Definition of Intellectual Capital:spidi2.iimb.ac.in/~networth/CCS/2005/589 CCS... · Web viewHowever, the method is not very useful as the company doesn’t know what went wrong

Introduction

Definition of Intangibles Assets1:It broadly means invisible assets that include employee competence, internal

structure and external structure.

The International Accounting standards Board defines an intangible asset as “an

identifiable non-monetary asset without physical substance held for use in the

production or supply of goods or services, for rental to others, or for

administrative purposes”

According to this definition, an item can be recognized as an intangible

asset if it meets the definition and it is probable that the future economic

benefits will float to the enterprise. Otherwise, the item is to be treated as

an expense.

As a result many intangible resources cannot be recognized on the

Balance Sheet

Another common term in accounting is goodwill. Goodwill is defined as the excess of the cost of an acquired company over the sum of identifiable net assets

Nowadays the most important factors of production are the intangible assets.

These intangible assets include staff skills, strategic and process quality,

software, patents, brands, supplier and customer relationships etc. They are the

highest contributor to corporate competitiveness.

1 Daniel Andriessen, Making sense of Intellectual Capital-Designing a method for the valuation of Intangibles, Elsevier Butterworth-Heinemann, 2004

1

Levels of IntangiblesBlair and Wallman (2001) have defined three levels of intangibles2:

Level 1: These intangibles can be owned and sold. For example, patents,

copyrights, brands and trademarks.

Level 2: These intangibles can be controlled but not separated out and sold. For

example R & D in process, business secrets, reputational capital, proprietary

management systems and business processes.

Level 3: These intangibles may not be wholly controlled by the firm, for example,

human resources, organizational capital and relationship capital.


2

The Current Scenario3

Nowadays the most important factors of production in developed economies are

invisible. These intangible assets –

Patents Staff skills

Software Strategic and Process Quality

Brands Supplier and Customer Relationship

are delivering a fast-growing contribution to corporate competitiveness. And

massive investment is being made in these assets: in the figure below, Leonard

Nakamura from the Federal Reserve Bank of Philadelphia puts the total for the

USA in 2004 at USD one trillion, equivalent to about 9% of US GDP and fast

approaching capital expenditure on tangibles.

Source: L. Nakamura, Federal Reserve Bank of Philadelphia - 2005

As the figure below shows (Expensive Names), even in the classical

manufacturing sector, land, real property and machinery are becoming less

important relative to intangible assets. But it is with “R&D-intensive Producers”

and “Knowledge-Intensive Service Providers” where the intangibles play a really

prominent part. Together in 2006, they made up an average of one-third of

macroeconomic output in the G6 and the EU-15. Figure below shows that the

3 Deutsche Bank Research, October 19, 2005

3

International trade in patents and licenses is also growing apace which provides

more scope for market-based valuation.

Sources: Interbrand, Business Week, Bloomberg 2005

4

Brisk Trade in Intangibles4

a) Income from and b) Expenditure on patents and licenses

b) in international payments in % of GDP

Sources: IMF Research 2005

In short, the oft-heralded knowledge society is very much a reality. One might be

tempted to believe that this would be reflected in the valuation of companies and

their projects; that their creditworthiness and attractiveness as an investment

would rest in large and an increasing measure on the analysis of their

intangibles. Unfortunately, ground-realities are wide off this mark. At present,

intangible assets enter into company ratings – if on any notable scale at all – on

a generally unsystematic basis, accorded rather superficial treatment and

virtually impossible to compare. Inevitably, therefore, many companies’

performance is under- or overestimated. The consequence is misallocation on

the capital market and ultimately passed-up growth. Therefore in our study, we

examine methods for more intensive analysis of intangible assets, outlining

obstacles and showing how financial services providers and their clients can

secure a competitive lead.


5

Stepmotherly Treatment5

In a survey of fund managers, private equity investors, venture capitalists and

bank analysts dating from 2001, almost 90% of survey respondents considered a

company’s intellectual property an important factor in their investment

assessment. So what is the contention? In the same study 70% of respondents

felt convinced that the market lacked reliable tools to value intellectual property

effectively. 56% even stated that the value of intellectual property could not be

measured at all, leaving them no alternative but to rely on a subjective, inevitably

unrelated assessment hardly consistent with their own estimation of the

significance of intellectual property in valuing a company.

Value Intangibles!6

Intangible capital can and must be valued – Owners and Valuers alike will benefit

The reality is that we are living in the knowledge society. Yet even now intangible

capital, from employee training to brands, is scarcely valued systematically at all.

That is an unhealthy sign: The cost of capital has steadily increased to very high

levels for the knowledge-intensive companies. Investors and lenders are missing

out on potential earnings and the economy on potential growth. A lack of suitable

methods is perceived as the key obstacle to more extensive valuation. However,

on closer inspection we observe:

Promising valuation models do already exist 7

Various methods of Non-Monetary and Monetary Valuation (which by no means

is necessary) of intangible assets are already available – and some of them

tested in practice. We offer an overview to set of 25 methods from the field of

Intangible Valuation.

5 Deutsche Bank Research, October 19, 20056 Deutsche Bank Research, October 19, 20057 Deutsche Bank Research, October 19, 2005

6

These methods can optimize investment and lending8

Each has its specific strong points, and each area of application have certain

requirements in particular. The methods available can, some as stand-alones

and some in combination, crucially improve the information base in many

valuation situations, from internal resource planning through lending to M&A.

Companies should (be allowed to) report more on intangibles 9

Restrictive accounting rules, fear of divulging secrets and the absence of a

common language are major impediments while reporting on intangibles.

Cautious opening-up of mandatory reporting requirements and the development

of voluntary reporting would be needed to improve the level of knowledge

presented to the capital market.

Takers and providers of capital alike can secure themselves a tangible

competitive edge with more systematic measurement of intangible capital. For

this they need experience and, most importantly, a close relationship with one

another. This can be built up only slowly – often in the course of new business

processes. Those who start capitalizing early would have an added source of

competitive advantage. The early bird catches the worm.

Still a long way to go!Bitter are the roots of knowledge, but its fruit is sweet - Marcus P. Cato, 234-149 BC

Tangible benefits from knowing about intangibles

Clearly investors and lenders stand to gain a lot from more systematic valuation

of intangible capital. But companies themselves often lack information about the

returns on investments in intangible assets. Companies are missing an important

element of the image they wish to portray -

8 Deutsche Bank Research, October 19, 20059 Deutsche Bank Research, October 19, 2005

7

To investors, lenders and public sponsors - Leading to inordinately high

costs of capital for knowledge-intensive service providers and R&D-

intensive good manufacturers in particular

To Customers – To whom innovation or cost leadership should be

communicated more transparently

To Labor Market – It is often receptive to a company’s “soft values”

From a welfare point of view more systematic valuation of intangible assets

should lead to more growth:

Companies aware of the value of their IP can better trade these assets or

licences

Capital would be channeled more reliably to its most efficient uses. This

would enable a better access to equity and dept for fledgling, knowledge-

intensive companies – a pivotal innovation driver.

Improved information on intangible assets would render capital markets

less volatile, and investors and companies would have more faith in them.

This, in turn, could increase the investment in equities.

Given that more appropriate valuation requires better corporate reporting

on intangible assets, so information asymmetry between wholesale and

retail investors could be partially alleviated. From the point of view of big

investors, some of whom are already extremely well informed, this would

admittedly have less appeal, but in terms of perceived fairness on the

capital market as a whole – and hence its efficiency – it would presumably

be beneficial.

But the contribution of these assets is not reflected in the valuation of the

companies. This is due to the fact that it is very difficult to measure and value

these intangibles.

Difficulty in Measurement of Intangibles10:


8

The intangibles of different companies include intangible resources that are all

very different by nature. Some are intellectual or knowledge assets and some are

not.

The unique characteristics of intangibles mean that it is impossible to fit them into

the transaction based accounting system. (Webber, 2000)

As a result they are given only a very superficial treatment. This results into a

lack of transparency of intangibles which makes it very difficult for companies

that lack tangibles assets to raise money from investors or banks as the banks

are biased against lending to companies with few tangible assets. This lack of

transparency also leads to undervaluation of companies that are intangible

intensive.

Not all Plain Sailing11

Given the advantages to all concerned, what is preventing greater recognition of

intangible capital in corporate valuation?

First, companies say too little about their intangible assets…

…because of the shackles imposed on them by accounting regulations.

Without the appropriate information from within a company, an outsider is

unable to analyze its intangible assets.

…because they do not want to divulge any competitive advantages.

…because there is still no generally received vocabulary for intangibles.

Even if companies were prepared to publish more information on

intangibles, in many cases there is still no common language.

Second, valuers and the capital market are out of their depth…

…because it is often virtually impossible to compare intangibles. The

value of a tangible good becomes apparent when it is sold. Staff skills and


9

organizational processes unfold their value only in the context of a specific

company.

…because intangibles are often particularly risky.

…because they lack knowledge of valuation methods. What is more,

varying methods are suited to different fields of application.

…because the capital market still lacks faith.

Thus the Method Knowledge is the pivotal driver for the promoting the trend of

Intangible Capital Valuation

Why Classification of Intellectual capital is difficult?12

Mouritsen et al. (2000c) have said that the classification of intellectual capital is

difficult:

Mainly because the categories are interrelated and even integral to each

other. People(human capital) work through technology (structural capital)

and customers (relational capital) get services from people (human

capital)

Also, because the same indicator can sometimes fall into two categories

at the same time. For example, employee training in technology may fall

under human capital or structural capital. It is in fact this synergy between

intangibles that creates uniqueness and wealth, not the individual

resources.

Another problem is that when the same classification scheme is used for

different companies, every company starts to look the same. While this

similarity helps in benchmarking, it is a hindrance when it comes to

making strategic management decisions on how to improve or sustain

company success.12 Daniel Andriessen, Making sense of Intellectual Capital-Designing a method for the valuation of Intangibles, Elsevier Butterworth-Heinemann, 2004

10

Finally, classification does not provide any guidelines for handling issues

or solving problems.

11

Valuation

Approaches to valuation13:

There are three main approaches to financial valuation:

1) Cost approach

2) Market approach

3) Income approach

1) The cost approach: It is based on the economic principles of substitution

and price equilibrium. These principles assert that an investor will pay no

more for an investment than the cost to obtain an investment of equal

utility. The problem with the cost approach is that in many cases cost is

not a good indication of value. However, this methods is appropriate to

value intangible resources when setting transfer prices, royalty rates etc

2) The Market approach: It is based on the economic principles of

competition and equilibrium. These principles assert that in a free and

unrestricted market, supply and demand factors will drive the price of any

good to a point of equilibrium. However, when the subject resources are

unique, this approach is not appropriate.

3) The Income approach: It is based on the economic principle of

anticipation. The value of intangible resources is the current value of the

expected economic income generated by these resources.

A standard critique of valuation models, in general, and discounted cash flow

models in particular is that they fail to fully account for the many intangible assets

possessed by firms. There have been attempts to value brand name, trade


12

marks and copyrights and bring them on to the balance sheet. Other intangible

assets include patents and customer lists. We would expand this list to consider

the flexibility that a firm may preserve to expand its market or enter new markets.

Company Valuation - Categorizing Methods14

On critical examination, the method of estimating a company’s intangible assets

already in common use – determining goodwill, i.e. the difference between the

market and book value – does not appear very suitable, as is immediately

apparent from the often high volatility of this indicator owing to market

fluctuations. That hardly makes it an appropriate means of modeling values such

as staff skills, process knowledge and customer relations, which tend to develop

slowly over time. Intangible asset valuation models less widespread at present

than goodwill can be categorized according to various criteria:

Objective - Is a company seeking a loan? Are there plans to invest in the

company? Is it up for sale?

Granularity - Are individual intangibles (e.g. specific patents or bundles of

patents), knowledge-intensive projects, business divisions including their

intangible assets, or entire companies being valued?

Perspective - Does the company’s management value its intangible

assets itself, or are they valued by an external player (a lender, a private

equity or venture capital company, a fund manager, rating agency or

private investor)?

Measure - Does the analysis set out to deliver a monetary value? Or is a

non-monetary indicator, but one which still permits comparisons, sufficient

as a value metric (e.g. an industry benchmark)? Or are pure-play

statistical readings without a measure of value (e.g. the average number

of hours’ training per employee and year) adequate?


13

The latter distinction is particularly important. Whether monetary valuation is

necessary, or an alternative value metric will suffice, depends on the valuation

objective. However, a model merely recording purely statistical measurements is

of only very limited use. Who can judge, without a standard metric to go by,

whether a certain number of hours’ training is sufficient? Yet in a recent

comparative study12 nine of the 25 methods examined delivered measurements

only without a benchmark – among them the best-known, the “Skandia

Navigator” developed by insurers.

14

Method Modules for the valuation of intangible capital…15


15

Literature on the other methods for the valuation of intangibles16:

Many authors state many different methods of valuation of intangibles. We have

studied 25 methods used in the measurement or valuation of the intangibles.

These 25 methods address a wide variety of problems.

1. Problems involved in improving internal management

2. Problems involved in improving external reporting

3. Reasons to analyze the value of intangible resources-statutory or

transactional

The issue of improving internal management is a wide one and various

problem definitions fall into these categories:

a) How to measure the intangible resources as only what gets measured,

gets managed.

b) How to improve the management of intangible resources.

c) How to create resource based strategies.

d) How to monitor effects from actions

e) How to translate business strategy into action.

f) How to weigh possible courses of action

g) How to measure income in a reliable way

h) How to enhance the management of the business as a whole

The second issue is of improving external reporting. The basic premise is

that improving disclosures makes the capital allocation process more efficient

and reduces the average cost of capital. The various problem definitions

categories are:


16

a) Closing the value gap between book and market value

b) Improving information to stakeholders about the real value and the future

performance of the enterprise

c) Reducing information asymmetry

d) Increasing the ability to raise capital

e) Enhancing corporate reputation and affecting stock price

The third issue is of Statutory and Transactional reasons for valuing intangible resources. Statutory provision, administrative ruling or regulatory

authority can mandate a valuation. Alternatively, valuation an be discretionary in

the case of a transaction.

Some other noteworthy points in these 25 methods are:

1) Twelve methods are financial valuation methods that use money as the

denominator of value. The other 15 do not use money

2) Nine methods do not use values, norms or other yardsticks and hence are

not considered valuation methods. They are merely measurement

methods.

17

Methods used for Valuation and Measurement of Intangibles17

Exhibit 1 provides a summarized review of the following 25 methods. Exhibit 2 provides different frameworks in which a prospective firm can match its

parameters to those in framework and arrive at a suitable Intangible Valuation or

Measurement Technique that can help further its Accounting/Business

Strategy/Monetizing of intangibles.

