CORPORATE VALUE CREATION, INTANGIBLES, AND VALUATION: A DYNAMIC MODEL OF CORPORATE VALUE CREATION AND DISCLOSURE

Transcription

1 CORPORATE VALUE CREATION, INTANGIBLES, AND VALUATION: A DYNAMIC MODEL OF CORPORATE VALUE CREATION AND DISCLOSURE by John Holland, Department of Accounting and Finance, University of Glasgow, Southpark Avenue, Glasgow G12 8LE, Ph , Fax , E mail J.B.Holland@accfin.gla.ac.uk Acknowledgments to ICAS for funding this research: The report begins in section 1 with an introduction to the field, a discussion of policy issues, and a brief summary of the literature. In section 2, the research questions and research methods are discussed. The literature revealed that there have been major changes in the way companies create value in the new knowledge intensive economy of the 21st Century. This has created problems for public disclosure by companies. In addition, the research literature on disclosure has been dominated by positivistic and analytic model building. With the exception of the work by Lev (1998), such approaches appeared ill suited to explaining the new world of corporate value creation and associated disclosure behaviour. There has been some case study research and the development of grounded theory and this has proved to be more promising route to explaining the new drivers of corporate disclosure behaviour and outputs. Prior work by Marston (1996), Barker (1997), Holland (1998), Holland (2000), revealed the significance of qualitative information and private meetings with financial institutions as an important way of disclosing information about companies sources of value. As a result, this research began from the premise that understanding corporate disclosure behaviour required an investigation of the new corporate value creation processes and their impact on corporate disclosure behaviour. Sections 3, 4 and 5 dealt with main grounded theory results of the case interview and archival research. The report was based on case interviews with 30 large UK FTSE 200 companies (24 in FTSE 100) during April to November Substantial archival data in the form of web site disclosures, corporate reports, and media comment, were also employed. The companies interviewed were subject to continuous pressure from the 'Market for information', consisting of analysts, financial media, and fund managers (FMs) in the City of London. These FTSE 200 companies were subject to almost continuous pressures of quarterly or half yearly reporting, of subsequent 1:1 meeting with FM and analysts, and ad hoc telephone calls. They faced strong demands to provide analysts, fund managers, and the financial media, with new qualitative information to explain their value creation story, to report changes, and to discuss the stock price implications of such information, all within Stock exchange rules on 'price sensitive' information. As a result the firms faced three major issues, 1. How can we understand and articulate (to ourselves) how value was and is created in the company - What is the nature of our value creation process? and what is the role of knowledge intensive intangibles and tangibles in this process? 2. How can we value elements of the value creation process in

2 a share price value equation? How do our (value creating) intangibles and tangibles effect our share price? 3. How can we disclose information about the above processes and sources of value? Subject to what constraints? The case interviews focused on the above areas. As result, the case data had a bias towards issues of corporate financial communications or private disclosure to analysts and fund managers the City of London. It had a strong bias towards a capital market and shareholder concepts of value as opposed to a wider stakeholder concept of value. The internal managerial uses of knowledge of the value creation process and the internal management of knowledge intensive intangibles, were not addressed in this study. However, the results may be of considerable interest to other major corporate stakeholders such as middle managers, other employees, suppliers, customers, and governments. Intellectual Capital (IC) is likely to be seen as critical to the value creation process, irrespective of whether shareholder, customer, employee or other stakeholder views of 'value' are employed to assess the process. Section 3 outlined the broad nature of corporate value creation processes, and the central role of intellectual capital or knowledge intensive 'intangibles' in this process. These qualitative value creation factors were discussed within the context of the prevailing debate on intellectual capital and intangibles. Intangible assets referred to knowledge intensive assets such as the quality of brands, corporate reputation, a coherent strategy, the quality of management, effective risk management, effective R&D, and many others specific to companies or industries. These types of asset were recognised as difficult to categorise or measure, but they were also recognised as being increasingly important in corporate share prices in the knowledge intensive economy. Tangible assets referred to the visible, concrete assets and value creation processes in companies. A specific group of these intangible assets or qualitative value creation factors, such as the quality of top management, coherence and credibility of strategy, structure and functioning of the board, the quality of public and private disclosure mechanisms, and the quality of internal communication systems, were identified as the primary drivers of the wider range of other internal human and structural capital elements to be found in value creation processes. Notably, top management, the coherence of their strategy, and their ability to communicate these within the enterprise were identified as primary drivers of middle management and other employee human capital. These were used to fully exploit human and operational structural capital during sourcing decisions and processes, transformation decisions and processes, and output decisions and processes. Section 4 provides the outline of a valuation equation that seeks to connect the case companies concepts of the corporate value creation process with their understandings of stock market valuation processes. There was no direct matching or alignment of the value creation process model and a stock price valuation equation or model. The share price valuation model has been transposed on the corporate value creation process. The share price valuation model reflected how corporate management perceived the stock market valued the company, and this did not necessarily fully incorporate how the

