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by Paul Strassmann
Prophecies Don't Serve Knowledge Capital
Using analysts' earning forecasts to estimate the worth of intellectual capital is misleading.By Paul A. Strassmann
As I have noted before, the proliferation of articles about the value of knowledge is propelled by the stratospheric stock-market valuations of high-technology start-ups. Even though the profits of these dot-coms may be negligible or nonexistent, attributing their stock appreciation to a new financial artifact -- conveniently labeled "intellectual capital" -- enables many analysts to rationalize their otherwise fantastic valuations. By discounting projected earnings into the distant future, anyone could come up with a calculation to justify any quoted stock price, no matter how unrealistic.
Last May, when the market valuations of technology stocks were at their peak, I discussed my own approaches to the valuation of knowledge capital at a two-day conference in Washington, D.C. The audience included many prominent advocates of the "new economy." Their leading spokesman (a successful investor in risky IPOs and a frequent keynoter at global conferences about the information age) opined that my method for calculating knowledge capital is wrong. Since I recognized only historical -- not potential -- earnings, he concluded that I would advise the audience to sell their holdings in such companies as Microsoft Corp., Cisco Systems Inc., Amazon.com or Xerox Corp. My response was that valuations that project up to 50 years of continued growth in earnings were fantasies unworthy of a prudent investor.
In this case, my conservative views were in clear contrast with the position taken by Baruch Lev, a professor at New York University, who explained to the same audience that knowledge capital valuations "must recognize a company's full stream of expected future earnings ... discounted to determine the present value of the company's intangibles."
By the way, I agree with Lev on many fundamentals (as noted in "In Search of Knowledge Capital," September 1999 KMM) other than relying on future earnings estimates. He published an influential list of intellectual capital valuations of 90 leading U.S. corporations in the financial weekly Barron's (November 20, 2000). To create earnings forecasts, Lev says he "used analysts' consensus estimates of companies' long-term growth rates to come up with the first five years of expected earnings." Using other approximations and discount factors, he then projected the future earnings for another six years, at a declining rate of growth. Attempting to peer 11 years into the future makes little sense if the record shows that the financial analysts' predictions are materially in error in less than six months.
Since many KMM readers may be confronted by the intellectual capital valuations from Barron's, it may be helpful to understand the flimsy foundation on which stock- market analysts' projections are based. On December 26, 2000, The New York Times featured a summary comparison of predictions, as shown in the chart "Analysts' Earnings Growth Forecasts in 2000." According to the chart, in only four months (from early September to late December) the analysts' visions of the future dropped sharply from more than 16 percent growth to only about 5 percent for the current financial quarter (the last quarter of 2000) and from an optimistic 14 percent growth to almost nothing for just one quarter ahead (the first quarter of this year). This decline in confidence should make proponents of knowledge management projects think twice about using such estimates as a basis for explaining the worth of their projects to leaders of their company.
Of course, this is not to imply that knowledge capital is not valuable. It is a demonstrable fact that the worth of most corporations is not reflected in their accounting ("book") valuations. And it is now widely acknowledged that assets considered "intangible" by auditors determine most of the earning capacity of a company. Rather, the point is that most of what has been written to date about such intangibles has been described in qualitative terms often bordering on puffery (see "Intelligence in Question," October 2000 KMM).
Lev's work in this field is the most thoughtful attempt I have seen to come up with a method that would make it possible to quantify the dollar worth of knowledge capital. Unfortunately, an approach like his could backfire when you are trying to convince executives to make investments in knowledge capital formation. Seeing the stock-market analysts' faulty prognostications included in the justification of a budget for knowledge management, any shrewd executive would decide it was wiser to give priority to public relations, advertising or manipulation of the accounting numbers than to investments in people.
Paul A. Strassmann originated the trademarked concepts "information productivity", "return-on-management" and "knowledge capital."
© 2001 Freedom Technology Media Group