the much needed IP
services with a blend of Technology, Management and Law, some of which
services were traditionally offered by law firms that emphasized primarily on law.
Brain League made exponential progress during the first year of its existence by
developing a client base in chemical, telecom, software, electronics and biotech
sectors. The Consultancy has also developed an important component of their IP
Management Software that would enable them to implement their services
Profile of Kalyan C Kanakanala 29
Kalyan C. Kankanala , CKO and Co-founder, has experience in IP Consulting and is
an expert trainer. During his illustrious career as an IP consultant, Kalyan worked
closely with biotech and software companies on strategic IP analysis, IP
Collaboration, Licenses and Audits. He was instrumental in developing a strong
knowledge and training base for Brain League by developing IP content, devising
training programs and running online courses. He has trained more than 2000
corporate employees in biotechnology, software and telecom sectors. As a
visiting faculty at National Law School of India University and Institute of
Bioinformatics and Applied Biotechnology, Kalyan offers courses on Intellectual
Property aspects of Biotechnology. He has an LL.M. in Intellectual Property,
Commerce and Technology from Franklin Pierce Law Center and is pursuing his
doctoral studies at National Law School, Bangalore.
28 http://www.brainleague.com/CorporateProfile.htm
29 http://www.brainleague.com/CorporateProfile.htm
98
Profile of Arun K Narasani 30
Arun K Narasani, CEO and Co-founder, has profound knowledge and
experience in IP Management and Patent Drafting. After working as a software
engineer with various leading companies, Arun began his career in Intellectual
Property as a consultant. He worked with companies in software and electronics
sectors on IP Audit, analysis, due diligence projects and helped them develop IP
Management Strategies and processes. As a patent attorney, Arun has drafted
numerous Indian, US and PCT applications. He has a B.Tech. from IIT, Madras
and PG from IIM Bangalore. During his course at IIMB, Arun's research focus
was on internal factors of innovation in Indian companies with specific focus on
IP.
30 http://www.brainleague.com/CorporateProfile.htm
99
Exhibit 5 – Overview of Infosys31
IntroductionInfosys, one of India’s leading information technology (“IT”) services companies,
uses an extensive non-U.S. based (“offshore”) infrastructure to provide managed
software solutions to clients worldwide. Headquartered in Bangalore, India,
Infosys has seventeen state-of-the-art software development facilities throughout
India and one development center in Canada. These enable it to provide quality,
cost-effective services to clients in a resource-constrained environment. Through
its worldwide sales headquarters in Fremont, California (and 19 other sales
offices located in the United States, Canada, the United Kingdom, Belgium,
Sweden, Germany, Australia, Japan, and India), Infosys markets its services to
large IT-intensive businesses.
Although most Infosys’ revenues are from the United States, Infosys maintains a
diversified client base. This client base comprised of mainly Fortune 500
companies, growing Internet companies, and other multinational companies. As
a result of its commitment to quality and client service, Infosys has a high level of
repeat business.
HistorySeven software professionals founded Infosys in 1981 with the goals of
leveraging sweat equity and creating wealth legally and ethically in India. This
was a daunting task in a country where the government was allegedly more
concerned with redistributing wealth than creating it. Most of India’s commerce
was owned and controlled by an oligarchy of families to which Infosys had no
ties. Infosys’s competitive advantage has historically been derived from low wage
costs in India relative to service providers in the United States and Europe. Their
initial foray into the US market was through a company called Data Basics Corp.
as a “body-shop” or on-site developer of software for US customers. Later, in
31 Management of Human Assets at Infosys, Fordham Graduate school of business case study
100
1987, Infosys formed a joint venture with Kurt Salmon Associates to handle
marketing in the US. These initial entries into the US market were a stepping
stone for Infosys’ growth in later years.32 The liberalization of the Indian economy
has brought unprecedented competition to India. Such multinational corporations
as IBM, Sun Microsystems, and Motorola are now leveraging their vast financial
resources to compete for India’s most valuable resources, its people.