3 company created value. However, these two processes were connected by various linkages between value creation process variables and stock price valuation variables. The links were identified by the case companies during this field research and by case FMs in prior ( ) FM field research (Holland 2000). In principle, the valuation model employed by employees or by customers, could also be connected to the value creation process in the same way. The main difference being that the corporate value creation processes identified in the cases were designed to increase shareholder wealth as their primary purpose. This may be due to the increase in use of value based management (VBM) systems such as EVA, in the past decade. The common shareholder wealth creation aim of the value creation and valuation processes made it possible to identify links between them. It therefore provided the means to discuss how knowledge intensive intangibles were driving share prices. The latter explanations assumed market sentiment and other disturbing factors were constant. At times, the dramatic changes in the latter dominated company stock market valuations and the fundamentals based on a knowledge intensive value creation process were thought to be made quite irrelevant from the case company view. This was a major problem in corporate disclosure. In section 5 of the report, a dynamic model of corporate disclosure is outlined. This was made up disclosure content, choices, and mechanisms, and constraints. The increasing role of knowledge intensive intangibles in stock prices has been identified in the literature as one major possible reason for the book value and market value gap. This was an important issue in the company cases, in that the perceived failure of company financial statements to measure and disclose intangible assets, was considered to be a failure in conventional corporate disclosure mechanisms. The case managers lamented this fact, but they recognised that the direction of change in current accounting conventions meant they had little control over this issue. The failure pointed up to the likely significance of intangibles in share prices. Nevertheless, this failure provided an incentive for managers to find alternative disclosure channels and to disclose new types of information consistent with the changes in corporate value creation processes. Private disclosure of information on intangibles in the value creation process, was the primary corporate response to this failure of public disclosure. In practice, company managers were strongly focussed on the stock price per se and the corporate, sector and market determinants of stock price. The book value and market value gap was not the main disclosure issue facing companies. The central issue concerning corporate and sector determinants was, what information on knowledge intensive intangibles was being reflected in the share price, and what could the company do to improve this information set? and hence get a 'correct' rating. Thus the case companies focussed on areas where they had considerable control. In terms of disclosure content, the main information content lay in a three major qualitative elements. These were, the telling of a coherent and credible story of the knowledge intensive value creation process, the disclosure of information concerning specific changes in the core intangibles driving this process, and the placing these changes in the context of the company story and competitive position. The 'story' was partially communicated through public disclosure means such as the OFR or through company web sites. However,

4 these sources were fragmented and limited, especially with regard to management qualities and coherence of the story. In contrast, in the private meetings the story was conveyed through diagrams outlining links in the value creation process, through dialogue, and interpreted and developed through question and answer sessions. It was held together by a common 'story line' or connecting thread running through the story. Thus the main aim here was to get over a larger, coherent picture and to explain how it changed through time. In addition, FMs and analysts were able to observe management in 'communication action' effectiveness and this provided some insights into their internal 'decision action' effectiveness. In terms of specific changes in intangibles, these were 'measured' in a variety of ways. Some intangibles such as effectiveness of R&D could measured in absolute terms by the absolute R&D spend, and by the number of observed innovations for this expenditure. Another example, was the absolute discovery costs for an oil company, and the number and size of observed new fields found by exploration. These absolute numbers were ranked against competitors. However, the bulk of intangibles and their contribution to value were difficult to measure. In these case the broad category of intangible could be identified, and its effectiveness could be ranked, implicitly or explicitly, on the basis of a FM or analysts subjective judgment, relative to competitors or the sector. Information was generated here by observing and perceiving changes in relative benchmark indicators such as changes in the perceived ranking of management relative to competitors, or the perceived market power of a brand relative to competitors. The perceived changes here, derived from private contact and observation, formed the basis of the disclosure. Some disclosure here could be involuntary on the part of the company as well as being deliberate. Such changes were placed in the context of the larger value creation story, via the dialogue and question and answer sessions, and this provided further disclosure content. This disclosure model also provided a comprehensive view of the main elements and choices in a purposeful corporate disclosure process. It generated important insights into the conditions under which private and public corporate disclosure processes functioned and it demonstrated how public and private corporate disclosure interacted and changed with various circumstances. It also revealed that the choices here were much wider and involved deliberate corporate secrecy and non disclosure. It therefore revealed how companies exploited these public, private and non disclosure choices. Much of this choice behaviour was driven by managerial opportunism, as well as the qualitative and difficult to measure nature of knowledge intensive corporate value creation processes. These choices were much constrained by external regulation, by external benchmarking by analysts and fund managers, and by financial market forces. This section therefore revealed forms of private FI corporate disclosure behaviour which were somewhat different to that discussed in the literature on public domain corporate disclosure. They provided a major expansion of the prior work by Marston (1996), Barker (1997), and Holland (1998) concerning private corporate disclosure. Such disclosure behaviour followed on closely from the corporate value creation processes, and top managements understanding of the valuation equation implicit in stock market valuation processes. Management therefore had to connect up their understanding of their

