Shareowner Value Creation and the Management of Intangible Assets
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1 Shareowner Creation and the Management of Intangible Assets Poster Presentation Slide Deck 20 th International Conference of the System Dynamics Society Grand Hotel Villa Igiea Palermo, Italy July 28 - August 1, 2002 Dr. Roland Burgman AssetEconomics, Inc. 200 Park Avenue South New York, NY 10003
2 Æ is a registered trademark of AssetEconomics, Inc. Seer, ConView, Pathfinder, 4-Column Balance Sheet, Intangible Added, IVA, Tangible Added and TVA are trademarks of AssetEconomics, Inc. EVA is a registered trademark of Stern Stewart & Co. Current Operations, COV, Future Growth and FGV are trademarks of Stern Stewart & Co. 2
3 Managing for Managing for value has required that a company grow profitably. This imperative has in turn required that the following Creation Cycle be understood and managed. Returns to Shareholders Economic Profitability Capital Allocation Competitive Advantage Quantum Period Distinctive Competence Assets Resources Capabilities Strategic Assets The Creation Cycle is agnostic as to whether strategic assets are tangible or intangible! Non-Strategic Assets 3
4 Managing for - Today! The Creation Cycle is reliant on a complete understanding of what constitute strategic assets (and what do not). In essence,strategic assets are all those resources (things we own) and capabilities (things we can do) that give rise to distinctive competence and ultimately to competitive advantage (which is the basis for achieving positive economic profit). Today, this more and more means understanding what the intangible assets are that are under management as well as their behavior, both independently and interactively. This fundamental to the prime responsibility of the managers of (especially publicly listed) economic entities - to create wealth for the owners of their companies. 4
5 Shareholder Added = Market Added, or MVA...but, Enterprise is not the same as Shareholder Added Enterprise (EV) = Market of Equity (ie. the number of shares on issue x current share price) + of Interest Bearing Debt Obligations Market of Equity Debt Market Added (MVA) Equity Debt Shareholder Added Capital Employed 5 Stern Stewart & Co.
6 EVA Expectations Drive MVA and therefore the of the Enterprise MVA represents the expectations of the present value of a company s EVAs MVA = EVA tt EVA t+2 t+2 (1 + WACC) 1 (1 + WACC) 2 EVA t (1 + WACC) 3 Enterprise Capital Employed MVA = Present of of Future EVAs The The value of of future returns is is brought back to to today s value of of the the enterprise and and added to to the the capital 6 AssetEconomics, Inc. Stern Stewart & Co.
7 MVA s (and Creation s) link to EVA Shareholder value is created when expectations are met and exceeded Expected Improvement over Current EVA Enterprise MVA Capital Employed Current EVA MVA represents the expectations of the Present of an enterprise s total EVA stream 7 Stern Stewart & Co.
8 The Components of Enterprise! Enterprise MVA Capital Employed PV of Future Growth PV PV of of Current EVA EVA Capital Employed Future Growth (FGV ) Current Operations (COV ) 8 Stern Stewart & Co.
9 Share Price Volatility - What Gives! Enterprise Enterprise = Market of Equity (ie., the number of shares on issue x current share price) + Debt (ie., the net value of Interest Bearing Debt Obligations) What changes are expectations about future growth (Future Growth ) - since everything else is constant. Such changes in expectations are reflected in changes in the Share Price. Managing for means managing for FGV! 9
10 What is the FGV/EV View for the Wealth Creation Majors? The Stern Stewart Performance 1,000 and its update (published in Fortune, December 10 th, 2001) shows the following - Top 20 Top 50 Top 100 Top Median 61.9% 54.9% 51.0% 51.2% Average 59.9% 52.1% 50.0% 39.7% 2000 Median 79.8% 75.4% 74.2% 72.1% Average 78.1% 78.9% 75.8% 73.5% * Using the company share price as at October 30 th, 2001 and
11 A New View on Asset Management arising from... Tangible Assets Intangible Assets Share Price components... Current Operations Traditional Management Focus* Effect? Future Growth Embedded Growth The New Management Imperative! * The traditional management focus (and basis for firm valuation) is mainly through the Income Statement and Balance Sheet. Thus the emphasis in valuations is on extrapolating Current Operations based on the exploitation of Tangible Assets. Enterprise 11
12 Findings on Future Growth in the United States! The dynamics of FGV are important! The better you are doing (EVA), the more is expected of you in the future (FGV) The larger you are (EV), the more (proportionally) is expected of you in the future (FGV) FGV expectations have increased over time for all companies and now represents the major component of share price (FGV vs. EVA/WACC vs. CE) The largest companies (EV) no longer rely on traditional capital (CE) - meaning that balance sheets are increasingly underspecified (don t recognize the intangible assets that are increasingly relied on by management to create value and are increasingly valued in share prices) rather than mis-specified (don t capture recognized intangible assets properly ) 12
