Return on Intangibles

This article appears in the October 2013 issue of Chief Learning Officer.

Understanding learning’s value depends on measuring what can’t be touched. 

In his marvelous book Intellectual Capital, Tom Stewart asked, What’s new? Simply this: Because knowledge has become the single most important factor of production, managing intellectual assets has become the single most important task of business.”

In the last twenty years of the twentieth century, Wall Street investors changed the way they determined what a company was worth. That’s why Return on Intangibles is the most important metric in the CLO’s toolkit.

In the Industrial Age, tangible assets produced wealth, so investors put their money on plant and equipment. In the Network Era, know-how, innovation, and relationships became the keys to profitability, and investors began to value these invisible things more than physical assets. Things you couldn’t see (intangibles) became more valuable than things you could see and touch (tangibles).

In 1980, tangible assets accounted for 80% of the market cap of companies in the S&P 500. In a scant two decades, an amazing flip-flop took place. By 1999, intangible assets accounted for 80% of the value of the market. Instead of relying investing in expectation of a continuation of a stable past, investors began betting on the future.

In a scant two decades at the end of the twentieth century, an amazing flip-flop took place. Investors who had put their money predictable output began betting on the future. In 1980, tangible assets accounted for 80% of the market cap of companies in the S&P 500. By 1999, the situation was reversed, with intangible assets accounting for 80% of the value of the market.

That change in what investors value is fundamental to understanding return on investment, but sadly many L&D managers are saddled with outmoded, mid-twentieth century notions and procedures that don’t value intangibles at all.

Mechanically, intellectual capital is a company’s market capitalization (its value on the stock market) less its book value (the value reported on its balance sheet). When I attended business school in the seventies, nobody had this anomaly figured out. Shouldn’t stockholder’s equity be marked to market? The historical figures on the balance sheet failed to report what a company was worth.

Intellectual capital comes in several forms. Human Capital is the know-how and abilities of an organization’s people; Relational Capital is personal and business links to customers, partners, and suppliers; and Structural Capital is the infrastructure, processes, culture, and intellectual property that define how the organization operates.

Intellectual capital is largely a matter of mind and relationships. It’s impossible to measure directly, but you know in your heart that it’s real. What’s more important, the plant or the people? Where’s the real value to come from? The biggest upside is improving know-how, relationships, and processes; that’s what gives investors the confidence to up their ante.

Yet some experts tell CLOs not to quantify the returns on intangibles. Fearing a lack of precision in assessing their value, they leave them out of Return on Investment calculations entirely.

Business people love the security of firm numbers: they feel objective, even when they’re not the right numbers. The downside is that leaving intangibles out of the equation almost guarantees that they will not receive the attention they deserve, leading to unbalanced and suboptimal decisions.

Most business managers recognize that they’re managing a living organization, not a balance sheet, but many managers of L&D are still in a fog. Why? Because they’ve learned a narrow view of Return on Investment, namely ROI as seen through the eyes of a bank loan officer.

Commercial loan officers want assurance that if a loan goes south, they will be able to get their money back. Presumably, a borrower who cannot repay a loan is in trouble, perhaps bankrupt. The business is headed down the tubes. The banker looks at “liquidation value.” What could the bank sell the pieces of the company for? What can be salvaged?

In a fire sale intangibles are worthless. The Human Capital has already walked out the door. Relationships are frayed and there’s no one to maintain them. Brand is tarnished. Perhaps some IP and proprietary processes can be sold off at a discount but you can’t bank on it.

Were I evaluating a company in foreclosure, I’d list intangibles off to the side because I wouldn’t expect to be able to liquidate them.

When I’m working with a going concern, it’s the opposite. I pay more attention to leveraging the intangibles because that’s where the big upside resides.

 

#ITASHARE

Measure what’s important

In the last twenty years of the twentieth century, investors shifted from Industrial Age thinking to Knowledge Era thinking. The shift changed how owners value businesses. The change is fundamental to optimizing return on investment, but sadly many L&D managers are mired in mid-twentieth century thinking.

