Valuing Intangible Assets: “The Reporting Gap”

“The Reporting Gap: Earnings and other financials no longer suffice as measures of corporate health,” March 1, 2001, Bill Roberts. Link.

There’s a growing consensus that traditional corporate reporting won’t cut it in the 21st century, especially in knowledge-rich industries like electronics.

Executives and investors alike believe the true worth of a company cannot be gauged solely by the financial indicators that have evolved from the accounting practices of the past 500 years. Equally important are such factors as capital spending, research and development, brand value, market share, customer and employee retention, intellectual property and other so-called intangible assets that traditional corporate reporting does not include.

Several pieces of evidence underscore a significant dissatisfaction with the status quo in reporting. In a recent survey by PricewaterhouseCoopers, New York, high-tech executives, sell-side analysts and institutional investors agree that improved disclosure of non-financial measures would benefit everyone. They rank strategic direction, market growth and cash flow as the three most important measures. The top 10 in importance include only three financials-cash flow, earnings and gross margin. Three-fourths of the executives say their share prices are under-valued based on actual performance. However, less than 15% of analysts and investors surveyed say technology companies provide enough information.

In the survey, PricewaterhouseCoopers interviewed CEOs and CFOs at 160 high-tech companies in various sectors, including semiconductors, computers, networking, software and e-commerce. The firm also interviewed 51 sell-side analysts and 28 institutional investors. Participants were asked to rank 37 performance measures, including traditional financials such as earnings and non-traditional indicators such as management experience and intellectual property. A detailed report on the findings will appear this month in “The Value Reporting Revolution” (John Wiley & Sons Inc.), a book written by four PricewaterhouseCoopers senior fellows.

Analysts and investors are happy with the financial information they get, but want other kinds of information, says Robert G. Eccles, one of the book’s authors. The only information most corporate executives report are three financials that ranked in the top 10 plus strategic direction, leaving six non-financial indicators that are deemed relatively important, he says.

The result, Eccles says, is an information gap between how important the investor community thinks certain indicators are and how satisfied they are with the information they get. This gap exists, he says, because of a second disparity between how important management thinks the indicators are and how actively they report the information. Underlying both is a third gap between how important management thinks the information is and how adequate their internal systems are for gathering the information.

Eccles hopes the book spurs companies and the accounting community to action. He acknowledges the book is merely the latest in a growing body of research on the topic.

For example, the Cambridge, MA-based Center for Business Innovation of Cap Gemini Ernst & Young Inc. studied the stock prices of 250 start-up companies (most of them in high tech) that went public between 1986 and 1997. About half failed to maintain or exceed the price at which they went public. The surprise finding: Revenue and earnings did not differentiate good from poor stock performance for these companies. The only statistically significant indicators of improved stock performance were intangible assets such as management expertise, research leadership, strategy and strategy execution and employee satisfaction.

“Management teams that rely wholly on reporting of their past and current financial performance are operating with blinders on,” says Jonathan Low, the senior fellow who conducted the research (see graphic).

In another survey, Low found institutional investors put a great deal of emphasis on non-financial performance indicators when valuing companies. Non-financial measures account for 35% to 45% of their portfolio allocation decisions. “These investors will deny in public that they do anything more than complex mathematical calculations of financials,” Low says. “Some of them, however, have been privately asking companies about intangibles for years. Clearly they believe this gives them some advantage over other investors.”

One problem is that corporate reporting lacks standards for non-financial indicators. Groups like the Financial Accounting Standards Board (FASB), Norwalk, CT, aren’t convinced these indicators can be translated into dollars and cents. “Financial statements, no matter what we do, have to be in dollars,” says Wayne Upton, a senior project manager who is studying the matter. He says non-financial measures are idiosyncratic to their industries, if not to individual companies. That makes it almost impossible to establish standards that would let investors compare companies the way financials do.

Eccles puts the onus on CEOs and CFOs. “If you’re not happy with your stock price, and there’s information you think is important, don’t expect the market to get it right if you’re not reporting it,” he says. -Bill Roberts

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