1. Balanced Scorecard (BSC)18

This is a measurement method used to measure tangibles like skills,

competencies and motivation of employees, innovation in product and

services etc.

The use of this method helps the company to track financial results

and at the same time acquire the strategic skills necessary for the

future growth.

17 Daniel Andriessen, Making sense of Intellectual Capital-Designing a method for the valuation of Intangibles, Elsevier Butterworth-Heinemann, 200418 http://images.google.com/images?sourceid=navclient&ie=UTF-8&rls=RNWE,RNWE:2005-34,RNWE:en&q=Balance%20scorecard&sa=N&tab=wi

18

Intangible assets

Intellectual capital

The BSC looks at four perspectives: the customer perspective, the

internal perspective, the innovation and learning perspective and the

financial perspective. These four perspectives are used to create a

strategy map which illustrates the path by which improvements in the

capabilities of intangibles assets are translated into tangible customer

and financial outcomes.

The BSC consists of 20 to 25 measures grouped under each

perspective. All these measure should be measurable, reflect the

outputs, must be something that can be influenced by the people

responsible and more importantly must have a specific target attached.

However, the score card does not measure the size or value of the

intangibles.

2. Calculated intangible value

It is a financial valuation method used to help new knowledge intensive

businesses acquire loans. Since the knowledge intensive companies

have few tangible assets as collateral, the method assumes that the

premium on a company’s value is a result of its intangible assets.

Publicly available accounting information is used to calculate a

premium return on assets on tangible assets. This is compared to the

industry’s average ROA. The industry ROA is multiplied by the value of

19

Patents

the company’s intangibles. The present value of this premium is found

by using a discount rate.

However, the method doesn’t reflect the value of the intangibles that

contribute to normal earnings.

Also, if the intangible value for a company that performs below industry

average is calculated then it shows a negative value. This would

indicate a negative value of its intangibles which cannot be true.

Another limitation is the problem of finding the right benchmark.

The calculated Intangible value method is an elegant method that uses publicly

available accounting information to calculate a premium on tangible assets. It can

be used for benchmarking to show whether an organization is fading or whether

it has value not reflected in the balance sheet (Luthy, 1998). It can show traders

when they may be a buying opportunity (Stewart, 1997).

3. Citation-Weighted patents

The method assumes patents as a proxy for inventive output and

patent citations as a proxy for knowledge flows or knowledge impact.

The citation of a particular patent in other patent information provides

information about the size of the technological “footprint” of the cited

patents.

The method combines both these assumptions to construct a citation-

weighted patent index, in which the number of patents a firm has is

weighted by the number of citations.

According to the method citations-weighted patents are more highly

correlated with market value of the patents themselves, because of the

20

high valuation placed on firms that hold highly cited patents. An

increase of one citation per patent is associated with a 3% increase in

market value.

This method is used to value the portfolio of patents. But it is limited to

patents and is meaningful only when compared with other companies.

The other limitation is that it is easy to manipulate as a company can

influence the number of self-citations. Also, the time taken to grant the

patent and the time before it is cited are both too long.

The citation-weighted patent method is not meant to improve management but to

explain market value. However, the correlation found between the index and

market value can help to improve company performance. The method can

indicate the value of a portfolio of patents. Companies can benchmark a citation-

weighted portfolio against competitors and use this information to make

investment decisions. Furthermore, Hall et al. (2001) show that patents with more

than 20 cites has a strong impact on market value. This information can help

management to identify individual patents with high values.

4. Economic Value Added

EVA is a financial evaluation method.

However, there is only an indirect link between EVA and the value of

intangible resources.

It has never been the intention of the EVA method to measure the value of

intangible resources. Yet, EVA is on many lists of intellectual capital

measurement methods (Bontis, 2001; Bontis et al., 1999; Sveiby, 2002; Van den

Berg, 2003). However, EVA is not a stock but a flow indicator. It therefore cannot

be a measure of the value of intangible resources. At the most, it indicates the

added value of a resource. But whether it measure the added value of intangible

resources is debatable.

21

Intellectual Capital

HumanCapital

Relational Capital

Organizational Capital

5. Holistic Value Approach

It is a combination of Intellectual Capital Index method and Inclusive

Value Methodology.

Intellectual Capital is divided into human capital, organizational capital

and relational capital.

Measurement of intellectual capital is in two forms. Intellectual capital

stock is like a traditional balance sheet. It provides a snapshot in time

but doesn’t explain the causes of change in value. Intellectual capital

flow statement is like a profit and loss statement which provides

information on the transformation from one intellectual capital category

to another. When stock is used, value is created. However, value

created is different for each category of stakeholder.

But the major limitation of this method is that each stakeholder has a

different and a very subjective definition of value which cannot be

combined.

Roos was the first to acknowledge that there are two fundamentally different

perspectives in creating an intangible resources valuation system:

1. The logical-positivist perspective: value should be measured as

objectively as possible

2. The axiologist perspective: value is always subjective and should

be treated as such

22

Human Resources

Human Assets

The HVA is based on this axiologist perspective. The approach models the

mental maps of stakeholders of a company (for example, a management team, a

group of shareholders, environmental pressure groups, or public opinion).

Information derived from these stakeholders is translated into a model about how

these stakeholders is translated into a model about how these stakeholders

believe value is created within the company.

6. Human Resource Accounting

Human Resource Accounting is based on the assumption that people

are valuable organizational resource.

Human resource value models can be monetary, non monetary or a

combination of both. A number of monetary models calculate the value

of future wages and models that allocate a portion of discounted future

earnings to human resources. Non monetary models use indicators to

measure aspects of human resource.

However, this method focuses only on human resources and not other

intangibles.

Also, it has been accused of “putting a price on people” and is not

widely acceptable.

HRA is in many respects the predecessor of the intellectual capital movement. Of

course HRA focuses on human resources only whereas intellectual capital

focuses on other intangibles as well. But their aim seems to be the same. This

aim is well phrased by Sackman et al. (1989): “Specifically, it can contribute to an

23


Market assets

Human centered

assets

Infra-structure

assets

Intellectual property

assets

organizational culture in which the belief that people (or intangible resources) are

valuable organizational resources is actually manifested in managerial decisions

and actions”

7. Intellectual Capital Audit

This method defines intellectual capital as “the combined intangible

assets, which enable the company to function” and divided IC into four

categories-market assets, human-centred assets, infrastructure assets

and intellectual property.

The method aims to put a financial value on every asset and

recommends the use of either a cost or a market or an income

approach.

The method identifies the company’s intangibles and determines the

optimal state of the set of aspects for each asset. Each aspect of each

asset is audited and the current state of each aspect is compared with

the target value and is indexed on a scale from 0 to 5, 5 being the

optimal state. The scores are plotted on a target board (similar to a

dart board) with the size of dots reflecting the importance of the assets.

The target provides a comprehensive view of the strengths and

weaknesses of all intangible resources.

24

However, the method to put a financial value on these intangibles is

very generic and not very practical.

Brooking’s (1996) intellectual capital audit is one of the very few well-

documented methods to audit various types of intangible resources. She

describes 30 ways to audit various aspects of intangibles and provides 158

questions touching on a range of issues (Van den Berg, 2003). Each aspect is in

fact an indicator of some kind. The audit is a value measurement approach

because the method includes yardsticks for the optimal state of each aspect of

each asset. The intellectual capital audit target provides a comprehensive

overview of the strengths and weaknesses of all intangible resources.

8. Intellectual Capital Index

The method breaks intellectual capital into human capital (comprising

of competence, attitude and intellectual agility) and structural capital

(comprising of relationships, organization, renewal and development).


Human Capital Structural Capital

Competence

Intellectual agility

Attitude Relationships

Organization

Renewal and development

25


HumanCapital

Relational Capital

Organizational Capital

The method suggests a creation of a list of non financial indicators and

the identification of the key success factors which are vital for the

success of a company’s strategy. The next step is to identify the

indicators which reflect these key success factors. And then the

selected indicators by focus area are grouped together. All these

indicators are consolidated into one index using weights. This

intellectual capital index is then correlated with the market value.

The changes in the market value are reflected in the changes in the

index.

However, the method is not very useful as the company doesn’t know

what went wrong and the data is not useful for decision making.

The authors of the intellectual capital-index clearly learned from their pioneering

work on the first-generation of intellectual capital models. They try to avoid the

pitfall of coming up with long lists of meaningless indicators. Their solution is

based on a critical selection of indicators, rooted in the company’s strategy, and

the combination of indicators into one single index.

9. Inclusive Value Methodology

This method divides intellectual capital into human capital,

organizational and relational capital.

The method is based on the axiology that value is measurable with

respect to a well defined context.

26


Employee competence

External Structure

Internal Structure

A well defined objective of the stakeholder in the form of yardsticks is

used to measure value. These objectives are then translated into

attributes that can be measured. Different measurements are

combined into one measure and normalized to get a number between

zero and one.

Also, a mathematical model is used to stimulate various alternative

management actions. The simulation must provide output performance

measures as well as cost/revenue data. Then the output performance

measures are used as inputs to calculate the overall combine

intangible value. All financial data are processed separately.

The Inclusive Value Methodology has contributed to the intellectual capital field

by introducing elements of measurement theory and applying them to

multidimensional intellectual capital measurement. M’Pherson and Pike (2001ab)

have made the field aware of the many functional requirements for proper

measurement, thereby uncovering some bad practices.

10. Intangible Asset Monitor

This method is used to help manage knowledge-intensive companies.

Intangibles are divided into Employee competence, internal structure

and External structure. Measurement is a means to focus managers on

intangible assets and to allow them to monitor their assets.

27

Intangible assets

Innovation-related

Intangibles

Organizational Intangibles

Human Resource

Intangibles

The method consists of a three by three matrix. For each type of

intangible assets, there should be indicators of growth and renewal,

efficiency and stability. Management should select one or two indictors

for each cell.

It is useful for both internal management and external reporting.

However, because the indicators are company specific, in most cases

the only comparison available will be previous years.

The intangible asset monitor is a comprehensive framework that allows for

customization. One of its strong points is that it focuses on risks and

sustainability, as did the work of the Konrad group. Also important is the

emphasis on comparison to make the indicators meaningful. However, because

the indicators are company specific, in most cases the only comparison available

will be previous years.

11. Intangibles Scoreboard

It is a financial valuation method to value intangibles. Intangibles are

divided into innovation related intangibles, human resource tangibles

and organizational intangibles.

The method focuses on the problem of financial reporting of these

intangibles. A complete lack of transparency in the financial statements

leads to information asymmetry between the general public and those

28

who have access to information on investments and returns regarding

intangibles.

The method is a top down approach to estimate the financial value of

the intangible capital of a firm based on publicly available data.

First the company’s annual normalized earnings are estimated. Then

using the expected rates of return on tangible and financial assets the

earnings linked to these assets are calculated. Subtracting them from

normalized earnings results in IDEs (Intangibles-driven earnings). The

series of IDEs over three future periods based a three-stage valuation

model is forecast. Then a discount rate is used that reflects the above

average risk of these earnings to calculate the present value of these

earnings: the value of intangibles).

However, this method has its limitations. It calculates a fair return on

the tangible and financial resources used. But this may not be the

same as the contribution of these resources to earnings.

Lev’s drive to create a new, meaningful measures based on publicly available

data has added tremendously to the field. He is a well-respected member of the

accounting community and his comments and findings have helped to create

awareness about the problem of traditional reporting. His analysis of the causes

and consequences of the problem are very insightful. They provide clear starting

points for improvement.

The intangibles scoreboard is based on the idea that tangible, financial, and

intangible resources produce earnings. IDEs are the residual after a fair return for

tangible and financial capital has been subtracted. This is common practice in

financial valuation literature, for example, Reilly and Schweihs (1999).

29


HumanCapital

Relational Capital

Structural Capital

12. Intellectual Capital Benchmarking System

This method is a value assessment method. Intellectual capital is

divided into human capital, structural capital and relational capital.

The method focuses mainly on the knowing the causes that produce

the competitive gap between the company and the international market

leaders in the same business activity in order to increase the

company’s competitiveness.

For this a general model of business excellence is used to identify

factors to benchmark. From this general model specific models are

created for the specific business units of a company. These models

include criteria for excellent performance.

From these models, a set of questions is developed to measure

whether these criteria apply to the company under investigation and to

the world class competitor.

The criteria are measured on a scale from -5 to +, indicating whether

the company is doing worse or better than a competitor. An overall

reliability index of assessment is constructed. The results are

presented in the form of a balance sheet with assets including all the

factors on which the company is doing better than the competitor and

the liabilities side including where it is worse off.

30


Structural Capital

Human Capital

Market Capital

Innovation Capital

These factors are weighted and added, creating a weighted average.

This weighted average is used for benchmarking.

However, a weakness of this method is the dependency solely on the

judgement of an assessor.

Viedma is a pioneer in the field of benchmarking intellectual capital. In addition,

he is one of the first to use the concept of core competency as a unit of analysis

for intellectual capital. He has done ground-breaking work in operationalzing

normative models of excellent performance. His methods are methods for the

value assessment of intellectual capital using the world-class competitor as a

yardstick. The competitor functions as the yardstick on a 10-point scale. A weak

point is that the method depends solely on the judgment of an assessor, as does

the weighing of the various factors.

13. Intellectual Capital Dynamic Value

This method divides intellectual capital into four components: structural

capital, human capital, market capital and innovation capital.

Four perspectives of analyzing, reporting and managing intangibles are

identified: the input perspective, the output perspective, the internal-

managerial perspective and the external perspective.

31

Knowledge

Employees Customers Processes Technology

The approach is based on indicators in three areas-performance

indicators for purposes, processes and outputs.

These are combined into an overall index of performance. This overall

index is multiplied with by the market value of the company to calculate

the dynamic value of the intangible capital of the company.

The market value is then divided into three components- structural

capital, human capital and market capital.

However, it is not clear what the indicators stand for, the interpretation

of the overall indicator and why it is multiplied with the market value.

A more detailed description of the intellectual capital dynamic value approach is

needed to determine the strengths and weaknesses of the method. However a

few weaknesses can be mentioned. From the paper (Bounfour, 2002), it is not

clear the exact problem the method tries to solve. It is unclear what the indicators

stand for, how they are combined, and whether this meets the requirements for

proper multidimensional value measurement. Bounfour (2002) does not explain

how the overall indicator should be interpreted and why it is multiplied by the

market value.

14. Intellectual Capital Statement

Intellectual capital statements do not represent the size and the value

of the knowledge of the firm. But the purpose is to track the

32

Intangible Assets

management activities that are put to work to organize the knowledge

resources of the firm.