In the Industrial Age, tangible assets produced wealth, so investors put their money on plant and equipment. In the Knowledge Era, know-how and relationships became the keys to profitability, and investors began to value ideas more than physical things. Things you couldn’t see (intangibles) became more valuable than things you could see and touch (tangibles). 

assets

Mechanically, intellectual capital is a company’s market capitalization (its value on the stock market) less its book value (the value reported on its balance sheet). When I attended business school in the seventies, nobody had this anomaly figured out. Shouldn’t stockholder’s equity by marked to market? The historical figures on the balance sheet were an accounting fiction. 

In 1998, Tom Stewart clarified the situation in Intellectual Capital. Many a manager has yet to get the message. They somehow believe that intellectual capital is ephemeral, immeasurable, and need not be managed. Yet it’s the return on intellectual capital that makes or breaks a Knowledge-Era company.

Intellectual capital comes in several forms. Human Capital is the know-how and abilities of an organization’s people; Relational Capital is personal and business links to customers, partners, and suppliers; and Structural Capital is the infrastructure, processes, culture, and intellectual property that define how the organization operates.

Today intangibles are generally more important than tangibles in boosting value. Take Google as an example. Google’s book value (i.e. assets less liabilities on its balance sheet) is $75 billion. That’s the Googleplex and a whale of a lot of server farms. Google’s market cap (i.e. share price x number of shares) is $295 billion. That’s what investors expect to get back if Google continues to innovate and improve, discounted for the time value of money and risk. Investors rate Google’s intangible assets three times more important than its tangibles. Indeed, if you took away the knowledge in Googlers’ heads, the company’s reputation and relationships, and its secret sauce, you wouldn’t have much left. 

Yet some people refuse to quantify the returns on intangibles. Fearing a lack of precision in assessing their value, they leave them out of Return on Investment calculations entirely. Business people love the security of numbers: they feel objective. Leaving intangibles out of the equation almost guarantees that they will not receive the attention they deserve, leading to unbalanced and suboptimal decisions.

“You cannot manage what you cannot measure” is one of the oldest cliches in management, and it’s either false of meaningless. It’s false in that companies have always managed things–people, morale, strategy, etc.–that are essentially unmeasured. It’s meaningless in the sense that everything in business–including peole, morale, strategy, etc.–eventually shows up in someone’s ledger of costs or revenues. Tom Stewart

Most business managers recognize that they’re managing a living organization, not a balance sheet, but many managers of L&D are still in a fog. Why? Because they’ve learned a narrow view of Return on Investment, namely ROI as seen through the eyes of a bank loan officer. (The leading teacher of ROI-for-L&D is a former banker.)

Commercial loan officers want assurance that if a loan goes south, they will be able to get their money back. Presumably, a borrower who cannot repay a loan is in trouble, perhaps bankrupt. The business is headed down the tubes. The banker looks at “liquidation value.” What could the bank sell the pieces of the company for? What can be salvaged?

In a fire sale, most intangibles become worthless. The Human Capital has already walked out the door. Relationships are frayed and there’s no one to maintain them. Brand is tarnished. Perhaps some IP and proprietary processes can be sold off at a discount but you can’t count on it.

Were I evaluating a company in foreclosure, I’d list intangibles off to the side because I wouldn’t expect to get much back from them.

When I’m working with a going concern, it’s the opposite. I pay more attention to leveraging the intangibles because that’s where the big upside resides.

What’s new? Simply this: Because knowledge has become the single most important factor of production, managing intellectual assets has become the single most important task of business. Tom Stewart

Looking back

In early 1999, when I first encountered Tom Stewart’s book, Intellectual Capital, the title scared me away. Too cerebral. I overcame my reluctance and the book became a fantastic eye-opener. The concepts are too important to pass up, especially if you are dealing with a bean-counter/banker decision maker.

Intellectual capital is intellectual material–knowledge, information, intellectual property, experience–that can be put to use to create wealth. It is collective brainpower. Tom Stewart

If you, too, are temporarily stymied, perhaps this will help.

Internet Time Lines, the model railroad that runs on my desk, carts metaphors back and forth. Yesterday, we were hauling tangible and intangible assets.

since2000

 

1980

 

Does that help or does it get in the way?

 

 

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HRExaminer

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