Chapter 9
Investor relations today experience many changes caused by the changes in the economy, regulations, and the role of corporation in society. But one of the main factors fueling these changes is a shift to intangibles. Steve Wallman, a former SEC Commissioner, claims, “When historians look back at the turn of the century, they will note one of the most profound economic shifts of the era: The rise of Intangible Economy.”1
The role of intangible assets and nonfinancial indicators for present-day corporations is constantly growing:
Wealth and growth in modern economies are driven primarily by intangible assets, defined as: claims to future benefits that do not have a physical or financial form. Patents, bioengineering drugs, brands, strategic alliances, customer lists, a proprietary cost-reducing Internet-based supply chain—these are all examples of intangibles assets. The more traditional physical and financial assets are rapidly becoming commodities, since they are equally accessible to competitors, and consequently yield at best a competitive return on investment. Dominant market positions, abnormal profits, and even temporary monopolistic advantage are today most effectively achieved by the sound deployment of intangible assets.2
In other words, not only is the role of intangibles increasing, but the role of tangible assets is simultaneously diminishing as they become less and less capable of creating a competitive advantage and, thus, providing above-average returns.
This role of intangibles makes them an important contributor to understanding a value of a company. In fact, some scholars claim that intangible assets “account for well over half the market capitalization of public companies.”3 In fact, the market value of many corporations today significantly exceeds their “hard” assets even taking into account the difference between current market price of assets and the historical cost-based accounting. In total, the market value of all U.S. publicly traded companies is about “five times larger than their balance sheet value, which reflects primarily the net worth of physical and financial assets.”4 For Internet-related companies, the market price can exceed their “hard” assets value 100 times or more.
The importance of intangible assets and nonfinancial indicators of corporate performance is not escaping managers who readily recognize that intangibles are important to their company’s success. Financial analysts and professional investors also realize the importance of nonfinancial information for proper evaluation of a company. Ernst & Young conducted a series of surveys and experiments with financial analysts to discover that nonfinancial information has a significant influence in stock analysis and its importance is high.5 In fact, financial analysis of the company’s value is heavily dependent on the proper understanding of the contribution of intangibles:
The greatest part of the analysis is based upon intangibles and unmeasurable factors, such as management and the company’s ability to plan and meet its objectives. The more precisely and clearly the elements that define these intangibles are projected, the more readily the company’s ability to appreciate the invested dollar will be understood. The more readily this ability is understood, the more likely the acceptance—and the investment—by a financial community that discounts for the unknown—the risk.6
This means that intangibles should take the central role in “valuation calculus preformed by investors.”7
No doubt that traditional financial disclosure is still important. However, investors want to also understand what stands behind the numbers. Intangibles are the cause of the revenue stream and thus create a better and deeper understanding of the company’s business model. Intangibles are the foundation of the company’s business model, underlying reason for its success or failure. Financial statements, then, become the applications—how well the business idea is being managed and implemented.
Investors also realize this importance of intangibles and nonfinancial factors: “Investors give nonfinancial measures, on average, one-third of the weight when making a decision to buy or sell any given stock.”8 Thus, to better educate investors and shareholders about the company and to create a true understanding of the company, investor relations officers must be proficient at communicating intangibles to the financial publics.
Two accounting professors, Ittner and Larcker, in an article in Financial Times argue that intangibles and nonfinancial measures can be better predictors of financial performance of companies than financial indicators if taken in the long term:
Even when the ultimate goal is maximizing financial performance, current financial measures may not capture long-term benefits from decisions made now. Consider, for example, investments in research and development or customer satisfaction programs. Under U.S. accounting rules, research and development expenditures and marketing costs must be charged for in the period they are incurred, so reducing profits. But successful research improves future profits if it can be brought to market. Similarly, investments in customer satisfaction can improve subsequent economic performance by increasing revenues and loyalty of existing customers, attracting new customers and reducing transaction costs. Non-financial data can provide the missing link between these beneficial activities and financial results by providing forward-looking information on accounting or stock performance.9
In other words, investors and analysts, trying to predict the future financial performance of companies, have a better chance of getting it right if they take into account various nonfinancial indicators.