It consists of three elements-the knowledge narrative, the management

challenge and a set of indicators called an intellectual capital

accounting system.

There are four types of resources in a firm-employees, customers,

processes and technology. The accounting system consists of

indicators for each type of resource.

The complete intellectual capital management is a combination of

narratives, indicators and sketches.

However, the method does not solve the yardstick problem.

Mouritsen et al. have taken the concept of intellectual capital measurement and

reporting a step forward. Building on the Scandinavian tradition and reporting a

step forward. Building on the Scandinavian tradition and experiences in

intellectual capital measurement, they have created focus and have produced a

very practical method for reporting intangibles. An important step forward is the

way they focus the performance of resources. This focus not only clarifies the

purpose of the intellectual capital statement but also makes the statements

action oriented. The result of creating the statement is a practical management

agenda of issues.

15. iValuing Factor

This financial valuation method uses iValuing factor to create decision

risk ranges.

33

This decision risk range establishes the potential downside risk and

upside benefit of a decision with regards to that intangible. The

iValuing factor is determined by taking the ratio of the book value to the

share price. This ratio is used to determine a market value risk

associated with a specific management decision.

However, the method has many weaknesses and doesn’t explain how

the calculation of the iValuaing factor should influence management

decisions.

The iValuing factor contains a number of weak points. It is based on comparing

the difference between book value and market value. However, from the article

( Standfield, 2001) it remains unclear why this difference is a predictor for the

impact of a management decision on share price. In addition, Stanfield does not

explain how the calculation of the iValuing factor should influence management

decisions.

16.Konrad Group

Know-how Capital

Individual Capital Structural Capital

Formal Education

Social competence

Acquired experience and skills

Personal attitude

Problem solving ability

Customer Capital

34

This is a measurement method focussing on companies selling know-

how services like Consultancy

Such a company has two types of capital – Traditional Financial

Capital and Know-How Capital. The know-how capital consists of

Individual and Structural Capital.

The Individual Capital would be linked to the education, skills,

experience and social competence. The Structural Capital would be

linked to the people’s attitude, problem-solving ability and position with

its customer

Key Concern – Lack of information on personnel and so do not know

how to report their operations to an external shareholder

Solution – A list of 35 indicators to be reported by know-how

companies in categories of HR indicator, Value-Add per employee,

Business and Financial Stability

The Swedish Konrad group was one of the first to search for other forms of

capital besides traditional financial and tangible capital, and to introduce the

concept of structural capital. Their set of distinctions is not as sophisticated as,

for example, the one used by Edvinsson and Malone (1997). Their use of the

term structural capital is much broader than Edvisson and Malone’s (1997)

definition of structural capital, but at the same time it is more ambiguous. There

seems to be an over-lap between the concept of individual and structural capital,

because experience and skills fall in the individual category whereas attitudes fall

in the structural capital category.

17.Market-to-Book Ratio

Popular literature has stated market-to-book ratio as quick, easy and

reasonable indicator of Intellectual Capital (IC)

35

Market Value

Book Value

Market Value is most probable price for the company in a competitive

market whereas Book Value is the accumulation of accounting entries and

adjustments over the lifetime of the company

Simple Calculation of Intangible Value as the difference of Market & Book

Values

The above formula has been deemed to present a false value since all

resources of company combine and interact with each other i.e., Market

Value (MV) = Book Value (BV) + Intellectual Capital (IC) does not have

separable variables. Also the residual is result of MV and BV is result of

IC, brand, reputation and competitive position.

The residual also depends on the accounting policies and suffers from

book value being at historical costs

Andriessen (2002) states that subtracting market value and book value is not a

good method to calculate the value of intangibles because it is like comparing

apples and oranges. Book value is the reported stockholder’s equity (less the

liquidating value of any preferred shares), which represents the difference

between assets and liabilities, both of which are most often valued at historical

costs. Market value is equal to the perceived present value of the future cash

flow of the company.

36

Options

18.Options Approach

A refined approach to the income approach

Option Theory uses the analogy with financial options to calculate the

value of an investment opportunity. So this may be used as an

improved version of DCF valuation

Traditional DCF involves the comparison of NPV of expected cash flow

and expenditure. With OT, the investment decision can be deferred;

opportunity cost of alternate investment needs to be included in the

irreversible investments.

Used in case of investment option or deferral scope for the investment

Option theory is an interesting method to overcome some of the shortcomings of

the traditional DCF method. It can only be used when there is a decision to be

made regarding an investment. Under these circumstances, it can help to

improve decision making about investments in intangible resources. If there is no

investment option or the investment decision can no longer be deferred, then the

conventional NPV and the option value are identical.

37

19.Skandia Navigator

The Skandia Value Scheme and the Skandia Navigator are two models for

highlighting and describing the evolution of intellectual capital within Skandia.

These models visualize the value components that make up intellectual capital

as well as the method of managing them and reporting on their development.

Customer Capital

Customer capital is the present value of customer relationships. Customer capital

is refined and transformed into financial value through interaction with human

capital and organizational capital, as illustrated in the Value Creation model

below

Customer BaseThe Skandia group’s customer base today consists of nearly 8 million customer

relationships, including life assurance relationships. A geographical breakdown of

these relationships is shown in the pie chart below.

38

Customer Relationships

For Skandia a customer is not a temporary contact, but an investment in a

mutual value-creating relationship. A customer relationship therefore can be seen

as part of the value-creating organization’s potential for earnings, success and

evolution.

Customer Potential

The mutual creation of value through the interaction of company and customer

can be described as customer success. To an increasing degree this success is

influenced by developments in information technology. This is leading to new

types of relationships, often in networks and without geographical confines.

A Measurement Method for Intellectual Capital

Human Capital + Structural Capital = IC; here instead of sum, product

could also be taken to indicate the synergies

Structural Capital is from Customer Capital and Organizational

(Innovation + Process) Capital

39

Focussing on long-term future of Company, the Skandia Navigator

provides a 3-D compass for charting a course tomorrow as well as a

map of yesterday

Probably the most cited example of IC capital measurement. But the 160

Skandia Indicators show where you are, instead of showing where you

need to go. Also these indicators are not clearly divided amongst cause or

effect sides, making diagnosis of situation quite difficult

Edvinsson’s work has been by no doubt the biggest contribution to the field of

intellectual capital measurement. The Skandia navigator is probably the most

widely cited example of an intellectual capital measurement method. The method

has added significantly to the general awareness about the importance of

intangible resources and the shortcomings of traditional reporting. Edvinsson and

Malone (1997) admit that the navigator “is but the first systematic attempt to

uncover these factors and to establish the key indicators for establishing their

metrics”. However, they claim, “the Skandia Navigator has already proven to be

so effective that it will likely to be the basis for most future (intellectual capital)

navigation tools”. Edvinsson tries to solve a broad range of problems: the internal

management of intellectual capital, the external reporting to stakeholders, and

problems concerning the wealth of nations. He has found that the concept of the

navigator can be translated from the corporate to the national environment.

40

20.Sullivan’s Work

IC = Human Capital + Intellectual Assets

Now Intellectual Assets = Structural Intangible Assets + Intangible Assets

that can be commercialized. So second term of commercialization is a

process called value extraction

Uses value measurements of intellectual capital to improve decision

making – for e.g. the decision of investing further in developing an

intangible, to continue holding it or to sell it.

Thus emphasizes on the relative nature of value – “The value of an item

depends primarily on the needs of the person or organization that will be

using it”

A method for determining a purchase price for an acquired company. This

price should reflect the value that the acquired intellectual assets of this

company will bring for the buyer


Human Capital Intellectual Assets

Intangible assets that can be commercialized

Structural intangible assets

41

Intangible assets

CopyrightsPatents, propriety know-how and technology

Service marksTrademarks

Computer Software

Complimentary intangible assets

Assembled workforceCulture and managementCustomer listsEtc.

Sullivan (1998a) made an important contribution to the intellectual capital field by

emphasizing the relative nature of value. “The value of an item depends primarily

on the needs of the person or organization that will be using it”. The value of an

intangible strongly depends on a company’s vision and strategy. Sullivan does

not provide a practical method for valuing intangibles. His approaches do not

provide a practical method for valuing intangibles. His approaches do not provide

a practical problems associated with a DCF method. The two approaches he

proposes draw heavily on the notion that Market Value = Tangible Assets +

Intellectual Capital. In the Market-to-Book ratio method we can see that this is

automatically not the case.

21.Technology Factor

Consists of two parts – first is the calculation of the NPV of the

incremental business using income approach. Second is the estimation of

a technology factor between 0 to 100% that approximates how much of

the total incremental cash flow can be attributed to the specific technology

The technology factor is based on a qualitative assessment by a

multidisciplinary team of experts which looks at the utility and competitive

advantage issues

There are number of issues listed in the above two categories and each

issue is assessed using -, 0, or + for their impact on value creation

42

Market Value Replacement Costs

Technology Factor does not calculate which part of the cash flow can be

attributed to the technology

The technology factor method is a straightforward income approach to valuation.

The method separates elements of the income approach and incorporates them

into one technology factor. In theory, this factor calculates the part of the NPV

that can be attributed to the specific technology. As such, it tries to solve the

problem of income funneling and income allocation.

22.Tobin’s Q

Tobin’s Q is the ratio between the market value of an asset and its

replacement cost where the latter contemplates the cost to recreate the

utility of the subject asset

It is a measure to predict the whether capital investments would increase

or decrease. If as asset’s Q is less than one, a new investment in a similar

asset is not profitable.

Q happens to be a measure of “monopoly rent” as it manifests the power

of IC – you and your competitor presumably have similar fixed assets, but

one of you has something uniquely of its own – IC

Suffers from problems similar as Market-to-Book Ratio but it does

neutralize the depreciation policies of companies

43

CostsEconomic

IncomeMarket Value

ReproductionCosts

ReplacementCosts

The use of Tobin’s Q as a measure of intellectual capital is based on the same

assumptions as the use of the market-to-book ratio. The advantage of Q is that it

neutralizes the depreciation policies of companies because it uses replacement

costs instead of book value. However, the other problems associated with the

market-to-book ration as a measure of intellectual capital also apply to Tobin Q.

23.Valuation Approaches

Cost Approach which is based upon the economic principles of

substitution and price equilibrium. But in many cases cost is not a good

indicator of value

Market Approach is based on the economic principles of competition and

equilibrium. Applicable only when comparables are being transacted

Income Approach is based on the economic principle of anticipation. Best

approach but requires many assumptions on income projection, income

funnelling, income allocation, useful life estimation, and income

capitalization. The drawback is that it assumes non-deferrable investment

which is allowed in Options Theory

The problem with the cost approach is that in many cases cost is not a good

indication of value. Many of the important factors that drive value are not

reflected in the cost approach.

44

Capital Employed Intellectual Capital

Physical Capital

Financial Capital

Human Capital

Structural Capital

The market approach can be used only if data are available regarding the

transaction of intangible resources that are similar to the subject resources.

When the subject resources are unique, which is often the case, this approach is

not appropriate.

The income approach is often the best alternative but requires many

assumptions on income projection, income funneling, income allocation, useful

life estimation and income capitalization.

24.Value-Added Intellectual Coefficient

A financial valuation method

States two resources – Capital Employed (Physical + Financial) and

Intellectual Capital (Human + Structural Capital)

Value-Added (VA) = Op Income + Labour Exp

VAIC = Human Capital Efficiency + Structural Cap Efficiency + Capital

Employed Efficiency

Uses publicly available information but the basic assumption are very

questionable and thus poor indicator of company’s performance

45

The VAIC method is applied increasingly as an indicator of intellectual capital

performance in statistical analysis, because it uses data that are publicly

available. However, some of its basic assumptions can be seriously questioned.

The VAIC method does not properly separate expenses from assets. The

method confuses stocks and flows.

The aim of VAIC is to calculate the efficiency of capital employed, human capital

and structural capital. But it does not calculate efficiency. The assumption that

the effect of structural capital is the inverse from the effect of human capital

yields strange results. The method ignores the fact that value added is not only

produced by human capital, structural capital and capital employed individually,

but it is also the result of the synergies between these three. The solution to all

the efficiency indicators to come to one overall indicator is an interesting idea but

produces dissatisfying results.

Due to these limitations, the method produces dissatisfying results.

25.Value Chain Scoreboard

A measurement method with both top-down and a bottom-up approach

and uses same definition as the Intangible Scorecard Method (11)

46

It provides for the need of individual investors and myriad partners to

enable them to make and execute decisions at the level of professional

investors and managers

The scoreboard indicators should be quantitative, standardized for

comparison across firms and supported by empirical evidence

It is aimed at both internal and external decision makers with difference

being on the level of details provided

The strong statistical association that is required between an indicator and

a corporate value prevents the clutter in meaningless indicator. But the

framework requires additional fine-tuning

Lev’s value chain scoreboard is based on a thorough analysis of the problems of

current corporate disclosure. The value chain scoreboard incorporates the result

of research into the needs of investors and analysts for additional information.

The scoreboard focuses on innovation, which is one of the most important drivers

of growth and one of the most important variables explaining market-to-book

rations. The framework is easy to understand. It creates a logical (although not

causal) relationship between group of indicators, similar to the four perspectives

of a balanced score card.

47

Contemporary Concerns:19

Secondary InformationIt is by no means clear what the company's intellectual capital is, and even less

so if when the company's brand and intellectual capital are valued separately.

Brand valuation could, broadly, be categorized into three types. The first one is

valuation done as an academic exercise and for possible Business Strategy.

These are explained in the Notes to accounts. Ready examples are companies

such as Infosys, Satyam and Rolta. Second, brand valuation done by appointing

valuers, on the basis of which the balance sheet is adjusted for intangible assets

and capital reserve, as in the case of Sintex, Kitply and Emami. And, third,

brands actually paid for, as did Nirma and a subsidiary of Wipro.

Valuation done as an Accounting Exercise and used for Business Strategy:

Infosys

Satyam

Rolta

Valuation done by appointed Valuers for Accounting Purposes:

Sintex (done by Deloitte Haskins & Sells)

Kitply (done by Ernst & Young)

Emami (done by Ernst & Young)

19 Business Line, June 8, 2006

48

Valuation done for Brand Acquisition:

Nirma Ltd acquired the “Nirma” and other brands from Nirma Industries

Ltd through a demerger of Nirma Industries and a subsequent acquisition

of the demerged entity by Nirma Ltd.

