Intangible assets: the right balance?

The
recent
broadside launched by the Big Four accountancy firms, along with Grant
Thornton and BDO, against our current system of corporate reporting was aimed at
improving the quality of information investors receive on a company. The firms
argue that quarterly and annual reporting should be replaced with real-time,
internet-based reporting and that purely financial data should be augmented by
more meaningful indicators of a company’s future prospects, such as customer
satisfaction, product or service defects, employee turnover and patent awards.

Calls for more meaningful reporting have been going on for years and, for a
time, it looked as though the now-defunct mandatory operating and financial
review would encourage better practice. But by adding its voice to the debate,
this powerful lobby group of accountants could actually drive changes in
behaviour that have so far proved elusive.

However, the biggest potential benefit of any change in reporting will not be
better-informed shareholders, but better-managed companies. At present,
companies are making poor decisions, as they are neither measuring nor managing
the real drivers of value in their businesses because they don’t currently have
to report on them.

Tim Ambler, senior fellow at London Business School, argues that the typical
board spends just 10% of its time on the marketplace – what he calls “the
sourcing and harvesting of cash flow” – and the remaining 90% discussing what to
spend its money on. The reason is that “the typical profit and loss account has
just one line for sales revenue and fills the rest of the page with details of
how the company uses its cashflow”.

What’s more, continues Ambler, “The balance sheet is getting less and less
interesting because it explains an ever-smaller part of a company’s market
capitalisation.”

He is referring to the fact that intangible assets – including brands and
customer– and employee-related intangibles – account for between 30% and 70% of
a typical company’s market value, depending on the sector. This is a reversal of
the situation even 30 years ago when tangible assets held sway. But even though
they are key drivers in today’s economy, intangibles are inadequately reflected
on the balance sheet and neither boards nor investors properly understand them.
This skewed focus leads to poor decision making by companies and systematic
mispricing of stock by investors.

Michael Bleakley, beverages analyst at Crédit Suisse First Boston, says that
lack of information means analysts generally don’t take a sensible view about
how long brands will survive. “A common assumption is that they will fall off
and disappear within five to ten years,” he says.

And, on the management front, Gianni Ciserani, Procter & Gamble
vice-president and UK & Ireland managing director, drew attention to a prime
example of tactical decision making undermining long-term brand value in May
2006, when he criticised companies’ propensity to pour money into promotions,
which generate short-term sales, at the expense of innovation, marketing and
advertising, which build long-term brand equity.

Aggressive promotions
Retailers’ aggressive in-store promotion strategy is partly to blame and the way
to break this vicious circle is to counteract the downward price pressure by
investing in a strong innovation pipeline and building brand values through
advertising. But in the face of sales directors who are bonused on driving up
revenue rather than profits, this is easier said than done.

Robert Shaw, author of Marketing Payback and visiting professor at
Cass Business School, says: “Some finance directors don’t seem to realise what
is going on, while others admit to being frightened of tackling the sales
directors because they are so powerful.”

A greater understanding of the drivers of brand value and, by extension,
shareholder value, would clearly help. But IFRS3, which, from 1 January 2007
requires companies to break down the value of the intangibles they acquire as a
result of a takeover into five categories, including customer and market-related
intangibles rather than grouping them together under the catch-all term
‘goodwill’ as they have in the past, will be of only partial help.

Critics argue that IFRS3 is limited in the extent to which it reflects the
value of a company’s intangible assets. Only acquired intangibles can be
recorded on the balance sheet, giving a lopsided view of a company’s value and,
year-on-year, the value of those assets can only stay the same or be revised
downwards, thus failing to reflect the additional value that the new owners
ought to be creating.

David Kappler, former finance director of Cadbury Schweppes and now chairman
of HMV and Premier Foods, which recently acquired Hovis and Mr Kipling as a
result of its £1.2bn purchase of RHM, describes the discrepancy as bizarre.
“Cadbury Schweppes has something like £5bn-worth of intangibles sitting on its
balance sheet as a result of buying brands such as Halls, 7-Up, Dr Peppers,
Trident and Snapple, but neither of its inherited brands gets a look-in. If you
do a return-on-capital-employed (ROCE) calculation that is based purely on
balance sheet figures you come up with all kinds of weird and wonderful numbers
and make lousy decisions as a consequence,” he says.

Out of touch
Kappler believes that accounting has lost touch with business economics, with
potentially dangerous consequences for brand building.

“Typically, management is incentivised for growing profits, which may be
achieved at the expense of brand building,” he says. “As many marketers know to
their cost, one of the quickest ways to boost cash returns and accounting
profits is to cut the advertising and other investment in the brand. But the
economic value of the business may be reduced as a result.”

Premier Foods has historically specialised in buying brands that have had
little marketing attention – Bird’s Custard and Branston Pickle, for example –
and investing in them. “Our investment is paying dividends, but, again, we can’t
reflect the value we have created on the balance sheet,” says Kappler.

