By Pravin Palande

Anybody who has read Zen and the art of motor cycle maintenance will agree that there is a lot common between valuation experts measuring knowledge and Phaedrus, a character in the book, measuring quality.

Evaluating something intangible has been a challenge for many philosophers and thinkers. Probably the process is in its final stage. If put into perspective, valuation experts may have to consider some points mentioned below. Consider this:
Traditionally the capital employed in a company comprises of net worth and debt. Net worth has a portion attributed to different types of reserves. Capital reserve could become a very important element in the future because it will comprise the intellectual or intangible capital of a company.

The future may see elements of financing, which have never been used before, be it a technology or a manufacturing company.

Today companies are valuing themselves based on their brands and past performance. The intangible assets come at a later stage. This depends on a lot of parameters like customers, employee education, supplier network etc. Today the intellectual capital is arrived at after considering all these aspects.

Let us look at a situation where intangible assets such as brainpower and ideas finance a project in the initial stages. The whole concept might sound ridiculous. But then, one must remember that when money was first introduced in our system, it was not exactly well received. In fact, the first guy who introduced money in France went bankrupt. No point in getting into details.

Twenty years ago, nobody could have imagined what the Internet would do to society. Just as the Internet has converted geography into history, twenty years from now the traditional way of financing might become history. Traditional accounting concepts might become as rare as the cable that connects your television sets.

It is already happening in a crude way in venture capital. Venture capitalists are putting their funds as well as their know-how into start-up projects. In hindsight, one needs to note that the traditional ways of funding have changed. Earlier, banks financed projects with hard cash. Today, venture capitalists are doing this with hard cash and ideas. This proves that intellectual capital is gathering ground.

It is a proven fact that only venture capitalists and fund managers have the expertise to gauge the risk and return profiles of new firms evolving today.

The future might actually allow companies to arrange initial funding for intellectual capital. This funding could be in the form of debt or equity participation. And as the brand grows, these same venture capitalists can claim a stake in the brand value of the company. The company can later repurchase the brand stake from the venture capitalists.

The best part of this deal could be that companies would hate to disclose heavy reserves represented by intangible assets. For, a part of the intangible assets would belong to venture capitalists. And there could be real cash outflow when some deal goes through.

But then, all these are future possibilities where accountants will put a figure on brain assets at the start-up stage itself.

Valuing intellectual capital could also change the way certain key ratios are computed. Why, ratio analysis itself might take on a different meaning.

For example, when a company adds intangible assets to its balance sheet, the whole concept of return on capital employed (ROCE) changes.

ROCE is profit before depreciation; interest and tax divided by the capital employed expressed as a percentage. But this ratio works when the assets are fixed. What happens when capital employed is adjusted to include intangible or knowledge assets? Then the denominator - the capital employed - becomes large. This results in a poor ROCE. With the denominator so high, the whole concept of this ratio may not make sense to some analysts.

This is where the concept of hard ROCE and soft ROCE comes in. Though there is no clear measure for evaluating profitability in terms of intellectual capital, experts agree that it is possible to evaluate profits by attaching a premium to the profits. Such a premium could depend on the present value discounted at a pre-determined knowledge rate for the firm.

The only problem is that such a premium will be generated internally by the finance department.

The second part is the cost of capital. The beta values taken to look at cost of capital by many companies will be questioned time and again. Since stock price and volumes form an important part of calculating cost of capital, analysts will question the whole concept time and again. Again, there are many sceptics who doubt the economic value added (EVA), a very popular measure to look at value addition that a company makes to its shareholders' wealth.

Ultimately, we might have to see intellectual capital valuation as artistic methods based on scientific tenets. Valuation experts agree that the whole idea of valuing brands from a deal perspective is an art. Had these methods been completely scientific, valuations of big brands or mergers and acquisitions would be done in minutes.

The markets accept valuation ratios for firms based on the overall information available. This simply means that markets recognise knowledge better than individuals or fund managers.

So what is the problem with the accountants?

Conventional accountants argue that these concepts are impossible to practise as there is no actual inflow or outflow of cash. The practice of valuing intangible assets would allow some managements to fudge their accounts.