Subsidiary of Wipro acquired a trademark/ brand named “Chandrika”

Marico buying ‘Nihar” from HLL

Dabur’s buyout of “Balsara”

IBM “Thinkpad” by Lenovo

Common Thread in Primary DataTo study these contemporary concerns we studied the secondary data available

and interviewed the industry experts (Exhibit 3 provides an indicative

questionnaire for our industry survey) from Infosys, Brain League IP Services

(Exhibit 4 provides brief overview for the this IIM Alumni’s entrepreneurial

venture), Bizworth et al. The common thread we could see from all the responses

were that:

Valuation is a very under-researched area.

Most of the companies do not have process or policies in place for the

valuation of intangibles

Companies and people in India are not used to considering Intellectual

Assets as property especially from a legal point of view.

Understanding the market and assessing the value of an asset is very

difficult as each asset is unique

Most companies don’t consider it as an investment but rather treat it as a

cost.

Not many consultant companies are working in this space due to lack of

domain expertise.

Some of the companies doing the valuation in the Indian context are

Infosys, Satyam, Rolta, Delloitte Saskin & Sells, EnY, etc.

49

Dealing with Intangibles:Valuing Brand Names, Flexibility and Patents20

It is human nature to draw a distinction between the assets that we can see and

feel and the assets that we cannot and to feel a little more secure about the

former. Included in the latter, though, are assets as diverse as goodwill, brand

name, loyal employees and technological prowess. A common critique of

valuation approaches, in general, and financial analysts, in particular, is that we

pay little attention to intangible assets and consequently under value them.

In this part, we confront this criticism by looking at intangible assets across the

spectrum. We begin by looking at intangible assets that stand by themselves and

generate cash flows– commercially developed patents, copyrights, trademarks

and licenses – and argue that conventional discounted cash flow models do a

more than adequate job in valuing them. We follow up by looking at intangible

assets such as brand name and corporate reputation that generate cash flows

collectively for the businesses that own them, but are more difficult to isolate and

value independently. Nevertheless, we will argue that conventional discounted

cash flow valuation models can capture their values and that adding a premium

for them afterwards can result in double counting. In the last part, we look at the

most elusive intangible assets, i.e., those that have the potential to generate

cash flows in the future but do not right now. Included in this group will be assets

as diverse as undeveloped patents and operating flexibility and they are the most

difficult intangible assets to value since they possess option characteristics.

20 Ashwath Damodaran, “Dealing with Intangibles: Valuing Brand Names, Flexibility and Patents”, Stern School of Business

50

Independent and Cash flow generating Intangible Assets21

The simplest intangible assets to value are those that attach to a single product

or product line and generate cash flows. These assets usually have finite lives,

over which the cash flows have to be estimated, but they are qualitatively no

different from many tangible assets that share generate cash-flows over finite

periods. In this section, we will consider a few examples of such assets.

Trademarks, Copyrights and LicensesTrademarks, copyrights and licenses all give the owner the exclusive right to

produce a product or provide a service. As a consequence, their value is derived

from the cash flows that can be generated from the exclusive right. To the extent

that there is a cost associated with production, the value comes from the excess

returns that derive from having the exclusive right.

As with other assets, we can value trademarks or copyrights in one of two ways.

We can estimate the expected cash flows from owning the asset attach a

discount rate to these cash flows that reflects their uncertainty and take the

present value, which will yield a discounted cash flow valuation of the asset.

Alternatively, we can attempt a relative valuation, where we apply a multiple to

the revenues or income that we believe can be generated from the trademark or

copyright. The multiple is usually estimated by looking at what similar products

have sold for in the past.

In making these estimates, we are likely to run into estimation issues that are

unique to these assets. First, we have to consider the fact that a copyright or

trademark provides us with exclusive rights for a finite period. Consequently, the

cash flows we will estimate will be for only this period and there will generally be

no terminal value. Second, we have to factor in the expected costs of violations

of the copyright and trademark. These costs can include at least two items. The

first is the legal and monitoring cost associated with enforcing exclusivity. The 21 Ashwath Damodaran, “Dealing with Intangibles: Valuing Brand Names, Flexibility and Patents”, Stern School of Business

51

second is the fact that no matter how careful we are with the monitoring, we

cannot ensure that there will be no violations, and the lost revenues (profits) that

arise as a consequence will lower the value of the right.

Illustration: Valuing the Copyright on “Damodaran on Valuation – 2006”

Assume that John Wiley has been approached by another publisher who is

interested in buying the copyright to the book (Damodaran on Valuation). To

estimate the value of the copyright, we will make the following assumptions:

The book is expected to generate $150,000 in after-tax cash flows for the

next three years and $100,000 a year for the following two years. These

are the cash flows after author royalties, promotional expenses and

production costs.

About 40% of these cash flows are from large organizations that make

bulk orders and are considered predictable and stable. The cost of capital

applied to these cash flows is 7%.

The remaining 60% of the cash flows are to the general public and this

segment of the cash flows is considered much more volatile. The cost of

capital applied to these cash flows is 10%.

The value of the copyright can be estimated using these cash flows and the cost

of capital that has been supplied in the following Table:

Table: Value of CopyrightYear Stable

CashflowsPresent value @

7%Volatile

CashflowsPresent value @

10%1 $60,000 $56,075 $90,000 $81,8182 $60,000 $52,406 $90,000 $74,3803 $60,000 $48,978 $90,000 $67,6184 $40,000 $30,516 $60,000 $40,9815 $40,000 $28,519 $60,000 $37,255

$216,494 $302,053

The value of the copyright, with these assumptions, is $518,547 (which is the

sum of $216,494 and $302,053).

52

FranchisesA franchise gives its owner the right to market or sell a product or service of a

brand-name company. Examples of franchises would include the thousands of

McDonald’s around the world, dealerships for the automobile companies and,

loosely defined, even a New York City cab medallion. In each case, the

franchisee (the person who buys the franchise) pays the franchisor (McDonald’s

or Ford) either an up-front fee or an annual fee for running the franchise. In

return, he or she gets the power of the brand name, corporate support and

advertising backing.

Franchise value and Excess Returns

The acquisition of a franchise provides the franchisee with the opportunity to earn

above-market returns for the life of the franchise. While the sources of these

above market returns vary from case to case, they can arise from a number of

different factors.

Brand Name Value: The franchise might have a brand name value that

enables the franchisee to charge higher prices and attract more customers

than an otherwise similar business. Thus, an investor may be willing to

pay a significant up-front fee to acquire a McDonald’s franchise, in order to

take advantage of the brand name value associated with the company.

This brand name value is augmented by the fact that the franchisor often

provides the advertising for the product.

Product/Service Expertise: In some cases, a franchise has value because

the franchisor provides expertise on the product or service that is being

sold. For instance, a McDonald’s franchisee will have access to the

standard equipment that McDonald’s uses as well as the product

ingredients (the special sauce on the Big Mac).

Legal Monopolies: Sometimes, a franchise may have value because the

franchisee is given the exclusive right to provide a service. For instance, a

company may pay a large fee for the right to operate concession stands in

53

a baseball stadium, knowing that they will face no competition within the

stadium. In a milder variant of this, multiple franchises are sometimes sold

but the number of franchises is kept limited to insure that the franchisees

earn excess returns. New York City, for example, sells cab medallions that

are a pre-requisite for operating a yellow cab in the city. They also have

tight restrictions on non-medallion owners offering the same service.

Consequently, a market where cab medallions are bought and sold exists.

In essence, the value of a franchise is directly tied to the capacity to generate

excess returns. Any action or event that affects these excess returns will affect

the value of the franchise.

Special Issues in Valuing Franchises

Buying a franchise is often a mixed blessing. While the franchisee gets the

backing of a well-known firm with significant resources to back up his or her

efforts, there are some costs that may affect the value of the franchise. Among

these costs are the following.

The problems of the franchisor can spill over into the franchisee. For

instance, when Daewoo, the Korean automaker, borrowed too much and

got into financial trouble, their dealers around the world felt the

repercussions. Similarly, McDonald’s franchisees around the world were

picketed by anti-globalization activists. Thus, an efficient and well-run

franchise’s value can be affected by actions that it has little or no control

over.

Since franchisors tend to be large corporations and franchisees tend to be

small business people, the former often have much more bargaining

power and sometimes take advantage of it to change the terms of

franchise agreements in their favor. Franchisees can increase their power

by banding together and bargaining as a collective unit.

The value of a franchise derives from the exclusive rights it grants the

franchisor to sell the products of a firm. This value can be diluted if a

54

franchise is granted to a competitor. For instance, the value of a Burger

King franchise may be diluted if another Burger King is allowed to open

five miles down the highway.

Final Thoughts on Franchise Valuation

It is not difficult to value franchises using either discounted cash-flow or relative

valuation models. With discounted cash-flow valuation models, the key challenge

is estimating the incremental cash flows associated with owning the franchise as

opposed to operating the same business without a franchise. When valuing a

Burger King franchise, for instance, this would require estimating the cash flows

from operating a Burger King as opposed to a restaurant with the same menu but

no franchise name attached to it. These incremental cash flows will be

discounted back to the present at a risk-adjusted discount rate, reflecting the risk

of the business the franchise is in, to arrive at a value for the franchise.

With relative valuation, we would draw on the transactions prices at which

franchises are bought and sold. With widely held franchises such as McDonald’s,

we should be able to replicate what we did with stocks, which is to compute a

valuation multiple (franchise value/sales) based upon recent transactions and

use it to value a particular franchise.

55

Firm-wide Cash flow generating Intangible Assets22

The intangible assets that attract the most attention and have the greatest value

tend to be difficult to isolate and value. They do not generate cash flows on their

own but they allow a company to charge higher prices for its products and

generate more in cash flows. As a consequence, valuing these intangible assets

is more difficult to do, but there are three different ways we can go about

estimating their value.

Capital Invested : We can estimate the book value of an asset by looking

at what a firm has invested in that asset over time. With brand name, for

instance, this would require looking at advertising expenditures over time,

capitalizing these expenses and looking at the balance that remains

unamortized of these expenses today. While this approach is the least

subjective, it may not match or even be close to the market value of the

asset. It is, however, consistent with how accountants measure the value

of other tangible assets on the books.

Discounted Cash Flow Valuation : We can discount the expected

incremental cash flows generated by the intangible asset in question to

the firm. This will require separating out the portion of the aggregate cash

flows of a firm that can be attributed to brand name or technological

expertise and discounting back these cash flows at a reasonable discount

rate.

Relative Valuation : One way to isolate the effect of an intangible asset

such as brand name is compare how the market values the firm (with the

brand name) with how it values otherwise similar companies without a

brand name. The difference can be attributed to the intangible asset.

In the following section that follows, we will take a detailed look at brand name

value and a more cursory look at human capital.


56

Brand Name23

Brand name is the asset that comes to mind most often when there is talk about

intangible assets. After all, brand name accounts for a large proportion of the

value of many consumer product companies and accounting standards in many

countries have required companies to value brand name and show it on the

books. In this section, we will explore the choices that we face when trying to

value brand name and why they might give us different answers.

Historical Cost Approach

In the historical cost approach, we adopt a solution rooted in conventional

accrual accounting to value the brand name. We begin by making an assumption

about what expenses that a firm incurs are most likely to impact its brand name.

It stands to reason, for instance, that a portion of every firm’s advertising

expenses is spent to build or augment the company’s brand name. We then use

a process very similar to the one we used to capitalize R&D expenses to

compute brand name value.

1. We determine an amortizable life for the brand name expenditures, based

upon how long we think the benefits from the expenditure will accrue. For

consumer product firms, this may extend out to 20 years or longer since brand

names long lives.

2. We collect the data on brand name expenditures each year, going back

historically, for the amortizable life of brand name. Thus, if we choose 20 years

as our amortizable life, we will collect the brand name expenditures (or at least

the portion of it that we attribute to brand name) each year for the last 20 years.

3. Using a straight-line amortization schedule, we write off a portion (5%, for

instance, with a 20-year life) of the brand name expenditure from each year’s

expenditure in the subsequent years. As a result, we should be able to estimate 23 Ashwath Damodaran, “Dealing with Intangibles: Valuing Brand Names, Flexibility and Patents”, Stern School of Business

57

the total amortization of brand name expenditures in the current year (to be

treated like depreciation) and the unamortized portion of the previous year’s

expenditures, which will now be treated as an asset (brand name value).

While this approach has the benefit of simplicity and reduces discretionary

choices by firms, it does not really measure the value of the brand name. What it

does measure is the capital that has been invested in the brand name, which

may bear little or no resemblance to the actual market value today. After all,

there are firms that have spent billions of dollars in advertising and have no

brand name value to show for it, whereas there are other firms that seem to

establish brand name value with little or no advertising expenditure, often

because they happen to be in the right place at the right time.

Discounted Cashflow Approach

In a discounted cash flow approach, we try to isolate the effect of the brand name

on the cash flows of the firm. That is easier said than done because the effects of

brand name are felt through a firm and it is also difficult to separate out brand

name effects from other factors that may also impact the cash flows such as the

firm’s reputation for quality or service and market power.

1. Comparison to Generic Company

Perhaps the simplest measure of brand name value is obtained by comparing the

cash flows of a brand name company with an otherwise similar company (in

terms of product and scale) without a brand name. The difference in cash flows

then can be attributed to the brand name and the present value of these cash

flows should generate a value for the brand name.

While the approach is intuitive, the key constraint is finding a generic version of a

brand name firm. All too often, brand name companies dominate their sectors

and have different product mixes and much larger revenues than generic

companies in the same sector. Finding a generic twin to Procter and Gamble or

58

Gillette will be impossible to do. To simplify the process, we would recommend

one of the following approximations:

a. Generic operating margin approach : In this approach, we replace the

operating margin of the brand name firm with the operating margin of

generic companies in the same business. The implicit assumption that we

make is that the power of a brand name lies in pricing products and that

brand name companies will be able to charge higher prices for identical

products (produced by generic companies). Revaluing the brand name

company with a generic margin will have ripple effects, since lower

margins beget lower returns on capital and lower returns on capital result

in lower growth rates. As a consequence, even a small change in

operating margin can translate into a large change in value, which can

then be attributed to the brand name.

b. Generic return on capital approach : A close substitute for the first

approach involves replacing the return on capital of the brand name

company by the return on capital of a generic substitute. Here, we are

assuming that the power of a brand name ultimately will show up in higher

returns on capital. The resulting changes in operating income and growth

will reduce the value of the company, and the change in value is the brand

name value. Implicitly, we are assuming that the costs of capital are the

same for both the generic and the brand name company.

c. Generic excess return approach : In this approach, we replace the excess

returns (return on capital minus cost of capital) earned by the brand name

company by the excess returns earned by the generic company. In

addition to capturing all of the effects that changing the return on capital

has on value, this approach allows us to set the costs of capital at different

levels for the brand name and the generic company. A legitimate

59

argument can be made that brand name companies have less market risk

(unlevered betas), more debt capacity and lower costs of capital.