13 What s the Problem? The problem is one of conceptualizing stocks and flows. The bath tub metaphor that is often used in System Dynamics is of limited use here since we also have to worry about what is going on inside the bath tub! Intangible assets are qualitatively different from tangible assets. Tangible assets are more likely to... Intangible assets are more likely to... Have formal marketplaces Have stable values Not interact with one another (have additive effect) Not create a new asset (in combination) Depreciate steadily (and slowly) Be rigid (not able to be redeployed) Have immediate effect Have informal marketplaces Have volatile values Interact with one another (have multiplicative effect) Create a new asset (in combination) Depreciate suddenly (and totally) Be flexible (able to be redeployed) Have slow effect 13
14 What is Being d in Future Growth? The simple answer is that it is the Present of all changes to the current (EVA) performance arising from current activities, estimated into perpetuity, discounted to the present. The more complex answer is that the FGV Present represents a constellation of the following - l Foreseeable future operations l Unforeseen opportunities and future operations l Ownership claims l Path dependent behavior all valued and discounted to the present 14
15 Reconcile The 4-Column Balance Sheet - Reconciling Paradigms Identify and Specify Stocks Transforming Investment to Valuation! = = Enterprise Strategic Assets Marked-to-Market Strategic Assets Balance Sheet Accounting Income Statement and Balance Sheet 15
16 Strategic Asset Management Earnings... based on... Tangible Asset Intangible Asset Current Operations Traditional Management Focus* Effect? Future Growth Embedded Option The New Management Imperative! * The traditional management focus (and basis for firm valuation) is through the P&L and Balance Sheet - COV. This doesn t apply for FGV. 16
17 A New Asset Classification Assets are what what we have, capabilities are what we can do! Tangible Non-renewing Strategic Assets Self-renewing Replicable Intangible Non-replicable (exclusive) 17
18 What are the Strategic Assets that we Are Talking About? Not just the Traditional... l Brand equity (from advertising and promotion) l Intellectual property and patents (from R&D) l Human capabilities (from training) But also the New Old... l Knowledge creating capability l Right of access l Ability to utilize Information l Operating procedures and processes l Management capability l Ability to execute strategy l Innovativeness l Real Options 18
19 A New Methodology - Introduction This methodology, called Seer, has three phases and ten steps. The phases are - I II III Asset Identification Asset Quantification Asset Prioritization The process is a variation of the M Pherson, Roos and Pike IC process* which does two things - (i) introduces System Dynamic modeling to fully capture the value driver causal relationships and (ii) links current and future period economic profit outcomes (EVA) with the capital market valuation of the enterprise (the EV) to establish best possible cause and effect between management actions and share price outcomes. Refer, for example, Philip M Pherson, Goran Roos and Stephen Pike, Accounting, Empirical Measurement and Intellectual Capital, Journal of Intellectual Capital, Vol. 2, No. 3, 2001, pp
20 Seer Methodology - Flow Diagram (A) Phase I - Identification Identify Stakeholders 1. Determine Stakeholders Perceptions (Meanings) of 2. Develop and Test ConView Hierarchy Establish Operating Environment Establish Future Scenarios 3. Develop Causal Operating Business Model Using System Dynamics Methodologies 5. Carry Out Sensitivity Analysis to Establish Assets that Matter 6. Develop Transformation Matrix (Inputs to Outputs) 4. Develop Capital Market Financial Model Establishing Enterprise Components and Economic Performance (EVA ) 20
21 Seer Methodology - Flow Diagram (B) Phase II - Quantification Phase III - Prioritization 6. Develop Transformation Matrix (Inputs to Outputs) 7. Establish Pathfinder content for real management alternatives 7. Develop Pathfinder content for measurement alignment 8. Identify maximum and minimum values for response function (bounds) 9. Rank strategic assets in order of share price response to management action 10. Test for strategic asset combination that provides for the best share price gains 21
22 The Central Place of System Dynamic Modelling Establishing the drivers of performance and share price has traditionally been approached by financial modeling and its derivatives (such as DuPont schematics). The hidden assumption has been that all relevant management information is captured by a firm s financial statements or can be quantitatively linked to them. This historically workable assumption is no longer useful. Fortunately, System Dynamics can make a substantial contribution to identifying and quantifying the drivers of value through establishing the causal (stock and flow) determinants of shareholder value creation. 22
23 The Benefits of System Dynamic Modeling The Objective To develop a complete causal management model where that model s behavior and outputs are linked to shareholder value outcomes The Outcomes A complete descriptive business model What the critical drivers of shareholder value creation are (stocks and flows) How to manage the critical value drivers (since cause and effect are systematically linked) What management information is required in order to be able to manage for value (intervene in the system) What the content and expectations should be for performance monitoring 23
24 Case Study - Sun Microsystems, Inc. Work in Progress - Hand Outs to be Provided 24
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