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Charles Hulten University of Maryland, NBER & The Conference Board Janet Hao The Conference Board Kirsten Jaeger The Conference Board Intangible Capital.

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Presentation on theme: "Charles Hulten University of Maryland, NBER & The Conference Board Janet Hao The Conference Board Kirsten Jaeger The Conference Board Intangible Capital."— Presentation transcript:

1 Charles Hulten University of Maryland, NBER & The Conference Board Janet Hao The Conference Board Kirsten Jaeger The Conference Board Intangible Capital and the Valuation of Companies: A Comparison of German and U.S. Corporations Project funded by the European Commission under the Seventh Framework Programme Grant No Website :

2 2 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. Market to Book Value Puzzle The Puzzle Accounting Principle: Equity=Assets-Liabilities Theoretically: Equity=Market Value Actually: Equity<

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

4 Adding Intangible Assets Can Fill the Gap

5 5 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 Goal of the Analysis

6 6 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 capital R&D: 10 year useful life – Organizational capital 5 year useful life Comparison of traditional and “new view” financial statements Approach of the analysis

7 7 All 2008 (€ millions) Pharma 2008 (€ millions) Trad.+R&D+Org C.Trad.+R&D+Org C. 1. Conventional Revenue 41,127 17, Own Prod. R&D 02,422 02, Own Prod. org cap 001, , Total Adj.Revenue 41,12743,54945,157 17,81220,78922, Total Current Cost 35,527 13, Operating Surplus 5,6008,0229,630 4,2087,1859, Depreciation 2,410 1, Amort. own R&D 02,233 01, Amort. own org Cap 001, , Adj. Operating Surplus 3,1903,3793,213 2,7473,7684, Before-Tax Income 2,8153,0042,838 2,3843,4053, After-Tax Income 2,0162,2052,038 1,9432,9643, Earnings per Share “New View“ Income Statement Average of 12 German companies + Novartis and Pharma

8 8 All 2008 (€ millions) Pharma 2008 (€ millions) Conventional Balance Sheet 2008Trad.+R&D+Org C.Trad.+R&D+Org C. 2. Plant and Equipment8,264 5, Purchased Intangibles5,704 7, Goodwill3,140 4, Total Assets56,098 31, Total Liabilities38,957 15, Equity16,988 15,310 Adjustments for own Intangibles 9. R&D Capital0 16, , Organizational Capital00 5, , Assets adj. for own Intangibles55,94672,20278,124 31,04547,23054, Equity adj. for own Intangibles16,98833,24439,166 15,31031,49639,187 Company Valuation 13. Market Value of Equities35,733 34, Total Intangible Assets8,84425,10031,022 12,00328,18935, Tobin's Equity Qe % MV value explained (1/Qe) “New view“ Balance Sheet Average of 12 German companies + Novartis

9 Key Results – all sample companies, USGer %MV explained w/o Intan %MV explained w Intan ROE w/o Intan ROE w/ Intan Debt/EQ w/o Intan Debt/EQ w/ Intan R&D spending/conventional revenues (R&D & org. assets)/total conventional assets 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.

10 10 Matched-Company Comparisons Electronics US: GE, United Technologies Corporation; DE: Siemens 2.Pharmaceuticals – large US: Johnson & Johnson, Pfizer; DE: Bayer; CH: Novartis 3.Software US: Oracle; DE: SAP 4.Chemicals US: Dow, DuPont; DE: BASF

11 GEUTXSiemensJ&JBayerPfizerNovartis %MV explained w/o Intan % MV explained w Intan ROE w/o Intan ROE w/ Intan Debt/EQ w/o Intan Debt/EQ w/ Intan OracleSapDowDuPontBASF %MV explained w/o Intan %MV explained w Intan ROE w/o Intan ROE w/ Intan Debt/EQ w/o Intan Debt/EQ w/ Intan Key dimensions – matched pairs

12 12 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

13 13 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

14 14 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 Treatment of R&D under US GAAP and IFRS

15 15 Development costs in matched company groups Electronics GE, UTC: US GAAP – expensed as incurred Siemens*: Before 2007: expensed all Since 2007: research findings applied to a plan or design for the production of new or substantially improved products and processes Pharmaceuticals – large J&J, Pfizer: US GAAP – expensed as incurred Bayer*: Expensed as incurred, conditions are not satisfied Novartis*: Regulatory and other uncertainties inherent in the development of new products preclude the capitalization Pharmaceuticals – small Forest: US GAAP – expensed as incurred Stada*: In 2008, development costs in the amount of € 14.6 million were capitalized as internally- created intangible assets Software Oracle: US GAAP – expensed as incurred SAP*: Technical feasibility of software is reached shortly before products are available for sale. Costs incurred after technical feasibility have not been material. All R&D costs are expensed as incurred. Chemicals Dow, DuPont: US GAAP – expensed as incurred BASF*: Capitalized development costs are mostly in-house software (Ignored in our analysis) We adjusted R&D expenditures in our analysis accordingly *Capitalization of development costs only in accordance with narrowly defined conditions