In all of these approaches, we are making two key assumptions. The first is that

a generic company exists and that we have access to its financial statements,

though neither the brand name company nor its generic counterpart need to be

publicly traded. The second is that the brand name is the only reason for

differences in margins, returns on capital and excess return across these

companies. To the extent that brand name is intermingled with other intangible

assets, what we will get is a consolidated measure of value for all of these

assets. This makes it more appropriate for products where the only reason for

pricing differences is the brand name and not product quality or service. Thus,

this approach is more appropriate in valuing brand name at Coca Cola or Mars

Candy but less so in valuing brand name at Sony or Goldman Sachs.

2. Excess Return Models

When a generic company does not exist, there is an alternative approach that we

can use to value brand names, though it makes its own set of heroic

assumptions. If we assume that all of the excess returns (returns over and above

the cost of capital) earned by a firm can be attributed to its brand name, the

valuation of a brand name becomes simple. In chapter 6, we introduced the

excess return model for valuing firms and showed the in the absence of excess

returns, a firm will trade at the book value of capital invested. If we assume that

the excess returns are entirely attributable to brand name, the value of the brand

name can be computed as the difference between the estimated value of the firm

and the book value of capital invested in that firm.

Value of brand name = Estimated DCF value of firm – Capital Invested in firm

This approach will yield the same value as the generic firm approach, if generic

firms earn zero excess returns. The limitation of the approach is that excess

60

returns come from all of a firm’s competitive advantages and not just brand

name. In addition, accounting choices and manipulation can affect capital

invested estimates, and thus affect the brand name value estimates.

Relative Valuation ModelsIn relative valuation models, we try to extract the value of a brand name by

looking at how the market prices companies with and without brand name. The

first relative valuation approach draws from the generic firm computation we used

earlier with discounted cash flow valuation. The second approach grows out of

the multiple regressions where we regress the multiples that firms trade at

against the fundamentals that determine that value.

1. Comparing Valuation to Generic Firm

This approach is built on the premise that both the brand name company and a

generic company that resembles it are both publicly traded. Since we can

observe how the market values both firms, we can draw conclusions about the

value it attaches to brand name by looking at the difference between the two

valuations. The aggregate market values will be difficult to compare because the

generic firm may be smaller (or bigger) than the brand name company. Instead,

we compute enterprise value multiples for firms, using revenues, operating

income or book capital as a base. If brand name has value and is the only

difference between the two firms, the enterprise value multiple should be much

higher for the brand name company than it is for the generic company.

The brand name value can be backed out as follows:

Brand name value = [(EV/Variable)Brand name - (EV/Variable)Generic]* VariableBrand name

Thus, if we are using EV/Sales ratios as our multiples for comparison, this would

be modified as follows:

Brand name value = [(EV/Sales)Brand name - (EV/Sales)Generic]* SalesBrand name

This approach requires less work that the discounted cash flow approach, since

we are taking the market valuation as given and not trying to estimate value

ourselves. On the other hand, market mistakes will find their way into our

61

valuations and we are still assuming that the only reason for the differences

across firms is that one has a brand name and the other does not.

b. Comparing Market Valuations of different firms

What if we cannot find a generic company that is publicly traded? In multiple

regressions, we regress the multiples that firms trade against the fundamentals

that determine value. The resulting output allowed isolating the effect of each of

the fundamentals; for instance, we could estimate the effect of higher growth on

EV/Sales ratios of retail firms. By introducing a direct or an indirect measure of

brand name into the regression, we can estimate its effect on value.

a. Direct Measure of brand name: Assume that we are analyzing 30

consumer product companies, ten with strong brand names and twenty

with weaker brand names. We could introduce a brand name dummy

variable into the regression and capture its effect on value. For instance,

using EV/Sales ratio as the multiple, we would run the following

regression:

EV/Sales = a + b (Risk Measure) + c (Expected Growth) + d (Brand Dummy)

The brand dummy is set to one for the strong brand name firms and to

zero for the weak brand name companies. The coefficient ‘d’ on the brand

dummy will capture the value effect of having a brand name.

b. Proxy Measure of brand name: Earlier, we argued that the value of a

brand name was most likely to show up in higher operating margins.

Introducing the operating margin into the regression will capture this

effect.

EV/Sales = a + b (Risk Measure) + c (Expected Growth) + d (Operating Margin)

Presumably, companies with higher operating margins trade at higher

multiples of sales and the coefficient “d” on operating margin will capture

the effect. Using a generic or even an industry average operating margin

in this regression will yield an estimate of the EV/Sales ratio for a generic

62

firm. Comparing the actual EV/Sales ratio of a brand name company to

this predicted value will generate the brand name value:

Brand name value = [(EV/Sales)Brand name - (Predicted EV/Sales)Generic Margin]*SalesBrand name

Human Capital24

Rather than repeat what was said about brand name, we can map out how we can apply the approaches developed to value brand name to value other intangible assets that also generate value for the entire firm. One such asset is human capital. A firm with an well trained, loyal and intelligent workforce should be worth more than an otherwise similar firm with a less expert workforce. This is especially true for consulting firms, investment banks and other entities that derive most of their value from human capital.

Historic Cost Approach : With brand name, we considered advertising expenses to be the determining expense. With human capital, we would consider recruiting, training and employee benefit expenses as the determining force. As with brand name, firms may need to invest for years in human capital before the investment pays off, but we can attach an accounting value to human capital by assuming an amortizable life and collecting information on employee expenses for that period.

Discounted Cash flow Model : We can value the human capital invested in a company by comparing the value of the company with the investment with a generic company in the same business. Finding a generic company with regards to human capital can be more difficult than finding one with regards to


63

brand name. After all, every consulting firm believes that its consultants have special qualities; the difference is relative.

Excess Return Models : We can attribute all of the excess returns earned by a firm to its human capital, in which case the difference between estimated value and capital invested becomes a measure of the value of human capital.

Relative valuation models : We can compare the market multiples at which companies with superior human capital investments trade at, relative to firms with more average workforces.

With all of these approaches, we would add a note of caution. Unlike brand name, which is owned by a company, human capital is available only for rent. In other words, it will be very difficult to keep our skilled consultants or traders from moving to a competing firm at the right price; consider how often skilled traders on Wall Street move from one investment bank to another. Put in excess returns terms, it is conceivable that the entire excess returns from human capital may accrue to

the person or person possessing it rather than to the firm that hires them.

Goodwill: The non-assetIt may seem surprising that we have paid little attention to the most commonly

reported intangible asset on balance sheets, which is goodwill. Goodwill is not an

asset but a plug variable. Note that it shows up only after acquisitions and is

designed to capture the difference between what is paid for a target company

and the book value of its assets, thus allowing the balance sheet to still balance

after the acquisition.

The most charitable interpretation of goodwill is that it measures the estimated

value of growth assets in the target company; growth assets are investments that

64

the target company is expected to make in the future. This is true only if a fair

price is paid on the acquisition and the book value of the target company

measures the market value of assets in place, both of which are daunting

assumptions. In reality, the value of goodwill will be affected by

Mis-measurement of book value: If the book value of assets is understated

(overstated), because of accounting choices, the value of goodwill will be

overstated (understated).

Overpayment or underpayment on acquisition: If the acquiring company

overpays on an acquisition, its goodwill will increase by the overpayment.

If it underpays, the reverse will occur.

Though this may be asking for too much, our job in valuation would be made far

simpler if the goodwill item on balance sheets were broken down into smart and

stupid components, with the former being for growth assets (and thus justifiable)

and the latter capturing the overpayment on acquisitions. When computing the

return on invested capital, where we are often called upon to estimate the return

on assets in place, we would treat the stupid goodwill as part of the capital

invested (thus lowering return on capital) but not smart goodwill, since it is unfair

to expect companies to generate operating income on investments that they

have not taken yet.

65

Intangible Assets with Potential Future Cash Flows25

The most difficult intangible assets to value are those that have the potential to

create cash flows in the future but do not right now. While these assets are

difficult to value on a discounted cash flow valuation basis and often impossible

to evaluate on a relative basis, they do have option characteristics and are best

valued using option pricing models. In this section, we will begin by looking at

undeveloped patents and natural resource reserves as options and then move on

to consider two less clearly defined intangible assets – the option to expand into

new markets and products or to abandon investments.

Undeveloped PatentsA patent provides a firm with the right to develop and market a product or service

and thus can be viewed as an option. While an undeveloped patent my not be

financially viable today and generate cash flows, it can still have considerable

value to the firm owning it because it can be developed in the future. In this

section, we will consider first the mechanics of estimating the value of a patent as

an option and then expand the discussion to consider how best to value a firm

with both developed products and undeveloped patents.

Valuing a patent as an option

Using Standard Option Pricing Models with the parameters as input

Valuing a firm with patents

If the patents owned by a firm can be valued as options, how can this estimate

be incorporated into firm value? The value of a firm that derives its value

primarily from commercial products that emerge from its patents can be written

as a function of three variables.

The cash flows it derives from patents that it has already converted into

commercial products,


66

The value of the patents that it already possesses that have not been

commercially developed and

The expected value of any patents that the firm can be expected to

generate in future periods from new patents that it might obtain as a result

of its research.

Natural Resource Options

Natural resource companies, such as oil and mining companies, generate cash

flows from their existing reserves but also have undeveloped reserves that they

can develop if they choose to do so. They will be much more likely to develop

these reserves if the price of the resource (oil, gold, copper) increases and these

undeveloped reserves can be viewed as call options. In this section, we will

begin by looking at the value of an undeveloped reserve and then consider how

we can extend this to look at natural resource companies that have both

developed and undeveloped reserves.

Undeveloped Reserves as Options

Using Standard Option Pricing Models with the parameters as input

The Option to Expand into New Markets and Products

Firms sometimes invest in projects because the investments allow them either to

make further investments or to enter other markets in the future. In such cases,

we can view the initial projects as options allowing the firm to invest in other

projects and we should therefore be willing to pay a price for such options. Put

another way, a firm may accept a negative net present value on the initial project

because of the possibility of high positive net present values on future projects.

67

Case Studies

In the following section, We are going to take a number of case studies in the

following section. We take the Human and Brand Valuation done by Infosys

(Exhibit 5 provides a detailed overview of Infosys, the premier IT company with a

very reputed and clean corporate image) and compare it across the companies

and Last 7 years interval to understand any significance of the accounting

numbers provided by Infosys.

Brand ValuationValuation of Brand Infosys by Brand Earnings Multiplier Method

Method of Calculation of Infosys Brand Earnings Multiplier 26

Determine brand profits by eliminating the non-brand profits from the total

profits of the company

Restate the historical profits at present-day values

Provide for the remuneration of capital to be used for purposes other than

promotion of the brand

Adjust for taxes

Brand strength or Brand earnings multiplier Brand-strength multiple is a function of a multitude of factors

Leadership

Stability

Market

Internationality

Trend

Support and

Protection.

26 Infosys Annual Report 2006

68

These factors have been evaluated on a scale of 1 to 100 internally, based on

the information available within.

Interbrand, a leading branding company, uses a similar methodology to work out

the annual ranking of the world's most valuable brands. Exhibit 6 provides an

overview of their methodology.

69

Reconciliation of Brand Valuation of Infosys

Brand valuation (in Rs. Crore)2006 2005 2004

Profit before interest and tax 2,654 2,048 1,357 Less: Non brand income 124 112 111Adjusted profit before tax 2,530 1,936 1,246Inflation compound factor 1.000 1.053 1.108Present value of brand profits 2,530 2,039 1,381Weightage factor 3 2 1Three-year weighted average profits 2,175Remuneration of capital (5% of average capital employed)

309

Brand-related profits 1,866Tax 628Brand earnings 1,238 Multiple applied 18.51Brand value 22915

2006 2005 2004Brand value 22,915 14,153 8,185Market capitalization 82,154 61,073 32,909Brand value as a percentage of Market Capitalization 27.9

%23.20% 24.90%

Key Assumptions

Total revenue excluding other income after adjusting for cost of earning

such income is brand revenue, since this is an exercise to determine our

brand value as a company and not for any of our products or services

Inflation is assumed at 5% per annum

5% of the average capital employed is used for purposes other than


Tax rate is at 33.66% (Base rate of 30.0%, surcharge of 10% on base rate

and cess of 2.0%)

70

The earnings multiple is based on our ranking against the industry

average based on certain parameters (exercise undertaken internally and

based on available information)

The figures above are based on consolidated Indian GAAP financial

statements.

Net Profit before tax and interest 2724Provision for Taxation 303PAT 2,421P/E 33.93

ReconciliationBrand Earnings is a fraction of PAT 51% Tax 13% Weightage factor 15% Non Brand Income 8% Opportunity Cost 13%Total 100%

Brand Earning Multiplier is a fraction of P/E 55%

Brand Earning Multiplier is a fraction of P/E

Brand Earning Multiplier is a multiple for premium brand earnings which are significantly less robust than the company's ability to produce PAT without the Infosys brand

Given: Provision for taxation = Income tax – Deferred Tax = 325 – 22 = 303

Income taxes:

The provision for taxation includes tax liabilities in India on the company’s global

income as reduced by exempt incomes and any tax liabilities arising overseas on

income sourced from those countries. Most of Infosys’ operations are conducted

through Software Technology Parks (“STPs”). Income from STPs is tax exempt

for the earlier of 10 years commencing from the fiscal year in which the unit

71

commences software development, or March 31, 2009. Infosys now also has

operations in a Special Economic Zone (“SEZ”). Income from SEZs is fully tax

exempt for the first five years, 50% exempt for the next five years and 50%

exempt for another five years subject to fulfilling certain conditions. During the

year ended March 31, 2006, the tax authorities in an overseas tax jurisdiction

completed the assessment of income up to fiscal year 2004. Based on the

assessment order, management has re-estimated its tax liabilities and written

back an amount of Rs. 20 crore. The tax provision for the year is net of the write-

back.

Inferences

We can see from the above reconciliation that even though Non-Branded Income

is significantly less, the Brand Value is only one-fourth of the Market

Capitalization. Clearly market sees Infosys as just more than a brand. The

reasons are:

Its ability to save taxes with operations in STPs and SEZs

Brand is a signaling instrument. The resources put in signaling could and

is utilized by Infosys in productive activities

The brand earnings are less than branded profits since the growth in these

profits are not only attributable to brand but also to the organic growth

Most importantly Brand Earning Multiplier is a multiple for premium brand

earnings which are significantly less robust than the company's ability to

produce PAT without the Infosys brand. This itself leads to significant

difference of Brand Valuation and Market Capitalization.