Management of human assets at Infosys“Our assets walk out of the door each evening. We have to make sure
that they come back the next morning.” (Narayana Murthy, CEO Infosys).
At a time when organizations are debating the strategic importance of their
human resources, Infosys, a consulting and software services organization,
includes its human resources on its Balance Sheet to affirm their asset value. Mr.
Mohandas Pai, the Chief Financial Officer of Infosys, provides a rationale for this
practice:
“Investors examine financial and non-financial parameters that determine long-
term success of a company. These new non-financial parameters challenge the
usefulness of evaluating companies solely on traditional measures as they
appear in a typical financial report. Human resources represent the collective
expertise, innovation, leadership, entrepreneurial and managerial skills endowed
in the employees of an organization. Our representation is based on the belief
that intangible assets provide a tool to our investors for evaluating market-
worthiness of Infosys.”
As a knowledge-intensive company, Infosys recognizes the value of its human
assets in maintaining and increasing its competitive position. At the same time,
Infosys realizes that these assets can easily “walk away”, as competitors in India
and abroad covet its IT talent.
32 “Infosys: Can they make it?” Business World 7-21 November 1998, p. 19-22.
101
Future PlansInfosys plans to maintain its growth rate in India and to expand overseas. As a
part of its growth strategy, Infosys is exploring possible candidates for
acquisitions in United States. Infosys believes that pursuing selective acquisitions
of IT services and software applications firms could expand its technical
expertise, facilitate expansion into new vertical markets, and increase its client
base.
As part of its business strategy Infosys is gearing to move up the “value chain”
and provide end-to-end solutions to clients. Infosys will have to achieve these
objectives in the face of many challenges. These include increased global
competition and labor cost, rapid growth, and increased employee diversity. As
Infosys expands overseas, it will experience increased competition from firms
with potentially lower labor costs and with a greater ability to respond to changing
client IT preferences. Historically Infosys’ labor costs have been lower than those
of service providers in the United States and Europe. How ever, because w ages
in India are currently increasing at a faster rate than in the United States, Infosys
will experience shrinking profit margins in future. The rapid growth of Infosys
challenges its ability to transmit its corporate culture worldwide as well as its
ability to attract and retain skilled personnel. Overseas hires and acquisitions w ill
result in Infosys experiencing increased employee diversity of cultures. Increased
diversity will also come from a different set of skills required for expansion into
consulting business. Infosys’ human resource management accounting practices
will have to be assessed in light of these challenges.
Opportunities and threats 33
33 Infosys Annual Report of 2006
102
Innovation and leadership: They are a pioneer in the technology services
industry. Over the past decade, they have developed onsite and offshore
execution capabilities to deliver high quality and scalable services. They assist
clients in segmenting their internal business processes and applications,
including IT processes, and outsourcing these segments selectively on a modular
basis to reduce risk and cost and increase operational flexibility.
Comprehensive and sophisticated end-to-end solutions: Their suite of
comprehensive, end-to-end technology-based solutions enables them to extend
their network of relationships, broaden their dialogue with key decision makers
within each client, increase the points of sale for new clients and diversify their
service-mix.
Commitment to superior quality and process execution: The Company has
developed a sophisticated project management methodology to ensure timely,
consistent and accurate delivery of superior quality solutions to maintain a high
level of client satisfaction. They constantly benchmark their services and
processes against globally recognized quality standards.
Long-standing client relationships: They have long-standing relationships with
large multi-national corporations built on successful prior engagements with
them. Their track record of delivering high quality solutions across the entire
software life cycle and their strong domain expertise help them to solidify these
relationships and gain increased business from their existing clients. As a result,
they have a history of client retention and derive a significant proportion of
revenues from repeat clients.
