Intangible Capital and the Valuation of Companies:  A Comparison of German and U.S. Corporations
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Intangible Capital and the Valuation of Companies: A Comparison of German and U.S. Corporations. Charles Hulten University of Maryland, NBER & The Conference Board Janet Hao The Conference Board Kirsten Jaeger The Conference Board.

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Charles hulten university of maryland nber the conference board janet hao the conference board

Intangible Capital and the Valuation of Companies: A Comparison of German and U.S. Corporations

Charles Hulten

University of Maryland, NBER &

The Conference Board

Janet Hao

The Conference Board

Kirsten Jaeger

The Conference Board

Project funded by the European Commission under the Seventh Framework ProgrammeGrant No 217512

Website : www.coinvest.org.uk


Market to book value puzzle

Market to Book Value Puzzle

  • Absence of most intangible assets from financial statements

  • Expenditure on intangibles produced within a firm often treated as a current expense, not as an investment in firm’s future.  No output or value created.

  • No market transactions to measure the value of R&D and brand created within the company

  • Difference between stock-market value of a firm and the book value of its equity treated as “goodwill” and (more or less) loosely associated with intangibles.

The PuzzleAccounting Principle: Equity=Assets-LiabilitiesTheoretically: Equity=Market ValueActually: Equity<<Market value


Book equity does not explain market values of u s companies

Book Equity Does Not explain Market Values of U.S. Companies

Market value >> Equity


Adding intangible assets can fill the gap

Adding Intangible Assets Can Fill the Gap


Goal of the analysis

Goal of the Analysis

Market-to-book gap is too large to be attributed solely to the mismeasurement of conventional equity / vicissitudes of the stock market.

  • Construct estimates of the cost-in-house investment in R&D and organizational capital

  • Include “own” intangibles on corporate financial statements

  • Compare traditional financial statements with “new view” balance sheets and income statements narrows the gap between book value and market value

  • Matched-company comparisons  Compare performance of German companies with US companies

    US Companies: 617 R&D intensive firms + 6 large pharmaceutical companies

    German companies: 12 German companies + Novartis


Approach of the analysis

Approach of the analysis

  • Traditional balance sheet and income statement

  • New view balance sheet and income statement: capitalize own R&D and organizational capital

    • Estimate the cost of in-house investment in R&D Current cost of R&D plus markup for profit (total operating surplus is allocated to R&D according to R&D’s share in current expenses)

    • Estimate the cost of own production of organizational capital: CHS procedure - translate approximate proportions of brand equity and organizational development investment into a corresponding fraction of SG&A spending (~30%)

    • Amortization of R&D and organizational capitalR&D: 10 year useful life – Organizational capital 5 year useful life

  • Comparison of traditional and “new view” financial statements


Charles hulten university of maryland nber the conference board janet hao the conference board

“New View“ Income Statement Average of 12 German companies + Novartis and Pharma


Charles hulten university of maryland nber the conference board janet hao the conference board

“New view“ Balance Sheet Average of 12 German companies + Novartis


Charles hulten university of maryland nber the conference board janet hao the conference board

Key Results – all sample companies, 2008

Note: The US sample includes 633 R&D intensive firms. The Germany sample includes Adidas, Audi, BASF, Bayer, BMW, Daimler, Merck, SAP, Siemens, Stada and Volkswagen.


Matched company comparisons 2008

Matched-Company Comparisons 2008

ElectronicsUS: GE, United Technologies Corporation; DE: Siemens

Pharmaceuticals – largeUS: Johnson & Johnson, Pfizer; DE: Bayer; CH: Novartis

SoftwareUS: Oracle; DE: SAP

ChemicalsUS: Dow, DuPont; DE: BASF


Charles hulten university of maryland nber the conference board janet hao the conference board

Key dimensions – matched pairs


Findings

Findings:

  • Addition of internally intangibles increases the percentage of market value that can be explained by equity - All companies 2008: Germany 48%  110%; US 30%  77 % - Pharmaceuticals 2008: Germany 44%  113 %; US 29%  100 %