72

Comparative valuation of Infosys, Rolta and Satyam

Brand Valuation of Rolta

Brand valuation (Rs. In million) 2004-05 2003-04 2002-03

Profit before interest and tax 1226 1014 1504Less: Non brand income 103 88 57Adjusted profit before tax 1123 926 1447Profit for the brand and associated intangibles 1123 926 1447Average capital employed 5723 6200 5410Remuneration of capital (5% of average capital employed) 5%Remuneration of capital 289Profit attributable to brand and associated intangibles 834Tax 305Profit after tax attributable to brand and associated intangibles

529

Multiple applied 15.15Brand value 8011Market Capitalization 7662Brand value as a percentage of market capitalization 104.5%

Key Assumptions


such income is brand revenue, since this is an exercise to determine the

brand value as a company and not for specific products or services

5% of the average capital employed is estimated to be used for purpose

other than promotion other than the brand.

Tax rate is 36.5925% (Base rate of 35%, surcharge of 2.5% on base rate

and cess of 2%)

The earnings multiple is based on a brand strength model where Rolta is

ranked on various parameters such as leadership, stability, market,

geographic spread, trend, support and protection.

Brand Valuation of Infosys

73

Brand valuation (in Rs. Crore) 2006 2005 2004Profit before interest and tax 2,654 2,048 1,357 Less: Non brand income 124 112 111Adjusted profit before tax 2,530 1,936 1,246Inflation compound factor 1.000 1.053 1.108Present value of brand profits 2,530 2,039 1,381Weightage factor 3 2 1Three-year weighted average profits 2,175Remuneration of capital (5% of average capital employed)

309

Brand-related profits 1,866Tax 628Brand earnings 1,238 Multiple applied 18.51Brand value 22915

2006 2005 2004Brand value 22,915 14,153 8,185Market capitalization 82,154 61,073 32,909Brand value as a percentage of Market Capitalization 27.90% 23.20% 24.90%

Key Assumptions



brand value as a company and not for any of our products or services.

Inflation is assumed at 5% per annum.


promotion of the brand.


and cess of 2.0%).

74

The earnings multiple is based on our ranking against the industry

average based on certain parameters (exercise undertaken internally and

based on available information).


statements.

Brand Valuation of Satyam

Rs. in CroresParticulars 31-Mar-06 31-Mar-05 31-Mar-04Profit Before Taxation 1,445.89 661.94 867Add: Financial Charges 2.72 0.75 0.76

1,448.61 662.69 867.76Less: Other Non-Branded Income 342.08 84.52 91.64Adjusted Profit for Brand Valuation 1,106.53 578.17 776.12Inflation compound factor @ 5% (assumed) 1 1.1025 1.05Present value of profits for the Brand 1,106.53 637.43 814.93Weightage factor 3 1 2Weighted profit 3,319.59 637.43 1,629.86Three year weighted average profit 931.15Less: Remuneration of capital (5% of avg capital employed)

188.77

Brand-related profits 742.38Less: Income Tax @ 33.66% 249.89Brand earnings 492.49Multiple applied 15.61Brand Value 7,688 4,662 3,462Market Capitalization 28,366 13,406 9,796Brand value as a percentage of Market Capitalization 27.1% 34.8% 35.3%

Key Assumptions

As on March 31, 2006, the Brand value of the Company was Rs. 7,687.77 crores (US$ 1,728.37 mn.), as computed below:

75

PBIT reduced by non-branded income was taken as profit for brand

valuation.

Previous two years profits were considered at present value and

weightage factor was applied to arrive at weighted profit.

5% of average capital employed was provided for non brand purposes.

Income Tax at current rate was provided.

Brand multiple was estimated based on certain parameters and internal

evaluation.

Inferences

While the three companies are not comparable, Infosys uses a higher

multiplier for the calculation of its brand value, leading to the highest value

for its brand among the three companies.

Rolta’s Brand Valuation is higher than its Market Capitalization indicating

negative stub problem or futile brand valuation excercise. Negative Stub

situation arise when there is implied negative price for the tangible fixed

assets. Alternatively the brand valuation exercise might be futile since

their brand premiums might be low and their Brand Earnings Mulitple be

too high (15.15 compared to 7.51 of P/E)

Satyam’s Brand Valuation is closer to that of Infosys in terms of

percentage of Market Capitalization. It would indicate either aggressive

Brand Earnings Multiplier in previous years or Market correcting its implied

value of the “Satyam” brand.

76

Infosys Brand Valuation over Time

Brand valuation (in Rs. Crore)

Particulars 2006 2005 2004 2003 2002 2001 2000 1999Market capitalization 82,154 61,073

32,909 26,847 24,654 26,926 59,338

9,673

Brand value 22,915 14,153 8,185 7,488 7,257 5,376 5,2461,72

7Brand Value as a % of Market Capitalization 28% 23% 25% 28% 29% 20% 9% 18%

Brand Valuation Vs Market Capitalization

010,00020,00030,00040,00050,00060,00070,00080,00090,000

2006 2005 2004 2003 2002 2001 2000 1999

Year

Rs. C

rore

0

5,000

10,000

15,000

20,000

25,000

Rs. C

rore

Market capitalization

Brand value

77

0%

5%

10%

15%

20%

25%

30%

2006 2005 2004 2003 2002 2001 2000 1999

Year

Brand Value as a Percentage of Market Capitalization

Inferences

Due to the boom time in the year 2000, the market capitalization of the

company was very high, leading to a lower brand value as a % of market

capitalization

However, the crash in the year 2001 led to decrease in the market cap. As

a result Brand value as a % of market capitalization increased.

Over the last five years Infosys has increased its market cap and at the

same time increased its brand value.

The consistency reinforces the strong reputation for clean Financial

Statements by Infosys and strong Market Forces to correctly value the

premium Indian Software Firm

78

Brand Valuation for Sintex using Brand Earnings MultiplierAs in above cases, we’ll use the Estimated Brand Multiplier to estimate the Brand Value of Sintex.

Brand Strength ModelBrand valuation (in Rs. lacs) 2005 2004 2003Profit before interest and tax 9,546 7,545 6,293 Less Non Branded Income 1,053 876 692Adjusted PBIT 8,493 6,670 5,601Profit for the brand and the associated intangibles

8,493 6,670 5,601

Inflation compound factor 1.000 1.053 1.108Present value of brand profits 8,493 7,023 6,206Weightage factor 3 2 1Three-year weighted average profits 7,622Average capital employed 80562 65944 59708Remuneration of capital (5% of average capital employed)

3,827

Brand Related Profits 3,795Less: Income Tax @ 33.66% 1,278Brand earnings 2,518Multiple Appllied 15.00Brand value 37,767

2005 2004 2003Brand value 37,767Market capitalization 73907Brand value as a percentage of market capitalization 51%

Key Assumptions



brand value as a company and not for any of our products or services.

Inflation is assumed at 5% per annum.

79


promotion of the brand.


and cess of 2.0%).

The earnings multiple is based on a brand strength model where Rolta is

ranked on various parameters


statements.

Brand valuation (in Rs. lacs) Sintex GenericDealer 133 100Dealer Margin per unit 25 20Sales 108 80RM (45%) 48.6 40OpExp (35%) 37.8 30PBIT 21.6 10

Neglecting InterestPre-Tax Operating Margin 20.00% 12.50%After-Tax Operating Margin 13.33% 8.33%Sales/BV of Capital 1.19 1.19Return on Capital 15.87% 9.92%Reinvestment Rate 85% 85%Expected Growth 13.49% 8.43%Length 5 years 5 yearsCost of Equity 14% 14%E/(D+E) 64% 64%AT Cost of Debt 6% 6%D/(D+E) 36% 36%Cost of Capital 11.12% 11.12%Value/Sales Ratio 1.9468751

40.97385

Value of Sintex's Brand Name = (3.122-1.257)*68798 66942.17Value of Sintex as a Company = 3.122*68798 133941.1 49.98%

Brand Valuation – Value to Sales Method

80

Key Assumptions: Using the balance sheet the payout ratio was calculated as 14.8148% and

growth has been assumed at 6%. The growth period is five years.

The above expression has been used to calculate the value of a company.

Exhibit 7 provides similar working for the brand valuation of Coca Cola

and Kellog’s.

Inference

In the case of Brand Earning Multiplier, an indicative multiplier of 15 is

used but P/E is 11. So without the Brand Strength analysis, it is very

difficult to reach a brand valuation figure through this method.

The second valuation methodology assumes crucial forecast values of

growth rate, growth period, payout rate and so is debatable

81

Both methodologies estimate Brand Valuation to be 50% which could be

true only to a limited extent even with given strong “Sintex” brand

Human Valuation

In India, Infosys has been prime mover in valuing its Human Resources. It has

made the Lev and Schwartz Human Accounting model (Exhibit 8 provides the

overview of Lev and Schwartz) as a default model for Human Valuation. Other

companies like Rolta have chose to take a similar model that of Economic

Approach model (Exhibit 9 provides the overview of Economic Approach Model)

Comparative Human Valuation of Infosys, Satyam and Rolta

Human Resource Valuation at Infosys

Human Resource ValueInfosys has used the Lev & Schwartz model for computing the HR value.

As on March 31, 2006 As on March 31, 2005Particulars Number of HR Value Number of HR Value

Employees Rs. In crores Associates Rs. In croresSoftware delivery

49,495 43,336 34,747 26,550

Support 3,220 3,301 2,003 1,784Total 52,715 46,637 36,750 28,334Market Cap 82,154 61,073

Key Assumptions: Employee compensation includes all direct and indirect benefits earned

both in India and abroad

The incremental earnings based on group / age have been considered

The future earnings have been discounted at 12.96% (previous year –

13.63%) the cost of capital for the company.

Beta has been assumed at 0.78, the beta for the company in India

82

Human Resource Valuation at Satyam

Human Resource ValueAs on March 31, 2006 As on March 31, 2005

Particulars Number of HR Value US$ % Number of HR Value US$ %Associates Rs. In

croresmillion Associates Rs. In

croresmillion

Development 24,801 22,203.06 4,991.70 95.03 17,859 15,886.31 3,631.16 95.78Support 1,710 1,161.49 261.12 4.97 1,305 700.1 160.02 4.22Total 26,511 23,365 5252.82 100 19,164.41 16,586 3,791.18 100

Market Cap 28,366 13,406

Key assumptions:

HR value is the present value of future earnings upto retirement age and

in this model earnings are dependent on age alone.

The future earnings have been discounted at 17.01%, being the weighted

average cost of capital (WACC) for the past five years

Human Valuation at Rolta

Economic Approach model(Rs. In millions except numbers and ratios)Particulars 2004-05Total value of human resources 31,404Market Cap 7,662Revenues per employee 2.17Net Profit per employee 0.46Value of human resources per employee 16.01

83

Total Revenues/Total value of human resources (ratio)

0.14

Key Assumptions:

Employee compensation includes all direct and indirect benefits earnings

both in India and abroad

The average annual increment is based on the increment paid during the

last three years

Retirement age is as per company policy

Inference

While all the three companies are not comparable, Infosys has the highest

HR Valuation. But Satyam feels that its entire market capitalization is

equal to its HR valuation. multiplier for the calculation of its brand value,

leading to the highest value for its brand among the three companies.

Also Rolta’s HR Valuation is much higher than its Market Capitalization

indicating negative stub problem or futile brand valuation excercise.

Negative Stub situation arise when there is implied negative price for the

tangible fixed assets. Alternatively the HR Valuation exercise might be

futile since their HR skill-set might be low and market correctly recognizes

that.

84

Human Resource Value

Infosys has used the Lev & Schwartz model for computing the HR value.

Summary of Human resources value

(in Rs. crore, unless stated otherwise)

Particulars 2006 2005 2004 2003 2002 2001 2000 1999No. of Employees 52,715 36,750 25,634 15,356 10,738 9,831 5,389 3,766Value of Human Resources 46,637 28,334 21,140 10,417 9,539 5,123 2,237 946Market Capitalization 82,154 61,073 32,909 26,847 24,654 26,926 59,338 9,673Software revenue 9,521 7,130 4,853 3,623 2,604 1,901 882 509Total Employee Cost 4,801 3,539 2,451 1,677 1,118 718 335 166Value added excluding exceptional items 8,027 6,053 4,185 3,043 2,239 1,563 723 374Net profits excluding exceptional items 2,479 1,846 1,244 958 808 623 286 133Key ratiosHR Valuation/Market Capitalization 57% 46% 64% 39% 39% 19% 4% 10%Total software revenue / human resources value (ratio)

0.2 0.25 0.23 0.35 0.27 0.37 0.39 0.54

Value added / human resources value (ratio) 0.17 0.21 0.2 0.29 0.23 0.31 0.32 0.4Value of human resources per employee 0.88 0.77 0.82 0.68 0.89 0.52 0.42 0.2511Employee cost / human resources (%) 10% 12% 12% 16% 12% 14% 15% 18%Return on human resources value (%) 5% 7% 6% 9% 8% 12% 13% 14%

Human Resource Valuation of Infosys over time

Inferences

The numbers of employees have steadily grown and there is inverted

parabolic shape for value added per employee over the years. Similarly for

the Revenue per employee

The HR Valuation/Market Capitalization shows similar trend as the Brand

Valuation/Market Cap but has a much higher steady state value, that of

50% compared to 27%

While employee cost has come down, the returns has also come down

indicating mass recruitment and dilution of elite Human Resources.

Conclusions

85

We can conclude that most of the companies are not doing a good job of

assessing the value of the intangible assets. For instance, Sintex Brand

Valuation was estimated at 165 crores in 2000-01 but they haven’t gone for any

new rounds of re-valuation even though the Brand Assets is sizeable 30% of

their Fixed Capital.

To encourage better valuation and measurement of intangibles we believe the

following measures are crucial:

1. Opening up Accounting Standards . Indian GAAP should permit the step

by step capitalization of intangibles. Further, efficient voluntary reporting

standards should be set up and companies should be given incentives for

better transparency in their accounting reports. Companies should go

beyond the existing voluntary reporting. Also, a set of standards should be

developed for the wide spectrum of intangibles in different industries.

2. Increased awareness of benefits of sharing the information : The

companies do a cost benefit analysis whenever they want to report the

measurement or valuation of intangibles done by them. But many

companies are not sufficiently aware of the benefits that may arise from

sharing this information. Hence, an increased awareness about the range

of benefits – from attracting talent to brand building and easier entry in

overseas market - will lead to an increase in voluntary sharing by the

companies.

3. Silent Zone Agreement : Publication of Information should not be made

mandatory regarding certain crucial areas. If an agreement can be

reached regarding a silent zone then the companies will have less to fear

and hence will have less reason to hold back.

