Source: The AREOPA Group
Quantification of Intellectual Capital
One of the first companies in the world that actually tried to quantify their non physical assets in a coherent manner was a Swedish insurance and finance company, Skandia. Leif Edvinsson, their Intellectual Director, not only managed to quantify Skandia’s invisible or intangible assets –Intellectual Capital-, but also contributed to the increased awareness of the concept of Intellectual Capital in Europe. His approach is shown in Figure 1.
Figure 1
The lack of means to determine the Intellectual Capital value of an investment opportunity often makes investment decisions very risky. A company with a large share of Intellectual Capital, which is not illustrated in line with the traditional accounting principles, and which has a high future earnings potential, can easily be wrongfully valued. The consequences may be under capitalization and reduced ability for the company to perform optimally.
Measuring the acquisition and use of knowledge assets excites great interest and great skepticism. Even people who decry the inadequacy of today’s accounting worry about putting untried, possibly subjective, non-financial measures into annual reports. Corporate financial statements are clustered enough with goodwill, restructuring charges, and other items, that many complain that they no longer describe financial performance clearly. Yet if it would be a mistake to mingle measures of Intellectual Capital with financial data, it would be a greater one not to use them at all. Ultimately managing Intellectual Capital depends on finding rigorous ways to track it, which correlates with financial results. The data we want should, first, allow management to evaluate year-to-year performance – to measure progress towards goals – and, second but more difficult, permit company-to-company comparisons. Undoubtedly measuring knowledge assets must be imprecise, but there is a lot of informed guesswork in “hard” numbers, too.
Value is defined by the buyer, not the seller: something is worth what someone is willing to pay for it. A company, therefore, is worth what the stock market says: price per share x total number of shares outstanding = market value, what the company as a whole is worth. The simplest, and by no means worst, measure of Intellectual Capital is the difference between its market value and its book equity. The assumption here is that everything left in the market value after accounting for the fixed assets must be intangible assets. If Microsoft is worth $85.5 billion and its book value is $6.9 billion, then its Intellectual Capital is $78.6 billion. But market-to-book ratios have three problems. First, the stock market is volatile and responds, often strongly, to factors outside the control of management. Second, there is evidence that both book value and market value are usually understated. Third, while it is nice to say that Microsoft has $78.6 billion in intangible assets, so what? What can I, as a manager or investor, do with this information?
The research regarding the measuring and visualization of Intellectual Capital and the intangible assets of companies and organizations have, during the last decades, resulted in various methods, models and theories concerning this area of study.
These methods can be classified into four categories of the measurement approaches, as illustrated in the figure below. They are: component-by-component and non-monetary, component-by-component and monetary, organizational level and non-monetary and organizational level and monetary, represented in each quadrant of Figure 2.
Figure 2
Some believe that Intellectual Capital can be quantified and precisely expressed in monetary terms, others deny that such an approach would be possible or viable. AREOPA* belongs to the former, believing in the component by component direct monetary calculation. Intellectual Capital remains the Intangible Asset by excellence, volatile, invisible, impossible to count or measure at first sight. The problem was that until recently, hardly any objective measures of non-financial assets existed, and where they did, they were very specific and limited in scope.
AREOPA’s Methodology to Measure Intellectual Capital
The importance of financial assets in the determination of a company’s market value is decreasing fast and it is equally recognized that non-financial (or intangible) assets are now the main drivers of performance and market value. To date, however, there exist little or no objective quantitative measures of intangible assets, and where they are claimed to exist (e.g. in the valuation of brands, intellectual property, patents, etc.) they are very specific and limited in scope.
AREOPA has developed a model for identifying and quantifying intangibles as components of Intellectual Capital (IC). This model serves to evaluate a company’s return on all the capital it employs, helping to explain the difference between book and market value. It also provides guidance as to how and where management should put its attention to grow the organization’s overall Intellectual Capital.
AREOPA positions Intellectual Capital calculation as a management tool and not as a simple financial calculation of the intangible assets of the organization and thus explaining the difference between book value and market value. Management wants to understand the value of the Intellectual Capital of their organization. By giving a monetary value to the Intellectual Capital, management starts to understand the value and the impact.
AREOPA’s 4-Leaf Model® identifies the sources of added value and competitive advantages in businesses and in particular of virtual organizations -collaborative networks of otherwise independent economic entities- that build their business models around the Internet using minimal financial assets. This model is depicted in Figure 3.
Figure 3
The Four Intellectual Capital (IC) Classes
The four base classes are Human, Customer and Structural Capital, plus Strategic Alliance Capital.
The latter gives recognition to the fact that partnerships, alliances and networks are increasingly important factors of business in the New Knowledge Economy. The strength of the alliance or network significantly impacts the leverage any one company may have in its market, and therefore affects its value.
A second crucial observation is that, apart from Structural Capital, the base IC classes are in fact shared capital. For instance, Human Capital (HC) is shared with its ‘owners’: when a staff member decides to leave the organization, he/she takes his/her skills and competences, reputation and potential along. Similar rules apply to both Customer Capital (CC) and Strategic Alliance Capital (SAC): when the customer takes his business elsewhere or an alliance breaks up, the customer’s revenue potential and partnership’s leverage are gone too.
However, not all may be lost in such extreme but realistic scenarios since at least the customers’ name may remain on the company’ reference list, and a former partner may still perform as an ‘at arm’s length’ supplier: these indicate that some CC and SAC has become structural, and is therefore unaffected by the departure of a customer or a strategic alliance.
The consequence of this is that Intellectual Capital may flow from one sector into the next. And this is where management of Intellectual Capital comes into play. It is important for companies to realize where their Intellectual Capital is situated, and which actions need to be taken to convert Intellectual Capital that is at risk of being lost into Intellectual Capital that has become structural, i.e. to structuralize its Human, Customer and Strategic Alliance Capital to the maximum extent possible.
The IC calculation (ICC) developed by AREOPA contributed to improve a better understanding of the intangible assets of an organization and its related management issues.
The way forward
The accounting community is struggling with a decrease in relevance of traditional financial information and is working on ways to recognize intangible assets in financial statements.
The IASC recognizes that investments in, and awareness of the importance of intangible assets have increased significantly in the last two decades. It has worked for almost 10 years to produce International Accounting Standards on Intangible Assets.
In Europe, steps have been taken by national governments, especially in the Nordic countries, to produce some legislation to force private organizations to make public some Intellectual Capital items. The European Commission is investing heavily in the research and promotion of Intellectual Capital, which, at some point in time in the near future, will hopefully result in some general rules and instructions for the economic community at large to start reporting their Intellectual assets next to the traditional financial values.
* AREOPA was founded in 1987 as a management consulting firm. AREOPA has built up a strong reputation over the years in the development of methods, models and tools in such areas as “Change Management”, “Intellectual Capital” and “Knowledge Management and e-Learning” and the provision of consulting services making use of these methods, models and tools.
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