  • German companies

    • Have larger fraction of market capitalization explained by conventional equity, both before and after own-intangibles are counted

    • Have lower return of equity, before and after own-intangibles

    • Have higher debt-equity ratios

    • And are comparably R&D intensive as measured by ratio of direct R&D outlays to conventional revenue, but less own-intangibles-intensive as measured by R&D and organizational stocks as fractions of total conventional assets

12


Caveats

Caveats

  • “New view” estimates on intangibles are inaccurate. They are based on imputations rather than on market transactions, and are inferred from the cost of investment

  • The German sample is much smaller, thus more prone to idiosyncratic variation (it is more heavily weighted to the auto industry)

  • Different accounting system in the US and Germany: US GAAP vs. IFRS

  • Differences is corporate structure & governance may matter, so accounting differences may not reflect underlying structural differences

13


Treatment of r d under us gaap and ifrs

Treatment of R&D under US GAAP and IFRS

US. GAAP

  • All costs related to research and development are expensed as incurred, with few exceptions (certain website development costs and costs associated with developing internal use software)

    IFRS: IAS 38

  • Differentiation between “research” and “development” costs

  • Research expenses are expensed as incurred

  • Development costs are capitalized if specified criteria are met

    • Development cost can be measured reliably

    • The product is technically and commercially feasible

    • Future economic benefits are probable

  • Conditions for capitalization are often not satisfied in full development costs mostly expensed


Development costs in matched company groups

Development costs in matched company groups

*Capitalization of development costs only in accordance with narrowly defined conditions


Conclusions i

Conclusions I

  • Capitalized internal R&D and organizational capital  large impact on income statements and balance sheets both countries

  • Own-intangibles appear to be more important in U.S. business, though this is not a general rule

  • Current practice of largely omitting intangibles from financial statements  biased perspective about the drivers of company value

  • Addition of internally intangibles increases the percentage of market value that can be explained by equity - All companies: Germany 48%  110%; US 31%  75 % - Pharmaceuticals: Germany 44%  113 %; US 29%  100 %


Conclusions ii

Conclusions II

  • Over-explanation may be caused by our assumptions on own R&D and organizational capital

  • Intangibles can explain most (or all) of the market-to-book gap does not necessarily mean that they actually do explain the gap.

  • But: intangibles = important factor to determine the value of companies on both sides of the Atlantic.

  • Direct company comparisons generally support previous findings, but there are exceptions.

  • Note that Siemens, BASF, SAP, Bayer, and Novartis are global companies, as are the U.S. counterparts, and may therefore not be representative of the average


Back up charts

Back-up charts


Accounting issues general areas with significant differences between us gaap ifrs i

Accounting Issues: General areas with significant differences between US GAAP & IFRS (I)

  • Equity and financial liabilities (IAS 1, IAS 27, IAS 32, IAS 39)*e.g. IFRS: Components of compound financial instruments with liability and equity characteristics, are accounted for separately.; US GAAP: Instruments with characteristics of both debt and equity are not always split up

  • (Post ) Employee benefits (IAS 19, IFRIC 14)*e.g. IFRS: No further differentiation between post-employment benefits; US GAAP: Division of post-employment benefits into post-retirement benefits and other post-employment benefits. Accounting for post-employment benefits depends on the type of benefit provided

  • Income taxes (IAS12, SIC-12, SIC-25)*e.g. IFRS: Deferred tax liability is recognised for the difference in tax bases between jurisdictions as a result of an intra-group transfer of assets, US GAAP: is not recognised...

*See back-up slides for more details


Us gaap ifrs general areas with significant differences ii

US GAAP & IFRS: General areas with significant differences (II)

  • Inventories (IAS 2)*e.g. IFRSinventories measured at the lower of cost and net realisable value; US GAAP measured at the lower of cost and market.