Status as an employer of choice: They have among the best talent in the
Indian technology services industry and they are committed to remain among the
industry’s leading employers. Their diverse workforce includes employees of 59
nationalities. Their training programs ensure that new hires enhance their skills in
103
alignment with their requirements and are readily deployable upon completion of
their training programs. Their lean organizational structure and strong unifying
culture facilitate the sharing of knowledge and best practices among their
employees.
Ability to scale: They have successfully managed their growth by investing in
infrastructure and by rapidly recruiting, training and deploying new professionals.
They currently have 38 global development centers, the largest of which are
located in India. They also have development centers in Australia, Canada,
China, Japan, Mauritius and locations in the United States and Europe. Their
financial position allows them to make investments in infrastructure and
personnel required for continuous growth our business. They can rapidly deploy
resources and execute new projects through the scalable network of their global
delivery centers.
Risk Management by Infosys:
Human Resource Accounting:The dichotomy in accounting between human and non-human capital is
fundamental. The later is recognized as an asset and is, therefore, recorded in
the books and reported in the financial statement, whereas the former is ignored
by the accountants. The definition of wealth as a source of income inevitably
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leads to the recognition of human capital as one of the several forms of wealth
such as money, securities and physical capital.
Infosys uses the Lev and Schwartz model to compute the value of human
resources.
Brand Valuation:The wave of brand acquisitions in the late 1980s exposed the hidden value in
highly branded companies and brought brand valuation to the fore. Examples are
Nestlé buying Rowntree, United Biscuits buying Keebler, etc. An Interbrand study
of the acquisitions of 1980s shows that, whereas in 1981, net tangible assets
represented 82% of the amount bid for the companies, by 1988 this had fallen to
56%. Thus, it is clear that companies are being acquired less for their tangible
assets and more for their intangible assets. The values associated with a product
or service is communicated to the consumer through the brand. Consumers no
longer want just a product or service; they want a relationship based on trust and
familiarity. A brand is much more than a trademark or a logo. It is a ‘trustmark’ –
a promise of quality and authenticity that clients can rely on. Brand equity is the
value addition provided to a product or a company by its brand name. It is the
financial premium that a buyer is willing to pay for the brand over a generic or
less worthy brand. Brand equity is not created overnight. It is the result of
relentless pursuit of quality in manufacturing, selling, service, advertising and
marketing. It is integral to the quality of client experiences in dealing with the
company and its services over a sustained period. Corporate brands and service
brands are often perceived to be interchangeable. Both types of brands aim at
the enhancement of confidence and the reduction of uncertainty in the quality of
what the company offers. Therefore, companies rely heavily on the image and
personality they create for their brands, to communicate these qualities to the
market place.
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For many businesses, brands have become critical for shareholder wealth
creation. Global brands are still the most powerful and sustainable wealth
creators in the business world and will continue to be so in the near future. The
task of measuring brand value is a complex one. Several models are available
for accomplishing this. The most widely used is the brand-earnings-multiple
model. There are several variants of this model. For example, according to the
Business Week / Intrabrand annual ranking of the world’s most valuable brands
conducted and published in August 2005, Coca-Cola was valued as the most
valued brand in the world for the year 2005 at $68 billion, when its market cap
was $106 billion. Thus, the brand valuation of Coca-Cola was around 64% of its
market cap on the date of valuation. The study goes on to state that even
established brands like Coca-Cola and Microsoft have started to recognize the
need to nurture stronger ties with the customer. (Source:
www.businessweek.com) Goodwill is a nebulous accounting concept that is
defined as the premium paid to the tangible assets of a company. It is an
umbrella concept that transcends components such as brand equity and human
resources, and is the result of many corporate attributes including core
competency, market leadership, copyrights, trademarks, brands, superior earning
power, excellence in management, outstanding workforce, competition, longevity
and so on.