16 16 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 I

17 17 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 Conclusions II

18 18 Back-up charts

19 19 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

20 20 US GAAP & IFRS: General areas with significant differences (II) Inventories (IAS 2)* e.g. IFRS inventories 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

21 21 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 Intangibles (Similarities)

22 22 IFRSUS GAAP Expenditure on relocation or reorganisation is expensed as incurred. Certain relocation costs following a business combination are capitalised. Other relocation or reorganisation expenditures are expensed as incurred, like IFRS. Intangible assets may be revalued to fair value only if there is an active market. Intangible assets cannot be revalued. Internal research expenditure is expensed as incurred. Internal development expenditure is capitalised if specific criteria are met. These capitalisation criteria are applied to all internally developed intangible assets. Both internal R&D expenditure is expensed as incurred. Special capitalisation criteria apply to direct-response advertising, software developed for internal use, and software developed for sale to third parties, which differ from the general criteria under IFRS. Advertising and promotional expenditure is expensed as incurred. Direct-response advertising expenditure is capitalised if specific criteria are met. Other advertising and promotional expenditure is expensed as incurred, like IFRS. Source: KPMG (2008): IFRS compared to U.S. GAAP: An overview Comparison of US GAAP and IFRS Treatment of Intangible Assets - Significant Differences

23 23 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 on tax rate of acquiring company (IFRS) tax rate in the seller’s or manufacturer’s jurisdiction (US GAAP)

24 24 Key Results – all sample companies, USGer %MV explained w/o Intan %MV explained w Intan ROE w/o Intan ROE w/ Intan Debt/EQ w/o Intan Debt/EQ w/ Intan R&D spending/conventional revenues (R&D & org. assets)/total conventional assets 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.

25 25 “New View“ Income Statement – Large Pharmaceutical companies *Pharma = Bayer, Merck, Stada, and Novartis Bayer 2008 (€ millions) Novartis 2008 (€ millions) Pfizer 2008 (€ millions) J&J 2008 (€ millions) Trad.+R&D+Org C.Trad.+R&D+Org C.Trad.+R&D+Org C.Trad.+R&D+Org C. 1. Conventional Revenue32,918 29, ,064 43, Own Prod. R&D03,277 06, ,738 07, Own Prod. org cap003, , , Total Adj.Revenue32,91836,19539,761 29, ,91839,389 33,06443,80249,357 43,60151,16151, Total Current Cost26,652 21, ,068 30, Operating Surplus6,2669,54313,109 7,95714,74918,220 14,99625,73531,289 12,99620,55621, Depreciation2,722 1,826 3,481 1, Amort. own R&D03,025 04,094 06,403 03, Amort. own org Cap002, , , , Adj. Operating Surplus3,5443,7964,457 6,1318,8299,016 11,51515,85015,880 11,05914,92210, Before-Tax Income2,3562,6083,269 6,4979,1959,382 6,63010,96610,996 11,57915,44211, After-Tax Income1,7191,9712,632 5,6058,3038,490 5,5059,8419,870 8,85712,7208, Earnings per Share

26 26 “New View“ Balance Sheet – Large Pharmaceutical companies *Pharma = Bayer, Merck, Stada, and Novartis Bayer 2008 (€ millions) Novartis 2008 (€ millions) Pfizer 2008 (€ millions) J&J 2008 (€ millions) Conventional Balance SheetTrad.+R&D+Org C.Trad.+R&D+Org C.Trad.+R&D+Org C.Trad.+R&D+Org C. 2. Plant and Equipment9,492 8,960 9,088 9, Purchased Intangibles13,951 6,521 12,121 9, Goodwill8,647 7,719 14,681 9, Total Assets52,511 53,555 76,022 58, Total Liabilities36,171 19,057 36,656 29, Equity16,340 34,498 39,367 29,076 Adjustments for own Intangibles 9. R&D Capital019, , , , Org. Capital0012, , , , Assets adj. for own Intang52,51172,14485,021 53,55591,142105,055 76,022144,491166,603 58,078102,146123, Equity adj. for own Intang16,34035,97348,850 34,49872,08585,998 39,367107,835129,947 29,07673,14494,904 Company Valuation 13. Market Value Equities39,911 79,892 89, , Total Intang.Assets32,09051,72364,600 14,24051,82765,740 26,80295,270117,382 18,94363,01184, Tobin's Equity Qe % MV value explained