Yet surprisingly, despite the recognized importance, neither managers nor investors can manage, communicate, or evaluate intangibles as well as they can manage, communicate, and evaluate tangible assets. Several research projects conducted by Lev and his colleagues indicated that “investors systematically misprice the shares of intangibles-intensive enterprises.”10 The questions, however, arises as to why this mispricing occurs? Who or what is responsible for that “underpricing securities and misallocating corporate resources mean that both companies and investors are leaving substantial value on the table. Why would rational people give up large potential gains from optimal investments in intangibles?”11
The answer might lie in inability of investors, essentially outsiders of the company, to fully grasp the value of complex intangible profit-making capabilities. Or in time constraints of financial analysts who have to cover many corporations and digest large amounts of information to present their recommendations to the investors and thus often resort to simplified financial models that do not take into account much of intangibles value. Often the answer lies also in the lack of disclosure about intangibles assets and their value-creating contribution to the organizational business processes in the information that IROs provide to the financial markets. Such shortage of information can no doubt harm investors’ understanding and subsequent evaluation of intangibles: “Look carefully beneath the shiny veneer of intangibles and you will find a knotty and unattractive reality, one in which information deficiencies both at companies and in the capital markets feed negatively on one another.”12
The lack of disclosure to investors about the company’s intangible assets is an important contributor to the problem: “It is widely agreed that corporate financial reports provide deficient information about intangible assets.”13 However, it is unlikely to be the only reason. Another issue is the complexity and difficulty of evaluating these assets. One might argue that the burst of the dot-com bubble was partially caused by the inability of financial analysts and investor to correctly evaluate business models built on intangible assets:
Although managers and financial analysts intuitively perceive the importance of intangibles to business success, they currently lack knowledge about the systematic findings of research into the economic attributes of intangibles, particularly regarding measurement and evaluation. As a result, the management of intangibles and the investment valuation of intangible-intensive companies tend to be haphazard. For example, there are no widely accepted tools available with which a manager might assess the return on investments in intangibles (R&D, brands, employee training). Similarly, investor valuations of intangible-intensive firms are inadequate, leading to a systematic mispricing of securities and excessive stock price volatility.14
In addition to the lack of informative disclosures and lack of measurement matrix, intangibles are suffering from the inability to be evaluated by comparison. In fact, there are hardly ever comparables for intangible assets. Indeed, with tangible assets, investors can often rely on the market prices of such assets because there is a market for land, office space, cars, oil, tools, and other means of production. This helps to evaluate and compare the companies. When intangibles are involved, however, it is rare to find comparable intangibles traded on an open market. Even more, often such intangibles are unique to a specific firm and cannot be transferred to another corporation—like a unique organizational structure or historical ties with a supplier.
Lack of timely, extensive, and accurate disclosure of nonfinancial indicators, inability to measure their value, and nonexistence of market prices and comparables can lead to systematic undervaluation of intangibles causing the companies to suffer by harming their cost of capital and limiting their growth potential. An academic research project analyzed a sample of R & D–intensive companies from 1983 to 2000 and discovered that this underpricing of firms with heavy contribution of intangible assets to the corporate bottom line is, in fact, not random.15 Research and development, one of the intangible activities, can potentially generate a substantial value for a company and, subsequently, its investors. But can investors recognize that
If investors are capable of evaluating R & D activities fairly, then return on R & D–intensive stocks should not differ significantly from returns on the market; in other words, the stock market should fully reflect the future potential of such stocks. Yet study after study discovers that research and development stocks are constantly underpriced “as evidenced by the protracted large and positive returns over several years following portfolio formation.”16
Another reason for the lack of understanding and misevaluation of intangibles is the serious deficiencies and inadequacies in U.S. GAAP’s accounting standard when it comes to intangibles. Modern accounting standards do not include nonfinancial indicators of corporate performance and do not require the companies to disclose much information on intangibles. In this situation, a complete GAAP revision might be required:
But generally accepted accounting principles perpetuate the information deficiency. GAAP treats practically all internally generated intangibles not as investments but as costs that must be immediately expensed, thereby seriously distorting enterprise profitability and asset value. Furthermore, GAAP does not require firms to disclose any meaningful information about intangibles investments, except for aggregate R&D expenditures, lumping the rest of them in with general expenses. This keeps investors in the dark about, for example, how companies allocate R&D budgets to basic research, product development, and process improvements—not to mention the amounts being invested in a host of other intangibles, including software development and acquisitions, brand enhancement, and employee training. The financial reports likewise provide no information on revenue generated by these investments, such as patent-licensing fees or the share of revenues coming specifically from new products. No wonder, then, that investors, trapped in their forced ignorance about intangibles, apply an excessive uncertainty discount to the shares of intangibles-intensive enterprises. In capital markets, no news is bad news.17
In other words, investors have to estimate the value of intangibles without having any information about them—an impossible task. The companies are not required to disclose nonfinancial indicators to help investors in their efforts to understand corporate business models, earnings potential, or long-term vision.