Infosys have adapted the generic brand-earnings-multiple model (given in the
article on Valuation of Trademarks and Brand Names by Michael Birkin in the
book Brand Valuation, edited by John Murphy and published by Business Books
Limited, London) to value their corporate brand, “Infosys”. The methodology
followed for valuing the brand is given below:
Determine brand earnings• Determine brand profits by eliminating the non-brand profits from the total
profits of the company
• Restate the historical profits at present-day values
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• Provide for the remuneration of capital to be used for purposes other than
promotion of the brand
• Adjust for taxes
Determine the brand-strength or brand-earnings multipleBrand-strength multiple is a function of a multitude of factors such as leadership,
stability, market, internationality, trend, support and protection. These factors
have been evaluated on a scale of 1 to 100 internally by the company, based on
the information available within.
Intangible Assets Score SheetInfosys publishes models for valuing the two most valuable, intangible assets of
the company – human resources and the “Infosys” brand. This score sheet is
broadly adopted from the intangible asset score sheet provided in the book titled
The New Organizational Wealth, written by Dr. Karl-Erik Sveiby and published by
Berrett-Koehler Publishers Inc., San Francisco. They believe such representation
of intangible assets provides a tool to their investors for evaluating their market-
worthiness.
Value ReportingInfosys has been at the forefront of providing shareholders information beyond
the stipulations of the regulatory framework. The Value Reporting Revolution:
Moving Beyond the Earnings Game (published by John Wiley & Sons, Inc., USA,
©2001), authored by Robert Eccles, Robert Herz, Mary Keegan and David
Phillips, associated with the accounting firm, PricewaterhouseCoopers, was
successfully received.
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To bridge the gap between the information available to the management and the
information available to the stakeholders, the company provides several non-
financial and intangible performance measures to their stakeholders.
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Exhibit 6 - The Interbrand Method for Valuing Brands34
Criteria for ConsiderationUsing our database of global brands, populated with critical information over the
past 30 years, Interbrand formed an initial consideration set. All were then
subject to the following criteria, which narrowed candidates significantly:
Must be a publicly traded company
Must have at least one-third of revenues outside of their country of origin
Must be a market-facing brand
Economic Value Added (EVA) must be positive
The brand must not have a purely b2b single audience with no wider
public profile and awareness
These criteria exclude brands such as Mars, which is privately held, and Wal-
Mart which is not sufficiently global (it does business in some international
markets but not under the Wal-Mart brand).
MethodologyThe Interbrand method for valuing brands is a proven, straightforward and
meaningful formula that examines brands through the lens of financial strength,
importance in driving consumer selection and the likelihood of ongoing branded
revenue. Our method evaluates brands much like analysts would value any other
asset: on the basis of how much they’re likely to earn in the future. There are
three core components to our proprietary method:
Financial AnalysisOur approach to valuation starts by forecasting the current and future revenue
specifically attributable to the branded products. The cost of doing business
(operating costs, taxes) and intangibles such, as patents and management
34 Best Global Brands 2006, Interbrand, Business Week
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strength, are subtracted to assess what portion of those earnings is due to the
brand.
All financial analysis for the Best Global Brands is based on publicly available
company information. Interbrand culls from a range of analyst reports to build a
consensus estimate for financial reporting.
Role of Brand AnalysisA measure of how the brand influences customer demand at the point of
purchase is applied to the intangible earnings to arrive at branded earnings.
For the report, industry benchmark analysis for the role brand plays in driving
customer demand is derived from Interbrand’s database of more than 4,000 prior
valuations conducted over the course of 20 years. In-market research is used to
establish individual brand scores against our industry benchmarks.
Brand Strength AnalysisThis is a benchmark of the brand’s ability to secure ongoing customer demand
(loyalty, repurchase, and retention) and thus sustain future earnings, translating
branded earnings into net present value. This assessment is a structured way of
determining the specific risk to the strength of the brand. We compare the brand
against common factors of brand strength, such as market position, customer
franchise, image, and support.