86

4. Higher rating for companies that value intangibles : The rating

agencies should consider measurement and valuation of intangibles as an

important factor while rating the companies. This would also encourage

the companies to make further progress in this direction.

Hence, the road ahead must be paved by a combination of compulsory and

voluntary measures to encourage valuation and measurement of intangibles.

Exhibits 1 and 2 provide a company with frameworks so as to enable them to

identify an intangible valuation/measurement technique that suit their purpose

and parameters.

Learnings from Case Studies

1. The HR Valuation/Market Capitalization for Infosys shows similar trend as

the Brand Valuation/Market Cap but has a much higher steady state

value, that of 50% compared to 27%.

2. The consistency of Infosys reinforces the strong reputation for clean

Financial Statements by Infosys and strong Market Forces to correctly

value the premium Indian Software Firm

3. In case of Infosys, Brand Earning Multiplier is a multiple for premium

brand earnings which are significantly less robust than the company's

ability to produce PAT without the Infosys brand. This itself leads to

significant difference of Brand Valuation and Market Capitalization.

4. While employee cost has come down at Infosys, the returns have also

come down indicating mass recruitment and dilution of elite Human

Resources.

87

5. Rolta’s HR and Brand Valuation are quite high in comparison to its Market

Capitalization indicating negative stub problem or futile brand valuation

excercise. Negative Stub situation arise when there is implied negative

price for the tangible fixed assets. Alternatively the HR/Brand Valuation

exercise might be futile since their HR skill-set and Brand Premiums might

be low and market is correctly recognizing that.

6. For Sintex, In the case of Brand Earning Multiplier, an indicative multiplier

of 15 is used but P/E is 11. Thus, without the Brand Strength analysis, it is

very difficult to reach a brand valuation figure. The second valuation

methodology assumes crucial forecast values of growth rate, growth

period, payout rate and so is debatable

88

1. References

1) Jan Hofman, October 19, 2005, “Value Intangibles!”, Deutsche Bank

Research, Germany.

2) Andriessen, D. (2004). Making Sense of Intellectual Capital. Elsevier

Publications, Burlington, USA.

3) Annual Reports

4) Websites

5) Analyst Reports

6) Valuation by Aswath Damodaran

7) Best Global Brands – A Ranking by Brand Value, Interbrand Report

8) Aswath Damodaran, January 2006, “Dealing with Intangibles: Valuing

Brand Names, Flexibility and Patents”, Stern School of Business

89

Exhibit 1 - The Review of the 25 methods of Valuation and Measurement27

Review of 25 Methods for the Valuation or Measurement of Intangible

Sr. No. Method Purpose Means Methodological

ly sound?Measuring

Intangibles?Yardsticks or benchmarks?

Wide Range of

intangibles?Prospective?

Overall Apprai

sal

1 Balanced Scorecard

Internal Management Measurement + - + n/a n/a -

3Citation-weighted patents

External Reporting Measurement + + - - n/a -

5 Holistic Value approach

Internal Management and external

reporting

Measurement + + + + n/a +

6Human

Resource accounting


reporting

Measurement + + (-/+) - n/a -

7 intellectual capital audit

Internal Management Measurement + + + + n/a +

8 Intellectual capital-index


reporting

Measurement - + - + n/a -

9 Inclusive value MethodologyTM


reporting

Measurement + + + + n/a +

10 Intangible asset Monitor


reporting

Measurement + + - + n/a -

12


Benchmarking System

Internal Management Measurement + + + + n/a +

13Intellectual

Capital Dynamic value

Internal Management Measurement - + - + n/a -

14


Statement Reporting


reporting

Measurement + + - - n/a -

16 Konrad Group External Reporting Measurement + + - - n/a -

19 Skandia Navigator


reporting

Measurement + + - + n/a -


90

25 Value Chain Scoreboard

External Reporting Measurement + + - - n/a -

2 Calculated Intangible value

Statutory and transactional Valuation + - n/a n/a - -

4Economic

Value AddedTM

reporting


Valuation + - n/a n/a - -

6Human

Resource accounting


reporting

Valuation + + n/a - (-/+) -

11 Intangibles scorecard


reporting

Valuation + + n/a + + +

15 iValuing factor Internal Management Valuation - - n/a n/a - -

17 Market-to-book value


reporting


18 Options Approach All three Valuation + + n/a + + +

20 Sullivan's Work


reporting

Valuation + + n/a - + -

21 Technology factor

Internal Management Valuation - + n/a - + -

22 Tobin's Q


reporting


23 Valuation Approaches All three Valuation + + n/a + (-/+) +

24Value-Added Intellectual

CoefficientTM


reporting

Valuation - + n/a + - -

91

Exhibit 2 – Classification of 25 Methods

Financial Valuation, Value measurement, Value Assessment, and Measurement

Is there a value scale we can use that reflects usefulness or desirability?

Is money the unit used on the value scale?

Can the value be translated into observable criteria?

Is there a variable whose state can be observed?

No

No

No

No

Yes

Yes

Yes

Yes

Measurement

92

Financial Valuation

ValueMeasurement

Value Assessment

Exit

Blair and Wallman (2001) have defined three levels of intangibles:

Level 1: These intangibles can be owned and sold. For example, patents,

copyrights, brands and trademarks.

Level 2: These intangibles can be controlled but not separated out and sold. For

example R & D in process, business secrets, reputational capital, proprietary

management systems and business processes.

Level 3: These intangibles may not be wholly controlled by the firm, for example,

human resources, organizational capital and relationship capital.

Level 3

Level 2

Level 1

93

Classification of 25 Methods for the Valuation or Measurement of Intangible

Sr. No. Method Level

(Exhibit )Type of Method

(Exhibit) Community Problem Definition Scope Approach Time Span No. of

Indicators

1 Balanced Scorecard Level 2 Value

MeasurementPerformance Measurement

Internal Management

No Intangibles >1

3Citation-weighted patents

Level 1 Measurement Accounting External Reporting

Subset-Patents 1

5 Holistic Value approach Level 3 Value

MeasurementIntellectual

Capital

Internal Management &

External Reporting

All Intangibles 1

6Human

Resource accounting

Level 3 Value Measurement

Human Resource


External Reporting

Subset-Human

ResourcesDiverse

7 Intellectual capital audit Level 2 Value


CapitalInternal

ManagementAll

Intangibles >1

8 Intellectual capital-index Level 3 Measurement Intellectual

Capital


External Reporting

All Intangibles 1

9 Inclusive value MethodologyTM Level 3 Value


Capital


External Reporting

All Intangibles 1

10 Intangible asset Monitor Level 3 Measurement Intellectual

Capital


External Reporting

All Intangibles >1

12


Benchmarking System

Level 2 Value Assessment

13Intellectual

Capital Dynamic value

Level 2 Measurement Intellectual Capital

Internal Management

All Intangibles 1

14


Statement Reporting

Level 2 Measurement Intellectual Capital


External Reporting

Subset- Knowledge

Management>1

16 Konrad Group Level 3 Measurement Intellectual Capital

External Reporting

Subset-Human

Resources>1

19 Skandia Navigator Level 2 Measurement Intellectual

Capital


External Reporting

All Intangibles >1

25 Value Chain Scoreboard Level 2 Measurement Accounting External

ReportingSubset-

Innovation >1

94

2 Calculated Intangible value Level 2 Financial

Valuation Accounting Statutory & Transactional

All Intangibles Income Retrospective

4Economic

Value AddedTM

reportingLevel 2 Financial

Valuation

6Human

Resource accounting

Level 3 Financial Valuation

Human Resource


External Reporting

Subset-Human

ResourceAll Prospective &

Retrospective

11 Intangibles scorecard Level 3 Financial

Valuation Accounting


External Reporting

All Intangibles Income Prospective

15 iValuing factor Level 3 Financial Valuation Accounting Internal

Management n/aMarket-to-Book

RatioRetrospective

17 Market-to-book value Level 1 Financial

Valuation Accounting


External Reporting

All Intangibles

Market-to-Book

RatioRetrospective

18 Options Approach Level 1 Financial

Valuation Valuation Internal Management All or subset Income Prospective

20 Sullivan's Work Level 1 Financial Valuation



External Reporting

Subset- Intellectual

PropertyIncome Prospective &

Retrospective

21 Technology factor Level 1 Financial

Valuation Valuation Internal Management

Subset-Technology Income Prospective

22 Tobin's Q Level 1 Financial Valuation Accounting


External Reporting

All Intangibles

Market-to-Book

RatioRetrospective

23 Valuation Approaches Level 1 Financial

Valuation Valuation All three All or subset All Prospective & Retrospective

24Value-Added Intellectual

CoefficientTMLevel 1 Financial

ValuationIntellectual

Capital


External Reporting

All Intangibles

Income and Cost Retrospective

95

Method Modules for the valuation of intangible capital…

96

Exhibit 3 - Questionnaire designed by us for the interaction with the industry experts

1. What are some of the Intellectual Property (IP) or Intangibles in your company that

could or need to be measured or valued?

2. Are you currently involved in measurement or valuation of any of the above IP or

Intangibles?

3. If yes, which ones and which Method/Consulting Company you utilize for this

regard?

4. For above methods/Consulting Company, what are parameters do you consider

during the measurement/valuation of the IP/Intangibles? Could you provide a brief

indicative process of the measurement/valuation process?

5. What Limitations/Difficulties/Challenges have you faced in the Measurement or

Valuation of IP/Intangibles? How have you tried to overcome them?

6. We have created a detailed background and write-up on 26 methods suggested by

researchers for the use in various fields/scenarios. On Based of Different

Characteristics, we have summarized the methods in a table for ease of

comparison.

Would you like to look at this table of Methods and tell us which all have you heard

and which all could be useful for you company?

7. Do you have plans for doing valuation/measurement in future? If yes, which

IP/intangible would you value/measure and how?

Company Name -

Position of Responsibility -

97

Exhibit 4 – Brain League IP Services

History of Brain league28

Brain League was founded by Arun and Kalyan in July, 2004, with an aim of

providing IP Management and strategy services for knowledge driven

companies. They undertook this endeavor to provide the much needed IP

services with a blend of Technology, Management and Law, some of which

services were traditionally offered by law firms that emphasized primarily on law.

Brain League made exponential progress during the first year of its existence by

developing a client base in chemical, telecom, software, electronics and biotech

sectors. The Consultancy has also developed an important component of their IP

Management Software that would enable them to implement their services

Profile of Kalyan C Kanakanala 29

Kalyan C. Kankanala , CKO and Co-founder, has experience in IP Consulting and is

an expert trainer. During his illustrious career as an IP consultant, Kalyan worked

closely with biotech and software companies on strategic IP analysis, IP

Collaboration, Licenses and Audits. He was instrumental in developing a strong

knowledge and training base for Brain League by developing IP content, devising

training programs and running online courses. He has trained more than 2000

corporate employees in biotechnology, software and telecom sectors. As a

visiting faculty at National Law School of India University and Institute of

Bioinformatics and Applied Biotechnology, Kalyan offers courses on Intellectual

Property aspects of Biotechnology. He has an LL.M. in Intellectual Property,

Commerce and Technology from Franklin Pierce Law Center and is pursuing his

doctoral studies at National Law School, Bangalore.

28 http://www.brainleague.com/CorporateProfile.htm


98

http://www.brainleague.com/CorporateProfile.htm


Profile of Arun K Narasani 30

Arun K Narasani, CEO and Co-founder, has profound knowledge and

experience in IP Management and Patent Drafting. After working as a software

engineer with various leading companies, Arun began his career in Intellectual

Property as a consultant. He worked with companies in software and electronics

sectors on IP Audit, analysis, due diligence projects and helped them develop IP

Management Strategies and processes. As a patent attorney, Arun has drafted

numerous Indian, US and PCT applications. He has a B.Tech. from IIT, Madras

and PG from IIM Bangalore. During his course at IIMB, Arun's research focus

was on internal factors of innovation in Indian companies with specific focus on

IP.


99


Exhibit 5 – Overview of Infosys31

IntroductionInfosys, one of India’s leading information technology (“IT”) services companies,

uses an extensive non-U.S. based (“offshore”) infrastructure to provide managed

software solutions to clients worldwide. Headquartered in Bangalore, India,

Infosys has seventeen state-of-the-art software development facilities throughout

India and one development center in Canada. These enable it to provide quality,

cost-effective services to clients in a resource-constrained environment. Through

its worldwide sales headquarters in Fremont, California (and 19 other sales

offices located in the United States, Canada, the United Kingdom, Belgium,

Sweden, Germany, Australia, Japan, and India), Infosys markets its services to

large IT-intensive businesses.

Although most Infosys’ revenues are from the United States, Infosys maintains a

diversified client base. This client base comprised of mainly Fortune 500

companies, growing Internet companies, and other multinational companies. As

a result of its commitment to quality and client service, Infosys has a high level of

repeat business.

HistorySeven software professionals founded Infosys in 1981 with the goals of

leveraging sweat equity and creating wealth legally and ethically in India. This

was a daunting task in a country where the government was allegedly more

concerned with redistributing wealth than creating it. Most of India’s commerce

was owned and controlled by an oligarchy of families to which Infosys had no

ties. Infosys’s competitive advantage has historically been derived from low wage

costs in India relative to service providers in the United States and Europe. Their

initial foray into the US market was through a company called Data Basics Corp.

as a “body-shop” or on-site developer of software for US customers. Later, in

31 Management of Human Assets at Infosys, Fordham Graduate school of business case study

100

1987, Infosys formed a joint venture with Kurt Salmon Associates to handle

marketing in the US. These initial entries into the US market were a stepping

stone for Infosys’ growth in later years.32 The liberalization of the Indian economy

has brought unprecedented competition to India. Such multinational corporations

as IBM, Sun Microsystems, and Motorola are now leveraging their vast financial

resources to compete for India’s most valuable resources, its people.

Management of human assets at Infosys“Our assets walk out of the door each evening. We have to make sure

that they come back the next morning.” (Narayana Murthy, CEO Infosys).

At a time when organizations are debating the strategic importance of their

human resources, Infosys, a consulting and software services organization,

includes its human resources on its Balance Sheet to affirm their asset value. Mr.

Mohandas Pai, the Chief Financial Officer of Infosys, provides a rationale for this

practice:

“Investors examine financial and non-financial parameters that determine long-

term success of a company. These new non-financial parameters challenge the

usefulness of evaluating companies solely on traditional measures as they

appear in a typical financial report. Human resources represent the collective

expertise, innovation, leadership, entrepreneurial and managerial skills endowed

in the employees of an organization. Our representation is based on the belief

that intangible assets provide a tool to our investors for evaluating market-

worthiness of Infosys.”