Although not included in GAAP, intangibles can be a significant contributor to the value and thus omitting such contribution can render the whole financial reporting irrelevant. This creates an accounting paradox: “Internally developed intangible assets… are generally not permitted by generally accepted accounting standards (GAAP) to be recognized in the financial statements, but instead are immediately expensed. These assets, such as patents, technology and brand names, are often of significant value to a company.” As a result, the whole idea of usefulness and relevance of accounting reports to investors could be questioned.18
Various non-GAAP and internal performance measures also often suffer from similar fallacies—almost exclusive focus on the financial results. Such overreliance on financial measures versus drivers of value contributes to a short-term and narrow-focused investment perception. Indeed, Enron showed investors that it is possible to manipulate the numbers in the short term when managers are pressured to meet the monthly, quarterly, or annual targets. Focusing on the numbers limits the scope of the company activities and does not explain how these numbers were created: “Numbers are not the most complete or appropriate measure to demonstrate organizational performance… Financial measures also can be manipulated to meet the outcomes desired by the party reporting them.”19
Perhaps overreliance on the financial indicators is the remnant of not-so-distant past, the industrial era of development:
Executives also understand that traditional financial accounting measures like return on investment and earnings per share can give misleading signals for continuous improvement and innovation—activities today’s competitive environment demands. The traditional financial performance measures worked well for the industrial era, but they are out of step with the skills and competencies companies are trying to master today.20
As a result, if the investor relations function aims at building an improved understanding of the company and its business model, this becomes a job of the investor relations officers to present, explain, and educate investors on the value of intangibles the company has and is developing, as well as these intangibles’ contribution to the overall business model and value of the corporation:
Many non-financial factors have demonstrated that they contribute to and have a lasting impact on a company’s market value. Since these non-financial measures are more forward-looking and are linked to operational activities, they help to focus a manager’s efforts and better evaluate employee performance… Managers can no longer afford to hang on to preconceived notions of financial measures as the holy grail of organizational accountability. Integrating non-financial measures regarding the strategic performance of the organization will help to communicate objectives, assist in the effective implementation of strategic plans and provide incentive for management to address long-term strategy.21
This means that corporate executives must pay more attention to intangibles and nonfinancial measures to evaluate performance. The same claim can be extended to investors—who also must rely on intangibles to evaluate the performance of corporations. Investors, however, do not have such an easy access to the data about intangibles and nonfinancial measures—they are in a certain information vacuum because of inadequate disclosure as it relates to intangibles. Thus, it becomes an important part of the investor relations officer’s job to compensate this lack of information about intangible drives of corporate performance by enhancing the scope of information provided to investors and analysts. The nonfinancial indicators that carry information on the company’s corporate strategy, management, organizational capital, employees, research and development, market position, quality of products and services, and corporate social responsibility can satisfy this informational void and help investors and analysts value the company fairly.
This importance of intangibles and, subsequently, the need for disclosing nonfinancial indicators is only going to increase with time as commodization of physical assets will diminish their contribution to the corporations’ value-generation potential and bring the competition into the intangibles sphere. Today, intangibles are not limited to so-called new technology companies but rather become a foundation for creating value in every industry from retail to mining.
Therefore, intangibles become an important part of investor communications for publicly traded companies in every industry. Intangibles are creating competitive advantages for companies and as a result intangibles are the foundation of companies’ business models. Intangibles underlie the financial results and thus understanding a company requires understanding its intangibles. Intangibles allow investor relations officers to better explain the financial results and company’s prospects for future growth. Intangibles also focus attention on long-term performance and are better aligned with long-term organizational strategies and objectives instead of short-term financial results. Finally, intangibles help cultivate long-term relationship with the investors and shareholders. Consequently, it becomes important for investor relations to have a clear understanding what the terms intangibles and nonfinancials mean in regards to investor relations and communicating with the financial public.