Real Assets, Unreal Reporting

Why Generally Accepted Accounting Principles generally do an unacceptable job of accounting for the principal activities of knowledge-intensive companies.

t Berkshire Hathaway's annual meeting this year, Warren Buffett was asked, as he has been before, about investing in technology stocks, and he answered, as he has before, "Technology is just something we don't understand, so we don't invest in it." Usually memorable, Buffett was unusually memorable when he went on to discuss Internet stocks. He said, "If I taught a class, on my final exam I would take an Internet company and ask [my students], 'How much is this company worth?' Anyone who would answer, I would flunk."

With the stock market near record levels--but wobbling, like a little girl in her mother's highest heels--it's worth unpacking Buffett's comment. Is the challenge of putting a value on a company different when the company has few if any tangible assets, when its future depends on its ability to make and leverage investments in research and development and other knowledge, and when its market environment is changing rapidly? If the value can't be known by ordinary means, can it be known at all? Those are only partly investment questions. They are--profoundly--management questions too. Because creating value is what managers are supposed to do, they need to know whether they have done it.

The answers are yes, it's different, and yes, it's knowable, and one can prove both statements with Pythagorean certainty. Mind you, there are those who cry "bunkum" to the whole notion of a New Economy in which intellectual capital supplants some tangible assets. One magazine editor denounces the New Economy as the work of a cadre of "business Bolsheviks," including Peter Drucker and your humble & ob't servant, whose sinister aim is the "justification of irrationally overvalued companies." Why we Bolshies want the market to be high, I don't know.

In fact, pocket-watch-wearing, boot-on-the-neck-of-the-people capitalists have known for years that smart money invests in intangible assets. Notice, for example, that Buffett said he doesn't understand how to price technology--but said nothing against pricing intellectual capital, which he does all the time. He got interested in Coca-Cola, for example, about when Roberto Goizueta decided to hive off a lot of tangible assets, putting them on the balance sheets of Coke's bottlers in order to become, as chief financial officer James Chestnut says, a company whose market capitalization is the sum of the values of its brand and its management systems.

As for Internet companies, the market, in its collective wisdom--this is a given, comrades, that the market is wise, yes?--puts a value on them every day, not just during exam period. Right now the total market capitalization of the 31 companies Merrill Lynch considers Internet stocks, such as AOL, E*Trade, Netscape, and Yahoo, is about $41 billion. (That doesn't include the Net's contribution to the stock prices of Cisco Systems, IBM, Microsoft, and so on.) The value of Internet companies is about the same as that of Amoco.

Of course, Buffett doesn't want to be as wise as the market. He looks for occasions when he can be wiser; he wants to know what he calls intrinsic value, which is why he's happy when stocks are cheap and he can buy them for less than he knows they're worth. And intrinsic value is much harder to determine for companies with high intangibles, high R&D, and changing markets than it is for companies like Amoco--particularly when the companies are young.

That's the conclusion of an elegant study by Baruch Lev and Paul Zarowin, professors of accounting at the Stern School of Business at New York University. The question they sought to answer: Does financial reporting convey information that investors find useful--which is the No. 1 purpose of accounting? They looked at three foundation pieces of reported financial information--earnings, cash flow, and book value--for the thousands of companies in the Compustat database; then they correlated the information with changes in the companies' stock prices. This allowed them to determine, for example, how much value investors ascribed to a dollar's worth of earnings, cash flow, or equity. Their conclusion: "The association between key financial statement variables and both stock returns and prices has been declining over the last 20 years."

Because their sample was big--as many as 6,800 companies, 1,300 of which have been in the database for two decades--Lev and Zarowin were able to dig deeper to find out why the numbers reveal less than they once did. The conjoined villains: change and innovation. Where companies are young, where they change a lot (measured by changes in relative book or market value), or where they significantly increase or reduce the amount they invest in innovation (measured by R&D intensity), accounting information is much less useful than it is for mature companies.

What the NYU professors found is supported by a trio at Stanford's business school, Mary E. Barth, Ron Kasznik, and Maureen F. McNichols. The less useful financial statements are, they hypothesized, the more useful analysts' coverage is likely to be. The value of intangibles is rarely accounted for or disclosed, so the financial reports of knowledge-intensive companies probably reveal less about their value than traditional companies' do and adumbrate their future less well. If that's the case, Barth, Kaznick, and McNichols say, "the net benefits to covering these firms [should] exceed those for firms whose values are well captured by recognized assets." That is, an analyst is better off devoting his time to Internet stocks than to Amoco, whose stock price and intrinsic value are probably in sync. Sure enough: After controlling for factors like company size, the Stanford collaborators found that Wall Street does more research on companies that invest heavily in R&D and advertising, two proxies for intellectual capital.

