Imagine the following scene. The year: 2020. The place: anywhere in India. Late at night a young man clad in a T-shirt and jeans exits the building which houses a technology-driven major. A twenty-something, he is one of the many software engineers working for the company.

As he moves out, the financial department adds a few key figures to an existing database. Hold on, these key figures are nothing but the quantum of knowledge the engineer has gathered, the quantum of knowledge he is taking home and represents how much value-added knowledge the engineer has imparted to the company as on that date. Yes, intellectual capital has arrived.

What is intellectual capital all about. Are companies aware of this concept? Says Infosys Technologies vice president (finance and operations), M D Pai, "The debate on intellectual capital has been going on in India for many years. It is just that now everybody is talking about it."

The talk is actually about valuing intellectual capital and disclosing that value in the balance sheet of companies, not just service companies, even manufacturing ones. Valuing intellectual capital in manufacturing companies? Why not? Even small and mid-cap manufacturing companies do add a lot of value because of intellectual capital. When two companies from the same industry owning similar fixed assets report different growth rates, that difference should be attributed to intellectual capital.

Why do fast-growing companies have the customers they have and how is their product better than their competitors’? Why isn’t the competition able to match them? The answer: these companies could possess proprietary know-how, trademarks, brands and copyrights that are extremely valuable.

Process knowhow
Process knowhow is one form of intellectual capital. Consider the example of WalMart. The company’s operational costs in the areas of material handling and inventory control are significantly lower than its major competitors. The basic processes WalMart uses are not a secret. Not just that, WalMart implements these processes cost-efficiently. In short, for WalMart its process-knowhow represents its organisational knowledge that is difficult to replicate.

Not surprising that WalMart’s competitors have not been able to match its low costs.

Brands
Brands are another form of intellectual capital. Quite a few fast-moving consumer goods and infotech companies in India already value their brands. In the information technology industry, Infosys Technologies and Aptech have taken leads in valuing their brands.

And Pentafour Software is expected to follow. Brands are the most commonly valued intellectual asset today and brand valuation is gaining ground among Indian companies.

Why value brands? Successful brands help a company stand apart from the competition in ways that matter to potential buyers. A successful brand is always a market-puller and retains customers over a long period of time. While valuing brands, analysts concentrate on their retention values.

Consider this example from overseas. Interbrand is a United Kingdom-based valuation firm which offers consultancy services in brand-building. It has worked on brands such as BMW and Compaq. Interbrand has established that it is possible to value brands not only when they are acquired but also when they are created. One of the findings of Interbrand is that during periods of hectic mergers and acquisitions, companies are bought more for their intangible assets. And in many of the target companies, Interbrand’s study of acquisitions during the l980s reveals, the most frequently valued intangible assets were brands.

Brand valuation is an evolving game. Over a period, several techniques have been devised to value brands. Interbrand’s method assumes that the value of a brand, like that of any other economic asset, is the current value of benefits that arise from future ownership of a brand.

Brand Finance is another UK-based market finance consultant which has studied the phenomenon of brand valuation. It has published its "Brand Finance Report", wherein it states that almost 66 per cent of its sample of analysts believed that companies should disclose and publish more information on their brand values.

To quote from the report: "Analysts are on a learning curve about brand valuation and have determined that understanding all the assumptions that have gone on behind valuation of brands is essential for getting a good picture of what the underlying business is worth".

Notional assets
So, you understood what intellectual capital is all about. It could just be an idea whose time has come. Experts argue that the idea should be separable from its assets. If the idea cannot be separated from the underlying assets of the company, it cannot be valued independently.

There is a hitch here, however. By and large, investors and customers of the company find it difficult to accept the valuation of intangible assets and various other forms of intellectual capital. Says Zurich Asset Management Company fund manager, Prashant Jain, "Personally, I do not like the value of intangibles to be shown in the balance sheet of a company. For, it will be very difficult to confirm these figures."

He has a point here. For, intangible assets that make up the intellectual capital of a company are notional and not real money. For the sake of an argument, one can say that anyway all assets shown in a balance sheet are notional: unless a company sells its tangible assets, they too have notional values. So what are we talking about?

However, one has to remember here that valuation of intellectual capital is important. Infosys Technologies has managed to arrive at its brand value by using certain models and methodology. The company has valued its brand at Rs 17 26.9 crore and its human assets at Rs 945.69 crore. Software education major Aptech has valued its brand at Rs 600 crore.

As of now, these figures are merely "additional information provided to the shareholders" and these companies don’t want their investors to take decisions based on such information. The question here is when investors trust the audited figures of tangible assets such as land and buildings, why not accept the values of intangible assets?

Market perception
Tangible assets are hard assets and a value can be easily placed on them. However, management gurus such as Charles Handy have proclaimed that "on an average intangible assets are four to five times the value of tangible assets". By not valuing intangible assets, the true and fair value of a company cannot be arrived at. Yes, the market is always right.

One can look at intellectual capital from another angle too. Intellectual capital can be defined as the difference between the market price of a company stock and its book value, provided the market price is adjusted for all the information a valuer possesses.

