Does Knowledge Capital Explain Market/Book Valuations?

Two cheers for Professor Lev's approach to valuation. But his numbers still fall short.

The value of knowledge capital has become the financial community's favorite rationalization for the current stratospheric prices of some stocks. If you probe further and ask a broker to define "knowledge capital," you are likely to hear that it is the difference between what investors are willing to pay and the book value of a firm.

This circular reasoning is sufficiently vague that it seems to confirm the view that everyone in the U.S. is getting smarter because the stock market says so. It appeals to newly minted MBAs because it justifies high salaries and stock options. Gurus, pundits and intellectuals can then make claims about the priceless value of their knowledge capital despite the fact that it is not feasible to determine a valuation that can be verified independently.

There are, however, those who detest the flimsy rationale of self-serving knowledge capital claimants. It is the job of CFOs, auditors and accountants to come up with assessments of the worth of a firm's intangible assets. This is critically important when explaining the price paid for an acquisition, in granting stock options and in paying sign-up bonuses for unique talent. It is up to the financial scorekeepers to rein in exaggerated claims of intangible wealth and juxtapose reality against fantasy.

So when a recent issue of CFO Magazine - perhaps the most widely read monthly for senior financial executives - arrived, I was delighted to see that it tackled, for the first time, the thorny topic of knowledge capital. The cover proclaimed: "Seeing Is Believing - A Better Approach To Estimating Knowledge Capital." Indeed, my excitement was well rewarded. The article was by Baruch Lev, professor of accounting and finance at New York University. Professor. Lev is widely respected because of his record as a critic of current corporate accounting practices. His article was also heralded in the June 12 edition of The Economist as a major new and innovative insight into the valuation of knowledge and ideas.

In the article, Lev introduces a simple ratio for determining the valuation of a firm's knowledge capital. He defines it as "... the normalized earning minus earnings from tangible and financial assets divided by knowledge capital discount rate." The significance of Lev's article is great. In contrast to attempts published by other experts, which are more akin to judging beauty contests, we finally have before us a reproducible and independently verifiable calculation. Even more important is that Lev's concept of "comprehensive value," defined as the sum of financial capital (e.g. book value) and knowledge capital, provides a way to determine the worth of corporate knowledge and ideas.

Though I have some problems with the application of Lev's ratio (to be discussed in future columns I will be writing), what matters now is to test the utility of his theories as they apply to current stock market valuations. If the value of a firm is the sum of its tangible assets plus its knowledge capital assets, what does Lev's theory tell us about recent stock market valuations?

The following table is an extract from Lev's calculations as shown in CFO Magazine:

The stock market, as of May 31, 1998 (when the data for the above table was collected), did not care much about the calculated estimates. For instance, Merck–with calculated knowledge capital of about $48 billion and book value of $12.6 billion - had a market valuation of about $140 billion. Thus the market valuation of knowledge capital was total market valuation minus book value, more than $127 billion. That's a 265 percent overvaluation over the calculated number! Similarly, the market valuations of knowledge capital for most of the 47 firms listed in the CFO article are much greater than what Lev suggests.

Summary

Indeed, there is such a thing as knowledge capital. Indeed it can be calculated. If calculated correctly, it could explain why the purchase cost of most U.S. firms is greater than their book value ("carcass value") that accountants attribute to it as a generally accepted practice. As much as Professor Lev deserves our thanks and appreciation for opening a discourse on placing a dollar value on knowledge capital, his formula still does not reflect the valuations that the market places on firms. Stocks are either enormously overpriced or the knowledge capital, according to the Lev's ratio, is vastly under-priced.

I do not believe that the marketplace awards unreasonably excessive premiums to the valuation of corporate assets. A valuation bubble here and there has been always present, but that observation is not useful. This gets us back to the question whether one can arrive at the valuations of knowledge capital that are independent of any manic/depressive phenomena on the stock exchanges or the mumbo-jumbo of arbitrarily weighted multi-factor indicators. Professor Lev says that is possible, and I agree. However, we may have to sharpen our analytic methods to make the differences between theory and reality reproducible and verifiable. That's what the follow-on articles in this series will explore.

Paul A. Strassmann originated the trademarked concepts "information productivity", "return-on-management" and "knowledge capital."