As a knowledge-intensive company, Infosys recognizes the value of its human

assets in maintaining and increasing its competitive position. At the same time,

Infosys realizes that these assets can easily “walk away”, as competitors in India

and abroad covet its IT talent.

32 “Infosys: Can they make it?” Business World 7-21 November 1998, p. 19-22.

101

Future PlansInfosys plans to maintain its growth rate in India and to expand overseas. As a

part of its growth strategy, Infosys is exploring possible candidates for

acquisitions in United States. Infosys believes that pursuing selective acquisitions

of IT services and software applications firms could expand its technical

expertise, facilitate expansion into new vertical markets, and increase its client

base.

As part of its business strategy Infosys is gearing to move up the “value chain”

and provide end-to-end solutions to clients. Infosys will have to achieve these

objectives in the face of many challenges. These include increased global

competition and labor cost, rapid growth, and increased employee diversity. As

Infosys expands overseas, it will experience increased competition from firms

with potentially lower labor costs and with a greater ability to respond to changing

client IT preferences. Historically Infosys’ labor costs have been lower than those

of service providers in the United States and Europe. How ever, because w ages

in India are currently increasing at a faster rate than in the United States, Infosys

will experience shrinking profit margins in future. The rapid growth of Infosys

challenges its ability to transmit its corporate culture worldwide as well as its

ability to attract and retain skilled personnel. Overseas hires and acquisitions w ill

result in Infosys experiencing increased employee diversity of cultures. Increased

diversity will also come from a different set of skills required for expansion into

consulting business. Infosys’ human resource management accounting practices

will have to be assessed in light of these challenges.

Opportunities and threats 33

33 Infosys Annual Report of 2006

102

Innovation and leadership: They are a pioneer in the technology services

industry. Over the past decade, they have developed onsite and offshore

execution capabilities to deliver high quality and scalable services. They assist

clients in segmenting their internal business processes and applications,

including IT processes, and outsourcing these segments selectively on a modular

basis to reduce risk and cost and increase operational flexibility.

Comprehensive and sophisticated end-to-end solutions: Their suite of

comprehensive, end-to-end technology-based solutions enables them to extend

their network of relationships, broaden their dialogue with key decision makers

within each client, increase the points of sale for new clients and diversify their

service-mix.

Commitment to superior quality and process execution: The Company has

developed a sophisticated project management methodology to ensure timely,

consistent and accurate delivery of superior quality solutions to maintain a high

level of client satisfaction. They constantly benchmark their services and

processes against globally recognized quality standards.

Long-standing client relationships: They have long-standing relationships with

large multi-national corporations built on successful prior engagements with

them. Their track record of delivering high quality solutions across the entire

software life cycle and their strong domain expertise help them to solidify these

relationships and gain increased business from their existing clients. As a result,

they have a history of client retention and derive a significant proportion of

revenues from repeat clients.

Status as an employer of choice: They have among the best talent in the

Indian technology services industry and they are committed to remain among the

industry’s leading employers. Their diverse workforce includes employees of 59

nationalities. Their training programs ensure that new hires enhance their skills in

103

alignment with their requirements and are readily deployable upon completion of

their training programs. Their lean organizational structure and strong unifying

culture facilitate the sharing of knowledge and best practices among their

employees.

Ability to scale: They have successfully managed their growth by investing in

infrastructure and by rapidly recruiting, training and deploying new professionals.

They currently have 38 global development centers, the largest of which are

located in India. They also have development centers in Australia, Canada,

China, Japan, Mauritius and locations in the United States and Europe. Their

financial position allows them to make investments in infrastructure and

personnel required for continuous growth our business. They can rapidly deploy

resources and execute new projects through the scalable network of their global

delivery centers.

Risk Management by Infosys:

Human Resource Accounting:The dichotomy in accounting between human and non-human capital is

fundamental. The later is recognized as an asset and is, therefore, recorded in

the books and reported in the financial statement, whereas the former is ignored

by the accountants. The definition of wealth as a source of income inevitably

104

leads to the recognition of human capital as one of the several forms of wealth

such as money, securities and physical capital.

Infosys uses the Lev and Schwartz model to compute the value of human

resources.

Brand Valuation:The wave of brand acquisitions in the late 1980s exposed the hidden value in

highly branded companies and brought brand valuation to the fore. Examples are

Nestlé buying Rowntree, United Biscuits buying Keebler, etc. An Interbrand study

of the acquisitions of 1980s shows that, whereas in 1981, net tangible assets

represented 82% of the amount bid for the companies, by 1988 this had fallen to

56%. Thus, it is clear that companies are being acquired less for their tangible

assets and more for their intangible assets. The values associated with a product

or service is communicated to the consumer through the brand. Consumers no

longer want just a product or service; they want a relationship based on trust and

familiarity. A brand is much more than a trademark or a logo. It is a ‘trustmark’ –

a promise of quality and authenticity that clients can rely on. Brand equity is the

value addition provided to a product or a company by its brand name. It is the

financial premium that a buyer is willing to pay for the brand over a generic or

less worthy brand. Brand equity is not created overnight. It is the result of

relentless pursuit of quality in manufacturing, selling, service, advertising and

marketing. It is integral to the quality of client experiences in dealing with the

company and its services over a sustained period. Corporate brands and service

brands are often perceived to be interchangeable. Both types of brands aim at

the enhancement of confidence and the reduction of uncertainty in the quality of

what the company offers. Therefore, companies rely heavily on the image and

personality they create for their brands, to communicate these qualities to the

market place.

105

For many businesses, brands have become critical for shareholder wealth

creation. Global brands are still the most powerful and sustainable wealth

creators in the business world and will continue to be so in the near future. The

task of measuring brand value is a complex one. Several models are available

for accomplishing this. The most widely used is the brand-earnings-multiple

model. There are several variants of this model. For example, according to the

Business Week / Intrabrand annual ranking of the world’s most valuable brands

conducted and published in August 2005, Coca-Cola was valued as the most

valued brand in the world for the year 2005 at $68 billion, when its market cap

was $106 billion. Thus, the brand valuation of Coca-Cola was around 64% of its

market cap on the date of valuation. The study goes on to state that even

established brands like Coca-Cola and Microsoft have started to recognize the

need to nurture stronger ties with the customer. (Source:

www.businessweek.com) Goodwill is a nebulous accounting concept that is

defined as the premium paid to the tangible assets of a company. It is an

umbrella concept that transcends components such as brand equity and human

resources, and is the result of many corporate attributes including core

competency, market leadership, copyrights, trademarks, brands, superior earning

power, excellence in management, outstanding workforce, competition, longevity

and so on.

Infosys have adapted the generic brand-earnings-multiple model (given in the

article on Valuation of Trademarks and Brand Names by Michael Birkin in the

book Brand Valuation, edited by John Murphy and published by Business Books

Limited, London) to value their corporate brand, “Infosys”. The methodology

followed for valuing the brand is given below:

Determine brand earnings• Determine brand profits by eliminating the non-brand profits from the total

profits of the company

• Restate the historical profits at present-day values

106

http://www.businessweek.com/

• Provide for the remuneration of capital to be used for purposes other than


• Adjust for taxes

Determine the brand-strength or brand-earnings multipleBrand-strength multiple is a function of a multitude of factors such as leadership,

stability, market, internationality, trend, support and protection. These factors

have been evaluated on a scale of 1 to 100 internally by the company, based on

the information available within.

Intangible Assets Score SheetInfosys publishes models for valuing the two most valuable, intangible assets of

the company – human resources and the “Infosys” brand. This score sheet is

broadly adopted from the intangible asset score sheet provided in the book titled

The New Organizational Wealth, written by Dr. Karl-Erik Sveiby and published by

Berrett-Koehler Publishers Inc., San Francisco. They believe such representation

of intangible assets provides a tool to their investors for evaluating their market-

worthiness.

Value ReportingInfosys has been at the forefront of providing shareholders information beyond

the stipulations of the regulatory framework. The Value Reporting Revolution:

Moving Beyond the Earnings Game (published by John Wiley & Sons, Inc., USA,

©2001), authored by Robert Eccles, Robert Herz, Mary Keegan and David

Phillips, associated with the accounting firm, PricewaterhouseCoopers, was

successfully received.

107

To bridge the gap between the information available to the management and the

information available to the stakeholders, the company provides several non-

financial and intangible performance measures to their stakeholders.

108

Exhibit 6 - The Interbrand Method for Valuing Brands34

Criteria for ConsiderationUsing our database of global brands, populated with critical information over the

past 30 years, Interbrand formed an initial consideration set. All were then

subject to the following criteria, which narrowed candidates significantly:

Must be a publicly traded company

Must have at least one-third of revenues outside of their country of origin

Must be a market-facing brand

Economic Value Added (EVA) must be positive

The brand must not have a purely b2b single audience with no wider

public profile and awareness

These criteria exclude brands such as Mars, which is privately held, and Wal-

Mart which is not sufficiently global (it does business in some international

markets but not under the Wal-Mart brand).

MethodologyThe Interbrand method for valuing brands is a proven, straightforward and

meaningful formula that examines brands through the lens of financial strength,

importance in driving consumer selection and the likelihood of ongoing branded

revenue. Our method evaluates brands much like analysts would value any other

asset: on the basis of how much they’re likely to earn in the future. There are

three core components to our proprietary method:

Financial AnalysisOur approach to valuation starts by forecasting the current and future revenue

specifically attributable to the branded products. The cost of doing business

(operating costs, taxes) and intangibles such, as patents and management

34 Best Global Brands 2006, Interbrand, Business Week

109

strength, are subtracted to assess what portion of those earnings is due to the

brand.

All financial analysis for the Best Global Brands is based on publicly available

company information. Interbrand culls from a range of analyst reports to build a

consensus estimate for financial reporting.

Role of Brand AnalysisA measure of how the brand influences customer demand at the point of

purchase is applied to the intangible earnings to arrive at branded earnings.

For the report, industry benchmark analysis for the role brand plays in driving

customer demand is derived from Interbrand’s database of more than 4,000 prior

valuations conducted over the course of 20 years. In-market research is used to

establish individual brand scores against our industry benchmarks.

Brand Strength AnalysisThis is a benchmark of the brand’s ability to secure ongoing customer demand

(loyalty, repurchase, and retention) and thus sustain future earnings, translating

branded earnings into net present value. This assessment is a structured way of

determining the specific risk to the strength of the brand. We compare the brand

against common factors of brand strength, such as market position, customer

franchise, image, and support.

110

Exhibit 7 - Valuation of Coca Cola and Kellog’s Brand name35

35 www.stern.nyu.edu/~adamodar/pdfiles/brand.pdf

111

Valuation of Kellogg’s brand name36

Particulars Kellogg's Generic Substitute

Pre-tax Operating Margin 22.00% 10.50%

After-tax Operating Margin 14.08% 6.72%

Return on Assets 32.60% 15.00%

Retention Ratio 56.00% 56.00%

Expected Growth 18.26% 8.40%

Length of High Growth

Period5 5

Cost of Equity 13.00% 13.00%

E/(D+E) 92.16% 92.16%

D/(D+E) 8.50% 8.50%

Value/Sales Ratio 3.39 1.10

Value of Kellogg Brand Name = (3.39 - 1.10) ($6562 million) = $15,026 million

Value of Kellogg as a company = 3.39 ($6562 million) = $22,271 million

Approximately 67.70% ($15026/$22271) of the value of the company can be

traced to brand name value.

36 www.stern.nyu.edu/~adamodar/New_Home_Page/lectures/brand.html

112

Exhibit 8 - Lev and Schwartz human accounting model37

Infosys places an asset value on its human capital based on an accounting

model put forth by Baruch Lev and Aba Schwartz. Lev and Schwartz’s model is

based on human capital theory, which recognizes human capital as one of

several forms of holding wealth for a business enterprise, such as money,

securities and physical capital. In this model of accounting, human capital is

treated like other forms of earning assets and thus is an important factor

explaining and predicting the future economic growth of the company. Lev and

Schwartz’s accounting model is based on the measurement of human capital

using the formula, Vr = ΣT t=r I(t)/(1+r)t-r, w here Vr = the human capital value of

a person “r” years old; I(t) = the person’s annual earnings up to retirement; r = a

discount rate specific to the person; T = retirement age. The formula uses an

earnings profile, which is a graphic mathematical representation of the income

stream generated by a person. Typically, earnings increase with age. As the

person reaches retirement age, productivity declines as a result of technological

obsolescence and health deterioration. This model postulated in 1971 remains

largely unused as a result of criticism from Accounting professionals w ho argue

that human capital cannot be purchased or owned by the firm and therefore

would not be recognized as an asset. Additionally, critics of human capital theory

state that labor force does not have a “service potential”; meaning employees are

paid for rendering current services and no asset is formed by these payments.

Regardless, this model is one of few that exist to value human capital, a source

of know ledge for companies. While very basic, the Lev and Schwartz model

provides a means by which to disclose human capital values to

stakeholders.38The Lev & Schwartz model has been used by Infosys to compute

the value of the human resources as of March 31, 1999. The evaluation is based

on the present value of the future earnings of the employees and on the following

assumptions:

37 Management of Human Assets at Infosys, Fordham Graduate school of business case study38 Lev, Baruch and Aba Schwartz. “On the Use of the Economic Concept of Human Capital in FinancialStatements.” The Accounting Review 44(1971): 103-110.

113

1. Employee compensation includes all direct and indirect benefits earned both in

India and abroad.

2. The incremental earnings are based on group/age have been considered.

3. The future earnings have been discounted at the cost of capital for Infosys.

Beta is assumed based on average beta for software stocks in India.

114

Exhibit 9 - Economic Approach model - Rolta39

This model estimates the future earnings during the remaining life (in the

organization) of the employee and then arriving at the present value by

discounting the estimated earnings at the employee’s cost of capital. In this

model each employee’s cost to the company (CTC) should be forecasted and

discounted back separately. The growth rate of earnings of each employee till

retirement should be determined for projecting the CTCs after looking into the

company’s compounded annual growth, CTCs for different employee classes,

global industry trends for the future, and sustainable growth rates for the future

25-30 years. The attrition rates for the company/industry should not be

considered as a deduction factor, as the employees who will leave the company

will be replaced by others, to maintain the level of operations and thereby the

employee strength remains unchanged. The future earnings thus arrived at has

to be discounted at the company’s cost of capital.

Based on the above model the value of human resources of Rolta has been

arrived at by Grant Thornton at Rs. 31,404 million.

39 Rolta Annual Report 2005

115

Documents

Definition of Intellectual Capital:spidi2.iimb.ac.in/~networth/CCS/2005/589 CCS... · Web viewHowever, the method is not very useful as the company doesn’t know what went wrong