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Exhibit 7 - Valuation of Coca Cola and Kellog’s Brand name35
35 www.stern.nyu.edu/~adamodar/pdfiles/brand.pdf
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Valuation of Kellogg’s brand name36
Particulars Kellogg's Generic Substitute
Pre-tax Operating Margin 22.00% 10.50%
After-tax Operating Margin 14.08% 6.72%
Return on Assets 32.60% 15.00%
Retention Ratio 56.00% 56.00%
Expected Growth 18.26% 8.40%
Length of High Growth
Period5 5
Cost of Equity 13.00% 13.00%
E/(D+E) 92.16% 92.16%
D/(D+E) 8.50% 8.50%
Value/Sales Ratio 3.39 1.10
Value of Kellogg Brand Name = (3.39 - 1.10) ($6562 million) = $15,026 million
Value of Kellogg as a company = 3.39 ($6562 million) = $22,271 million
Approximately 67.70% ($15026/$22271) of the value of the company can be
traced to brand name value.
36 www.stern.nyu.edu/~adamodar/New_Home_Page/lectures/brand.html
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Exhibit 8 - Lev and Schwartz human accounting model37
Infosys places an asset value on its human capital based on an accounting
model put forth by Baruch Lev and Aba Schwartz. Lev and Schwartz’s model is
based on human capital theory, which recognizes human capital as one of
several forms of holding wealth for a business enterprise, such as money,
securities and physical capital. In this model of accounting, human capital is
treated like other forms of earning assets and thus is an important factor
explaining and predicting the future economic growth of the company. Lev and
Schwartz’s accounting model is based on the measurement of human capital
using the formula, Vr = ΣT t=r I(t)/(1+r)t-r, w here Vr = the human capital value of
a person “r” years old; I(t) = the person’s annual earnings up to retirement; r = a
discount rate specific to the person; T = retirement age. The formula uses an
earnings profile, which is a graphic mathematical representation of the income
stream generated by a person. Typically, earnings increase with age. As the
person reaches retirement age, productivity declines as a result of technological
obsolescence and health deterioration. This model postulated in 1971 remains
largely unused as a result of criticism from Accounting professionals w ho argue
that human capital cannot be purchased or owned by the firm and therefore
would not be recognized as an asset. Additionally, critics of human capital theory
state that labor force does not have a “service potential”; meaning employees are
paid for rendering current services and no asset is formed by these payments.
Regardless, this model is one of few that exist to value human capital, a source
of know ledge for companies. While very basic, the Lev and Schwartz model
provides a means by which to disclose human capital values to
stakeholders.38The Lev & Schwartz model has been used by Infosys to compute
the value of the human resources as of March 31, 1999. The evaluation is based
on the present value of the future earnings of the employees and on the following
assumptions:
37 Management of Human Assets at Infosys, Fordham Graduate school of business case study38 Lev, Baruch and Aba Schwartz. “On the Use of the Economic Concept of Human Capital in FinancialStatements.” The Accounting Review 44(1971): 103-110.
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1. Employee compensation includes all direct and indirect benefits earned both in
India and abroad.
2. The incremental earnings are based on group/age have been considered.
3. The future earnings have been discounted at the cost of capital for Infosys.
Beta is assumed based on average beta for software stocks in India.
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Exhibit 9 - Economic Approach model - Rolta39
This model estimates the future earnings during the remaining life (in the
organization) of the employee and then arriving at the present value by
discounting the estimated earnings at the employee’s cost of capital. In this
model each employee’s cost to the company (CTC) should be forecasted and
discounted back separately. The growth rate of earnings of each employee till
retirement should be determined for projecting the CTCs after looking into the
company’s compounded annual growth, CTCs for different employee classes,
global industry trends for the future, and sustainable growth rates for the future
25-30 years. The attrition rates for the company/industry should not be
considered as a deduction factor, as the employees who will leave the company
will be replaced by others, to maintain the level of operations and thereby the
employee strength remains unchanged. The future earnings thus arrived at has
to be discounted at the company’s cost of capital.
Based on the above model the value of human resources of Rolta has been
arrived at by Grant Thornton at Rs. 31,404 million.
39 Rolta Annual Report 2005
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