None of this is news to Susan M. Smith. For four years Smith has been "vice president, knowledge-based industries" at Royal Bank of Canada, the biggest financial services shop in the friendly giant to the north, and for a year has also been CEO of a new subsidiary, Royal Bank Growth Co. Royal Bank has become perhaps North America's lead banker to the New Economy, with some 5% of its loan portfolio--$4.5 billion (Canadian)--approved for knowledge-based companies, a figure growing 25% a year, and an investment returning upwards of 30% a year.

"It truly is a new economy," Smith says, "and the rules aren't written. We have to learn as we go how to lend based on intellectual and intangible assets in a marketplace where growth and volatility are extraordinary." The old rules were--are--literally written in manuals that tell Royal Bankers the standards that make for a creditworthy customer in a given industry. Forget them, Smith tells her staff. They don't fit biotech, where lead times are endless but sales can explode in a matter of weeks. Or software, where one can mass-produce without a plant. Or this borderless world, where a murderous competitor can go anywhere, presto, or appear from nowhere--zap. Says Smith: "A company in Winnipeg with five employees might make its first sale to Tokyo or Berlin." In addition to specialist knowledge-economy account managers, Royal Bank needed to train a cell of risk-management sans-culottes who wrap fish with Robert Morris Associates' Annual Statement Studies. Working closely together, they strive to distinguish between, as Smith puts it, "perceptual risks and real risks, or between a pause and a crash." The key to knowing the difference: knowing the management. Smith says: "We form an extraordinary level of intimacy with management. We have to. The quality of the management team that the technology is able to attract tells us a lot about the quality of the technology--more than anything else does."

At least until intangible-intensive companies become old and wise, like Coca-Cola, their values seem inherently volatile. "You can know the value of these companies, just not for long," Smith says. With few hard assets, they have few flywheels, few drags, and little safety. Microsoft keeps an 11-figure wad of cash--that's why Bill Gates' house is big: so he has enough mattresses in which to stuff it--out of fear that the company might need to be reinvented overnight. Others live in mortal dread that the Evil Empire will wipe out their worth simply by shifting in its chair.

On a lakeside near Zurich, a city where Lenin schemed, Dean LeBaron, former chairman of Batterymarch Financial Management, says: "We financial analysts were brought up looking at charts whose x axis represented time. You'd see trends. Time was a wave. In the New Economy, I'm beginning to think time is a quantum. What comes next bears no relationship to what came before." That glorious abstract image becomes an earthy one as LeBaron explains: "It used to be that information oozed out into the market. Now, it's dumped out all at once."

Take, for example, a pair of recent cases where the market had false information: Bre-X Minerals, the mining company that lied about tangible assets, and Cendant, the franchiser and direct marketer, which lied about intangible assets. As questions emerged about Bre-X, its shares oozed downhill for nearly three months before dropping down a mineshaft in March 1997.

In April 1998, Cendant shareholders (sadly, I am one) had just a week's hint, best seen in retrospect, that bad news was about to be dumped on their heads.

Both LeBaron and Lev hold accounting rules partly responsible for the fact that knowledge-intensive companies are hard to evaluate. Investments in intangibles--R&D, training, brand building, most software, etc.--are treated as expenses. Unlike investments in tangibles--such as trucks, computers, and buildings--their estimated value is never disclosed. You can't even know their full costs, except for R&D, because they're clumped with so many other expenses. As Lev and David Aboody, of UCLA, say, "This accounting treatment, amounting to an assumption of a 100% amortization rate for intangible capital, denies investors timely and vital information on the success of the projects under development."

But managers know, as banker Susan Smith says. A study by Aboody and Lev proves it like a thumbprint. They looked at stock trades and option exercises by insiders at nearly 2,900 companies, as reported to the SEC. They divided the companies into quintiles according to what percentage of sales they invested in intangibles, using R&D as the only available proxy. They then compared insiders' gains with those of public investors, across the quintiles. Bingo: As R&D intensity increased, insiders did better and better and better and better. The market didn't know the value of the companies, but the managers did.

But no one--probably not even the managers--can tell you how they know it. And that's a problem. Managers, as a class, are not smarter than Warren Buffett. If he's stumped and they're not, financial reporting isn't fulfilling its first responsibility.