27 $ BillionGeneral Electric 2008 United Technologies 2008 Siemens 2008 Conventional Income Statement10KR&DORG K10KR&DORG K10KR&DORG K 1. conventional revenue own production of R&D own production of org. capital total adjusted revenue total current cost operating surplus depreciation already accounted for amortization of own R&D amortization of own org. capital adj. operating surplus before-tax income adjusted net income earings per share Electronics

28 $ Billion General Electric 2008 United Technologies 2008 Siemens 2008 Conv. Balance Sheet10KR&D ORG K10KR&DORG K10KR&DORG K 1. current assets plant and equipment purchased intangibles goodwill other long term assets total assets total liabilities equity Adj. for own intangibles 9. R&D capital organizational capital assets adj. for own intang equity adj. for own intang Tobin's equity Qe % MV value explained Electronics

29 $ Billion J&J 2008 Bayer 2008 Conventional Income Statement10K+R&D+ORG K10K+R&D+ORG K 1. conventional revenue own production of R&D own production of org. capital total adjusted revenue total current cost operating surplus depreciation already accounted for amortization of own R&D amortization of own org. capital adj. operating surplus before-tax income adjusted net income earings per share Pharmaceuticals (1)

30 $ Billion J&J 2008 Bayer 2008 CONVENTIONAL BALANCE SHEET10K+R&D+ORG K10K+R&D+ORG K 1. current assets plant and equipment purchased intangibles goodwill other long term assets total assets total liabilities equity ADJUSTMENTS FOR OWN INTANGIBLES 9. R&D capital organizational capital assets adj. for own intang equity adj. for own intang Tobin's equity Qe Percent MV value explained Pharmaceuticals (1)

31 Pharmaceuticals (2) $ Billion Pfizer 2008 Novartis 2008 Conventional Income Statement10KR&DORG K10KR&DORG K 1. conventional revenue own production of R&D own production of org. capital total adjusted revenue total current cost operating surplus depreciation already accounted for amortization of own R&D amortization of own org. capital adj. operating surplus before-tax income adjusted net income earings per share

32 Pharmaceuticals (2) $billion Pfizer 2008 Norvatis 2008 CONVENTIONAL BALANCE SHEET10KR&DORG K10KR&DORG K 1. current assets plant and equipment purchased intangibles goodwill other long term assets total assets total liabilities equity58 32 ADJUSTMENTS FOR OWN INTANGIBLES 9. R&D capital organizational capital assets adj. for own intang equity adj. for own intang Tobin's equity Qe Percent MV value explained

33 $ Billion Forest 2008 Stada 2008 Income Statements10KR&DORG K10KR&DORG K 1. conventional revenue own production of R&D own production of org. capital total adjusted revenue total current cost operating surplus depreciation already accounted for amortization of own R&D amortization of own org. capital adj. operating surplus before-tax income adjusted net income earings per share Pharmaceuticals (3)

34 $ Billion Forest 2008 Stada 2008 CONVENTIONAL BALANCE SHEET10KR&DORG K10KR&DORG K 1. current assets plant and equipment purchased intangibles goodwill other long term assets total assets total liabilities equity ADJUSTMENTS FOR OWN INTANGIBLES 9. R&D capital organizational capital assets adj. for own intang equity adj. for own intang Tobin's equity Qe Percent MV value explained Pharmaceuticals (3)

35 Oracle 2008 SAP 2008 Conventional Income Statement10KR&DORG K10KR&DORG K 1. conventional revenue own production of R&D own production of org. capital total adjusted revenue total current cost operating surplus depreciation already accounted for amortization of own R&D amortization of own org. capital adj. operating surplus before-tax income adjusted net income earings per share Software

36 $ Billion Oracle 2008 SAP 2008 CONVENTIONAL BALANCE SHEET10K+R&D+ORG K10K+R&D+ORG K 1. current assets plant and equipment purchased intangibles goodwill other long term assets total assets total liabilities equity ADJUSTMENTS FOR OWN INTANGIBLES 9. R&D capital organizational capital assets adj. for own intang equity adj. for own intang Tobin's equity Qe Percent MV value explained Software

37 Chemicals Dow 2008 Du Pont 2008BASF 2008 Conventinal Income Statement10KR&DORG K10KR&DORG K10KR&DORG K 1. conventional revenue own production of R&D own production of org. capital total adjusted revenue total current cost operating surplus depreciation already accounted for amortization of own R&D amortization of own org. capital adj. operating surplus before-tax income adjusted net income earings per share

38 Chemicals Dow 2008 Du Pont 2008 BASF 2008 Conv. Balance Sheet10KR&DORG K10KR&DORG K10KR&DORG K 1. current assets plant and equipment purchased intangibles goodwill other long term assets total assets total liabilities equity Adjustments for own intan. 9. R&D capital organizational capital assets adj. for own intang equity adj. for own intang Tobin's equity Qe Percent MV value explained


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