• Business Intelligence
• Collaboration
• Competitive Intelligence
• Communities of Practice
• CRM
• Culture
• E-learning
• Enterprise Content Management
• Enterprise Search
• Intranets & portals
• Taxonomies

• News
• Events

Feature

posted 1 Oct 1998 in Volume 2 Issue 2

Intellectual Capital - The Rewards and the Risks

Derrick D'Souza and Ken Douglas recognise that there are significant rewards to be gained by those businesses that can relate their investments and management of intangibles explicitly to their market value. But first they need to define what 'Intellectual Capital' actually means.

The measurement of 'Intellectual Capital' is attracting a great deal of topical management interest. As companies spend relatively higher proportions of their funds on intangibles, significant inadequacies in traditional management models and reporting structures are being exposed. Two prime goals, therefore, lie at the heart of this interest:

1. How to help shareholders and investors quantify the value added by a company's intangible assets.

2. How to help make the right internal decisions relating to investment and management of intangible assets.

Underpinning these goals is the observation that market/book ratios are considerably higher now than has historically been the case. There are many reasons for this, including, for example, a trend to lease rather than own physical assets. In addition financial markets now place much more emphasis on the potential cash flow creation of businesses and it is here that intangible assets are increasingly recognised as having a key role to play.

There are clearly significant rewards to be gained by businesses that can relate their investments and management of intangibles explicitly to their market value. This is the Holy Grail of Intellectual Capital measurement. However, there are also significant risks. Our experience has been that it is all too easy for management to put faith in inappropriate or over simplistic measures, which can significantly hamper effective decision-making and/or do little to help investors understand how to assess such investments.

The problem of defining Intellectual Capital

Before we look at how to make effective use of Intellectual Capital measures it is important to recognise a fundamental flaw in one of the most common definitions. Intellectual Capital is often described as the difference between a business's market value and it's accounting book value, and that this can be divided into components including 'human capital', 'structural capital' etc. Various measures are then defined to represent each of these components and the objective for corporate management is therefore to increase their 'score' on each, thereby increasing intellectual capital and consequently the company's market value.

There are a number of problems with this approach. For example, it is difficult to tie market valuation to specific assets (whether physical or intangible). This is largely because an asset's ability to create value is not an independent variable: it is heavy influenced by interaction with other assets. Also, investors may see a 'score' for a particular asset but it is difficult to gauge if this represented a good return on investment or if best supports strategic aims. This approach also encourages the view that direct comparison of specific intellectual assets across organizations is meaningful. This is potentially very dangerous since absolute measures of intangibles (e.g. explicit knowledge) are difficult to achieve and their significance varies considerably depending on an organisation's strategy.

We need a better model to think about intangible assets and how they drive market value. When equipped with that we can begin to consider what action management can take to optimise the return on their intangible asset base, better inform their investors and be aware of what can and cannot be sensibly done to benchmark themselves against competitors.

Firstly, let's start by re-defining what we mean by Intellectual Capital. In economic terms, capital is equivalent to investment. Therefore, Intellectual Capital is a term that measures investments into non-physical assets or intangible assets. Unlike investment in most physical assets, accounting rules do not allow us to reflect investment in most intangibles in 'book value'. However, it is possible to conceive a 'true' book value as shown in figure 1.

Figure 1

Why should we care about measuring these investments? As with all investments, appraising those in intangible assets should include ensuring that the present value of future returns more than covers the cost of initial investment. We term the present value of all future returns generated by investments in intellectual capital, 'intellectual value'. By definition, therefore, the difference between intellectual value and Intellectual Capital is Intellectual Value Added (IVA). The objective for corporate managers is now very clear - invest in those projects that have the greatest positive IVA.

Implementing a useful management framework

There are several steps which management can sensibly take to begin to come to grips with their investments and returns on intangible assets. Measurement is a critical part of these steps but not necessarily the primary focus:

1. Understanding and classifying intangible assets.

2. Developing a strategy which explicitly develops and levers intangible assets.

3. Developing measures to gauge progress and success.

4. Communicating - as appropriate - key portions of the strategy and measures to external parties.

Let's look at each of these in turn.

Understanding and classifying intangible assets

There are many models for intangible assets. These are well described elsewhere and we will not cover these in detail here. The key point to recognise is that no one model is necessarily right or complete. This is not an exact science and so management should feel free to choose whatever model they feel most comfortable with - or make any changes they feel is appropriate.

Figure 2 outlines the main categories that business managers should be aware of and understand. It is quite possible to assign measures to all of the intangible assets at this time and undertake a program to improve these across the board. This approach is generally too unfocussed to work well. To be effective the measures need to be prioritised and tied more explicitly to strategy.

Developing measures to gauge progress and success

We noted earlier that measures of "absolute" value, which directly relate intangible assets to market value, are elusive at best and misleading at worst. However surrogate measures can be extremely useful for internal management. They can motivate action and, if properly defined and tracked, enable learning about how their strategy is working.

Typically we use a Balanced Scorecard framework for establishing the appropriate measures in a context that is easy to relate to business strategy (see Figure 4). Both "lead" measures (which relate to investment) and "lag" measures (which relate to returns/outputs) should be established along with appropriate targets. The process for doing this is often as important and revealing as the measures themselves since it provides management the opportunity to test, revise and understand their view about what drives results.

A lesson learned from experience is that looking at trends over time ("managing by deltas"), and avoiding the pitfalls of placing too much emphasis on absolutes, is usually the most effective way to use these measures. Tracking, monthly, quarterly and annual changes and testing whether original cause and effect assumptions are still valid provides senior management with a very powerful basis by which to govern their business.

Communicating key portions of the strategy and measures to external parties

Market value is driven by a complex interplay of supply and demand, and investor and analyst assumptions about the present value of future cash flows. It is therefore important to increase their confidence and belief in a business's ability to do this. As far as value added through intangible assets is concerned this is not solely achieved through measures.

Some companies have opted to publish such measures as supplements to their annual reports. It is arguable however that it is not the figures which are important but demonstrating a convincing plan to exploit and develop intangible assets and clearly linking this to strategy.

A final note is that explicitly communicating strategy and measures for intangibles is increasingly viewed as good investor relations practice, with a caveat, however, that there remains a need to weight the benefit of communicating this versus retaining competitive confidentiality.

In Summary

In summary, here are good reasons why management should take Intellectual Capital measurement seriously. Intangible Assets undoubtedly play a more significant role in dictating market value than has been the case previously. However, prescriptive methods to explicitly measure such assets can be dangerous and may not help management make the right investment decisions or help investors assess the likely returns. The key lessons learned in this field are:

Link investment decisions and measures directly to your strategy

Keep in mind that management is more important than measurements (measures will not per se improve performance)

Understand the cause and effect assumptions inherent in linking Intellectual Capital to financial results. Periodically review them, test them, and change them

Take a systemic view: it is the interplay of assets with each other and their use that creates value

Having a measure is less important than understanding what you are trying to measure and why

Beware of standard models - the measures could be misunderstood without the appropriate strategic context.

The Holy Grail of direct linkage of explicit predictable measures to value is still a long way from becoming a management reality.