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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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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 • 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 Market value >> Equity
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 • 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
“New View“ Income Statement Average of 12 German companies + Novartis and Pharma
“New view“ Balance Sheet Average of 12 German companies + Novartis
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 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
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 • “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 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 *Capitalization of development costs only in accordance with narrowly defined conditions
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 • 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
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) • 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) • 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 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 • 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)
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
“New View“ Income Statement – Large Pharmaceutical companies *Pharma = Bayer, Merck, Stada, and Novartis
“New View“ Balance Sheet – Large Pharmaceutical companies *Pharma = Bayer, Merck, Stada, and Novartis