To elaborate, one cannot take into consideration the market price on a particular day and the market price has to be normalised over a period of time. This does not mean just taking the average. One has to adjust for all material information and market statistics such as trading volumes.

Keyman
Keyman is another form of intellectual capital. Consider Colorchips for example. This Hyderabad-based company is involved in 2D and 3D graphics and the only asset the company has is Uttam Kumar, a computer graphics guru who has been getting rave reviews even from Hollywood studios. Recently Colorchips tookover Arham Fiscals, a listed company in the thinly-traded Z category.

After the reverse merger, the first day of trading saw Colorchip open at Rs 50 and close at Rs 290! Many Indians as well as foreign funds have acquired the shares of this company. Thus, in the case of Colorchips the market price could be entirely attributed to intellectual capital, in this case the keyman. For, apart from this intellectual capital, the company has no other great fixed assets to boast about.

Clearly then, nobody else realises the worth of intellectual capital better than the market. Agrees Sun Foreign & Colonial CEO, Nikhil Khatau, "As far as I am concerned, the market price is the ultimate determinant of value. Market is valuing intellectual capital in its own way. We have EVA, ROCE and P/E. All these measures are there to capture the element of intellectual capital. Whether accountants pick up intellectual capital in historical balance sheets or not, the market is placing a premium on these intangible assets."

You can see this argument is true if you compare public sector companies with the industry in which it operates. Most public sector companies have immense hard assets and thus great book values. However, most of these public sector companies are traded at a discount to their book values.

Whenever there is a change in the management, the market values of these companies soar. Says a Bombay-based equity analyst, "Nobody can underestimate the ability to judge the management of a company the way the market does."

Another Bombay-based fund manager has a very simple definition for intellectual capital. According to him, the value of intellectual capital is the normalised P/E multiple powered by the growth rate of the company. This definition bears a similarity to the idea propounded by the New York University professor of accounting and finance, Lev Baruch. According to Baruch, intellectual capital is the normalised earnings minus earnings from tangible and financial assets divided by knowledge capital discount rate (See page 7).

Calculation issues
Some key questions arise here: how to normalise share prices and earnings? What should be the growth rate or the discount rate for calculating intellectual capital? Should one look at the past rate of growth? Should one discount the growth rate for the future too?

If one looks at the future rate of growth, the discounted figure itself becomes a topic for debate. For, in today’s competitive world, companies do not follow a linear rate of growth. This holds true particularly in the case of the service sector where looking at companies beyond a certain period is difficult. Argues a US-based management consultant, Venkatasubramanian J Laxmanan, in a recent discussion at the CFOnet.com : "We don’t need to look at analysis in a linear way".

Laxmanan goes on to claim that non-linear analysis has more depth and more mathematical appeal. He argues: "Talking about knowledge capital, I find a great deal of misinformation and misinterpretation regarding the significance of financial data that is already available. For example, let’s take a look at Microsoft and Ford. Microsoft’s profits are about $4.5 billion whereas Ford’s are at about $7 billion. I predict that Microsoft will post profits of about $7 billion by 2002 at the latest, and at least $10 billion by 2005. How do I know this? Have a look at their employment, revenues and net income for the last decade.

This is where I think they are heading. This is not a gut feeling, this is based on a mathematical analysis of the data cited above. This is based on what I call a "non-linear" analysis of the data. Not everything in this world follows a straight line relation. This is what is wrong with much of the "knowledge" or "information" that is out there. General Motors has too many employees they say, based on a "linear" analysis of the data, mind you. A non-linear analysis will lead to very different conclusions. Ford and General Motors, on the other hand, have been cutting back on their employment levels. I don’t think they would ever be able to beat Microsoft. And for the same reason, Oracle, the number two company will lag far behind Microsoft because they have not studied their own financial data, or those of Microsoft that is available publicly".

Evolving equations
Now look at intellectual capital in a company where its value might fluctuate. In such cases, the linear analysis may not work. For instance, consider land. Based on an inflation index, you can realistically revalue land. However, intellectual assets cannot be revalued the way land or plants are revalued.

For example, the human resources are valued by many companies. But the value of these human resources could fluctuate based on the entry or exit of educated or semi-educated staff. And that is why one can always say that the worth of a company is continuously evolving.

This intellectual wealth is intangible. Says a software company’s vice president, "Intellectual capital is like air, you cannot see or touch it but certainly you can feel it. The point to be noted here is that the velocity of wind as well as its weight can be measured. So why can’t we allow intellectual capital to be measured?" Why, the market does put a value on this intellectual capital. Only that a few knowledge-based companies might not agree with the crazy valuations of their stocks in the market.

A beginning
That is the case for knowledge and service companies to value their intellectual assets. Internationally, service companies have begun valuing their knowledge-based assets on a regular basis. These companies that value intangible assets are traded at phenomenally high P/E multiples.

This is happening in India as well. Software companies are currently traded at high price-earning multiples. Says Aptech managing director, Ganesh Natarajan, "The market price is important but it is not the only thing. The valuation of a company should not consider the market price alone."