Rethinking ROI: The Metrics of Intangible Assets

(This article originally appeared in the November/December 2012 issue of KMWorld magazine with the title Intangible Gold.)

 Next to "What is the meaning of life?" perhaps the toughest question we KM'ers get asked is "What's the ROI (return on investment) for all this KM stuff?"

Making the transformation to an enterprise of the future requires investment. While those who are asked to make the investment may consider the meaning-of-life question intellectually stimulating, they demand a straight answer to the ROI question as they struggle to find the value in KM.

At the project level, it's rather straightforward. You can measure what goes in and what comes out (efficiency and effectiveness). You can compare the results before your KM pilot initiative and after, and take it from there. Justifying KM to promote fast learning and innovation enterprisewide is another matter entirely.

The purpose of an enterprise is to create, deliver, receive and grow value on a sustained basis. Defining value is the tricky part, because it's primarily based on the perception of the market in which the enterprise is engaged. For publicly traded companies, the best measure of perceived value, tangible and intangible, is market capitalization, i.e. the total value of all outstanding shares.

For many organizations, intangible asset value runs about 70 to 80 percent of the total. Just as you can take tangible assets such as cash and marketable securities (financial capital) and measure the return (interest plus appreciation), so too you should be able to do something similar with intangible assets such as intellectual capital, relationship capital and the like. Although more work needs to be done in this area, here are two intangible asset valuation methods that will likely get the attention of the folks sitting both in the c-suite and on the board of directors. One is based on past performance; the other is more forward looking.

Method 1: return on intangible assets

This is an easy exercise using simple arithmetic. All you need is a calculator or spreadsheet and annual reports for each of the past three years or more.

Step 1. Calculate the market value by taking the closing stock price on the last day of the firm's fiscal year times the number of shares outstanding.

Step 2. Calculate the intangible asset value by taking the market value from Step 1, subtracting shareholder's equity (also referred to as book value) and adding in goodwill, if any, both of which appear on the balance sheet.

Note that this is just an estimate of the value of the intangible assets of the business. Sometimes the intangible asset value is explicitly stated. However, if you examine the footnotes, you might find that the number represents only one specific item, such as the acquisition cost less accumulated depreciation of an enterprise software system, while leaving out the bulk of the firm's full array of intangible assets. Overall, it's best just to use the simple calculation in Step 2.

Step 3. Calculate the return on intangible assets by dividing the net income (from the income statement) by the intangible asset value found in Step 2.

Step 4. For as many years as you have available data, compare the values resulting from each step year by year, and note the trends.

The trends

For example, here's what the results look like for Apple's fiscal year ending  Sept. 25, 2009.

• Closing stock price: $181.59
• Number of shares outstanding: 907 million
• Market value: $164.7 billion
• Shareholders' equity: $31.6 billion
• Intangible asset value: $133.1 billion (81 percent of market value)
• Net income: $8.2 billion
• Return on intangible assets: 6.2 percent

There are other ways to do this. But the trends are what are important, as long as you're consistent in how you do the calculations. A good sign would be a steadily increasing return on intangible assets—an indicator that your KM practices as a whole are creating ever-increasing value for the organization and its stakeholders.

A troubling sign, as we often find, is a steadily decreasing return on intangible assets. For example, during periods of uncertainty, cash piles up as companies become more risk-averse. While that may result in a stronger-looking balance sheet in the short term, at some point down the road, you can expect to see a declining intangible/tangible asset ratio along with a declining return on intangible assets, and ultimately a corresponding decline in market value.

To further illustrate, during the brutal economic period of 2009 to 2011, Apple's return on intangible assets increased by over 38 percent from 6.2 percent to 8.6 percent, while Blackberry maker Research in Motion's (RIM) plummeted from 8.1 percent to a negative number (-43.2 percent). Clearly RIM was losing its edge, while Apple was unrelenting in its obsession with generating and implementing new ideas. The latest numbers show Apple's market value has increased by almost 300 percent to more than half a trillion dollars since 2009, with RIM's market value plummeting by more than 90 percent during the same period.

Method 2: innovation premium

This approach was developed by Hal Gregerson and Jeff Dyer, authors of The Innovator's DNA, Harvard Business Review Press, 2011. According to Gregerson and Dyer, the innovation premium estimates the proportion of a company's market value that cannot be accounted for from cash flows of current products and markets. In other words, it measures how much the company's current valuation exceeds the value implicit in its current business. While the innovation premium may be attributable to a variety of factors, most of it reflects the market's expectation of future growth resulting from the company's capacity for producing a steady stream of new products and services and expanding into new markets.

It's all explained at http://blogs.forbes.com/innovatorsdna, along with a list of the top 100 innovative companies in the world for 2012 based on the innovation premium. Apple has an innovation premium of 35.7 percent, while RIM didn't even make the list. High innovation premiums weren't limited to technology companies like Apple. The list also includes retailer Starbucks, 37 percent, and legacy consumer product giant Procter & Gamble, 35.3 percent.

Better than gold

If you don't work for an Apple, Starbucks or P&G, don't worry. The good news about competing in today's global marketplace is that nobody owns a monopoly on innovation. Success in the global knowledge economy comes from the capacity to innovate and learn at a rate faster than the speed of change in your market. And you do that through a combination of rapid learning from both past experience and new discovery in a consistent, systematic way.

In times of economic uncertainty, gold gains attraction as a tangible asset, partly because its purity doesn't degrade over time. But only a fixed amount exists on the planet. You can't grow it. On the other hand, nothing will add more glitter to an executive's eyes than the prospect of sustained revenue growth from a knowledge factory built on an economic engine of continuous learning and innovation.

Whether your enterprise is public, private or non-profit, much of its value consists of intangible assets. Now more than ever, you need to start measuring and unleashing the unlimited potential of your gold mine of intellectual capital.