5 value creation processes to stock market value creations processes. It was this understanding that was a primary driver of the corporate disclosure process. There was no direct matching or alignment of the value creation process model and the corporate disclosure model. These were quite different managerial activities and hence they had quite distinct structures. The value creation model was the precursor of the disclosure model, in the sense that the former provided the information raw material for the latter. The case company perception of stock price valuation equation or model intermediated here between the value creation process and the disclosure process. This was used to identify stock price information categories in the value creation process, which were likely to be relevant to the disclosure model. It was possible to bypass the valuation model and to just release information on the value creation story and changes in specific intangibles to the stock market. Thus the market for information could be left to deal with this. However, company management recognised the need to have beneficial information exchange relationships with analysts and fund managers. Thus by adapting the information releases to match the known valuation information needs of analysts and FMs the case managers expected to improve the flow of information to a better informed stock market. Sections 3, 4, and 5 indicated that the model of the value creation process did not reveal the value of a company's knowledge intensive or IC assets. It revealed how the company created knowledge, exploited knowledge, and used its knowledgeable individuals and teams, as well as knowledge intensive structures and processes to create flexible decisions options and innovative products and services for the company. When a company articulated its story of value creation, and this was combined with the valuation model, then this provided the company with basis for making informed decisions about disclosure to stock markets via public or private disclosure. The stock market actually valued the company and its intellectual capital assets. The company managers sought to ensure that this market valuation fully reflected the complex story of value creation in these modern knowledge intensive enterprises. They were not seeking to value the company per se. They were seeking to create a value creation process in the company and to communicate this effectively to the stock market, so that the company was 'correctly' valued. In this paper we see that the value creation story was primarily told or disclosed by the company. In a similar fashion, the company was in the best position to identify the core intangibles and means to rank them relative to competitors. However, the active dialogue on (the appropriateness of) the story and on the relative measures was conducted over many years. As a result, it could be argued that this was the story the City wished to hear. Thus the common shareholder wealth maximisation aim of the case companies value creation story, can be seen as companies internalising FMs performance needs expressed during this continuous dialogue. To some extent the choice companies made about their value creation processes, benchmark measures, and about their disclosure choices, were determined by FMs, analysts, the financial media, and other City influences. Thus in this paper the value creation story, the benchmark measures of intangibles, and the disclosure choices, are seen as a two way 'contracts' determined between the company top management and the City.

6 In section 6, the case results are discussed within the research literature on the corporate disclosure. Given, the limitations of this literature relative to changes in corporate value creation processes, then the case research reported here suggests that future theoretical modelling and empirical research should extend beyond these conventional approaches and consider the joint world of private and public domain corporate disclosure and their effect on valuation. Instead of modelling simple relationship between 'public disclosure' as a dependent variable and 'independent' variables, such as company characteristics, demand side characteristic, or national and international factors, the wider range of private and quasi public disclosure behaviours should also be explored. Thus the 'black box' of corporate value creation and its impact on corporate disclosure has to be unravelled. Once general models exist here they can be related to conventional disclosure research. For example the question could be asked how does company size, or listing status, alter the grounded theory models of value creation and of public vs private disclosure identified here? How do national characteristics such as the sophistication of stock markets or markets for information, alter the grounded theory models of value creation and of private vs public disclosure identified here? How do international developments as the integration of stock markets and their regulations, or of accounting harmonisation, alter the grounded theory models of value creation and of private vs public disclosure identified here? Finally, in section 7, the policy implications of the paper are discussed in terms of providing a much clearer target for future policy proposals for changing corporate disclosure practices, especially in the area of accounting standards and stock exchanges rules for company announcements.