Kappler has, tongue-in-cheek, coined the term EROTIC, which stands for
‘economic return on total investment capital’, to describe a method of combining
accounting profit with a measure of the growth or decline of the brands. “But
the complexity of the calculations required, along with the degree of judgement
that would have to be exercised, mean it is not a sufficiently robust measure
that can be taken seriously. Accounts have to be black and white,” he says. “If
you don’t report on it, you don’t measure it, and we only tend to pay bonuses
based on what is measured, so we are driving the wrong behaviour.”

Part of the problem, as Kappler acknowledges, is the lack of a robust and
consistent methodology for valuing brands. Give the same brand to five brand
valuation consultants, he points out, and they will come up with five different
values.

The brand valuation consultants themselves believe that ‘professional’
valuation can help give companies a greater understanding of their value
drivers. Joanna Seddon, executive vice president of Millward Brown, argues: “The
reason for determining the value of brands and other intangibles is not to find
the number but to identify the best way to manage the business, to get better
statistics, to invest better and to grow the value that marketing adds to the
business.”

Andrew Sharp, director of brand economics and finance at
PricewaterhouseCoopers, says that valuation should be based on good judgement
and that the output should be a range of values rather than one specific number.
While brand valuation is in its infancy, he believes the research and analysis
involved in getting to a set of figures can help companies get a grip on the l
evers of value creation.

Ken Lever, finance director of Tomkins, is not convinced. “Every time we make
an acquisition, we get 12 letters offering to help us with valuations,” he says.
“But we have as much ability in-house as any external ‘experts’. It is not
difficult to value brands – it is all about predicting future cashflows and
applying a discount rate. Brand valuation experts have particular methodologies
and offer a degree of consistency, but there is no need to create a new
industry.”

Lever believes the brand valuation consultants have a role in valuing brands
for accounting purposes – particularly with the new requirement to do an
impairment review every year to ensure the value of the acquired brand has not
fallen. Even then, he thinks the requirement in IFRS3 to break down goodwill
into its components is flawed in that “it tries to bring a spurious level of
accuracy to it and implies a level of reliability that is unrealistic”.

However, the more important job of understanding and growing economic value,
which takes into account all intangibles, including those that are home grown,
should be based on management’s own calculations, says Lever.

Tomkins started doing economic valuations of its business five years ago. “It
is an important internal discipline, because it affects the focus of management
and how management invests,” says Lever. “We calculate economic values of all
our businesses every year and it has changed management behaviour in terms of
where they allocate their investment and resource. All our business managers
understand that the value they are protecting and seeking to enhance includes
all the intangibles, even though it is difficult to reflect those in external
financial reports. Our bonus scheme is based on economic profits, not accounting
profits, which acts as a huge incentive to focus on enhancing intangibles to
make an economic return.”

Intrinsic value
But while the exercise is conducted primarily for internal management purposes,
Lever says: “Companies should communicate the economic value of their business
better, including all their intangibles, such as people, knowledge, distribution
channels and so on, as well as brands and intellectual property – all of which
drive the strategic position of the business – in order to give the market a
clearer idea of their intrinsic value.”

But the place to do that, he says, is in the business review, which requires
large companies – all listed and bigger private companies – to disclose most of
the non-financial data that was required under the OFR.

Indeed, though some mourn the demise of the mandatory OFR, the business
review is both mandatory, underpinned as it is by the
EU
Accounts Modernisation Directive 2003, and is much broader in its scope
than its predecessor. Pressure from the big accountancy firms for more
non-financial data could reinforce the need for companies to comply as fully as
possible with company law and to use the reporting exercise to get at the
underlying value drivers in their business rather than just viewing it as a
compliance exercise. But there is a danger that we reinvent the wheel, embarking
on yet another overhaul of reporting practice when, in the form of the business
review at least, we have a workable model in place.

The pressure to understand intangibles is mounting from investors as well as
standards setters. Under the Enhanced Analytics Initiative, for example, a group
of pension funds, fund managers and investment houses across Europe has decided
to allocate a minimum of 5% of their commission payments to sell-side analysts
who excel in covering non-financial issues. This is encouraging the brokers who
employ them to develop new tools and fresh approaches to dealing with the
challenge.

Businesses that do get a grip on their intangible value will reap
considerable benefits, including more realistic valuations of their stock,
better access to capital, a closer working relationship between finance,
marketing and human resources and, as a result, more informed managerial
decision making.

The Institute of Practitioners in Advertising has just launched a report
called The Intangible Revolution: How intangible assets are transforming
management and reporting practice, in which it calls for different business
disciplines to unite behind the common purpose of presenting a more accurate and
consistent picture of the key value drivers in companies. The debate will
continue at a conference in March hosted by the IPA, the Association of
Chartered Certified Accountants and the Institute of Chartered Secretaries and
Administrators.

It could be a useful date for FDs because, as Ambler says: “For most
companies, brand equity is the most important and valuable intangible asset they
have, but most don’t understand it. The fact that so much of British senior
management doesn’t understand its most valuable assets suggests a lack of
professionalism and an abrogation of responsibility.”