  • Property, Plant, and Equipment (IAS 16, IAS 23, IFRIC 1)*e.g. IFRS revaluation possible under certain circumstances; US GAAP not permitted

  • Impairment of Assets (IAS 36, IFRIC 10)*e.g. IFRS goodwill allocated to cash-generating units, US GAAP goodwill allocated to reporting units

  • Intangible Assets (IFRS 3, IAS 36, IAS 38, SIC–32) next slides

In general, IFRS is substantially similar to US GAAP

*See back-up slides for more details


Comparison of us gaap and ifrs treatment of intangibles similarities

Comparison of US GAAP and IFRS Treatment of Intangibles (Similarities)

  • Intangible assets… - are assets, not including a financial asset - lacks physical substance - are identifiable if they are separable or arise from contractual or legal rights - generally are recognised initially at cost = fair value of the consideration given - with finite useful lives are amortised over their expected useful lives

  • Direct-response advertising, software developed for internal use, and software developed for sale to third parties are recognised initially at cost.

  • Goodwill: recognised only in a business combination and is measured as a residual. Goodwill and other intangible assets with indefinite lives: no amortisation but impairment testing at least annually.

  • Subsequent expenditure on an intangible asset : No capitalisation unless it can be demonstrated that the expenditure increases the utility of the asset, (broadly like IFRS)

  • No capitalization possible: internally generated goodwill, costs to develop customer lists, start-up costs and training costs.


Comparison of us gaap and ifrs treatment of intangible assets significant differences

Comparison of US GAAP and IFRS TreatmentofIntangible Assets - Significant Differences

Source: KPMG (2008): IFRS compared to U.S. GAAP: An overview


Possible impact of us gaap and ifrs differences on income statements and balances sheets

Possible impact of US GAAP and IFRS differences on Income Statements and Balances Sheets

  • Compound financial instruments & Pensions and post-employment benefits- Different treatment under IFRS and US GAAP results in differences between carrying amounts of assets and liabilities

  • Capitalization of development costs - IFRS: Treatment of intangibles as assets in general: equity - Our analysis: adjusted R&D = R&D – amortization of capitalized development costs current costs , operating surplus  - Automobile companies: highest share of capitalized development cost in R&D costs- Pharmaceuticals: requirements for capitalisation seldomly fulfilled due the high level of risk up to the time products are marketed

  • Deferred taxes - Deferred taxes on intragroup profit: Net loss or depending ontax rate of acquiring company (IFRS) < or > tax rate in the seller’s or manufacturer’s jurisdiction (US GAAP)


Charles hulten university of maryland nber the conference board janet hao the conference board

Key Results – all sample companies, 2006

Note: The US sample includes 633 R&D intensive firms. The Germany sample includes Adidas, Audi, BASF, Bayer, BMW, Daimler, Merck, SAP, Siemens, Stada and Volkswagen.

24


Charles hulten university of maryland nber the conference board janet hao the conference board

“New View“ Income Statement – Large Pharmaceutical companies

*Pharma = Bayer, Merck, Stada, and Novartis


Charles hulten university of maryland nber the conference board janet hao the conference board

“New View“ Balance Sheet – Large Pharmaceutical companies

*Pharma = Bayer, Merck, Stada, and Novartis


Charles hulten university of maryland nber the conference board janet hao the conference board

Electronics


Charles hulten university of maryland nber the conference board janet hao the conference board

Electronics


Charles hulten university of maryland nber the conference board janet hao the conference board

Pharmaceuticals (1)


Charles hulten university of maryland nber the conference board janet hao the conference board

Pharmaceuticals (1)


Charles hulten university of maryland nber the conference board janet hao the conference board

Pharmaceuticals (2)


Charles hulten university of maryland nber the conference board janet hao the conference board

Pharmaceuticals (2)


Charles hulten university of maryland nber the conference board janet hao the conference board

Pharmaceuticals (3)


Charles hulten university of maryland nber the conference board janet hao the conference board

Pharmaceuticals (3)


Charles hulten university of maryland nber the conference board janet hao the conference board

Software


Charles hulten university of maryland nber the conference board janet hao the conference board

Software


Charles hulten university of maryland nber the conference board janet hao the conference board

Chemicals


Charles hulten university of maryland nber the conference board janet hao the conference board

Chemicals


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