Valuing intangibles and ESG performance
Few would dispute the importance of intangible factors such as a company’s brand, its networks, its people and its capacity for innovation, but intangibles are, by definition, not easy to quantify. Josh Dowse, Principal, DowseCSP, introduces a new approach to measuring the value of a company’s intangibles and the value of its efforts (including sustainability) to strengthen them.
Those who own and manage companies often throw metaphorical darts to work out how much their ‘intangibles’ are worth. It may be a valuable brand that they’re eyeing, or the sublimely sweet relationships they’ve nurtured up and down the supply chain. There’s an ‘innovation culture’ in the company that, hard as it is to define, is worth at least a swillion smackeroos: just think of the people who want to work for us, and the things that they can create!
It’s an esoteric debate, though, which only bites when the company gets bought or sold. In the meantime, those running the company have to work out which intangibles to invest in, how much to invest in them, and how they should do so. Their options include investing in nebulous cultures, brands, reputations, relationships, environmental cred, community largesse, head office colour schemes. It’s a tough ask, and one for which answers can’t wait forever. The whole idea, surely, is not to wait until the company is next sold, but to build that value in time for the sale.
For those managers and owners looking to build intangible value, there needs to be a credible way of valuing their intangibles, and being able to track that value from year to year. What they can’t measure, they can’t manage.
Frustratingly, however, most of the current methodologies for valuing intangibles use what could politely be termed a ‘top- down-what’s-left?’ approach. If listed, companies may have a known market value – often expressed as a multiple of earnings – and some tangible, saleable assets with an assessable market value. The gap, by definitional magic, is filled by ‘the intangible’.
To properly identify, assess, value and manage their intangibles, companies need a ‘bottom-up-what’s-real’ approach: one that is aligned with the management accounts of the company, and that identifies all of the actions and inactions that drive revenue and costs. Those that are interested in sustainability or environment, social and governance (ESG) performance may want to go one step further: to assess the contribution that sustainability or ESG may deliver to those intangibles, and hence to overall value.
This article introduces an approach that offers that guidance. We call the approach ‘sustainability and intangibles valuation analysis’, or SIVA for short. The article introduces the conceptual and practical underpinnings of SIVA, gives examples of how it works, and suggests some uses that can be made of SIVA.
A value driver tree approach
SIVA is in essence a comprehensive ‘value driver tree’ model of the firm’s revenues and costs. Value driver trees are an acknowledged tool for understanding what drives operational and financial performance – they break down every branch of that performance into more and more sub-branches. Traditionally, however, the branches don’t go beyond tangible, numeric components.
SIVA digs two levels deeper. It first identifies and quantifies the intangible factors that underpin immediate financial performance. It then identifies and quantifies the sustainability-related actions and metrics that influence those intangibles.
SIVA can then deliver sensitivity analyses to see how much a profit and loss (P&L) – and correlating net present value – changes with the strength of these factors, which of the factors have the greatest impact, and how much a specific action or initiative will influence those factors. The process is transparent, so that management can discuss and agree on the factors, and the relative influence they have.
It is reasonably well accepted that the collective value of a firm’s intangibles is quite high. A recent study by Ocean Tomo (Intangible Asset Market Value Study, 2010) suggests that, as our economies become more service-based, the average value of the non-physical assets has risen from 17% of a firm’s value in 1975, to 68% in 1995, to 81% in 2009.
The four core intangible assets are: the firm’s brand and relationships, and the productivity and innovation capacity of its people. These four deliver future financial performance, which is usually of more interest to investors than past performance. To understand how they drive value, we need to create a value driver tree.
First cut at a conceptual ‘tree’
The key to getting a shared view of the firm’s value drivers is visibility. We’re looking to capture connections and represent them in a way that people can see and discuss. So think big – butcher’s paper may be out of favour but a big roll of it is just what’s needed. Or a decent printing whiteboard. Or some decent mind-mapping software with a deft keyboard operator driving it and a big screen projection. You need to be able to drag things around, make mistakes and start over.
We need to build both revenue and cost trees, which are very different. Revenue trees will depend on whether the business can only achieve a share of a given market, or create its own market. If the business is doing both, you’ll need different trees. At some point, though, a share of some market or wallet will be needed – consumers or other businesses aren’t magic puddings and there’ll be a limit on what they will spend on any product or service you’re selling them.
Cost trees are a little bit more straightforward. The biggest conceptual differentiator is between investments the business is making in itself – ‘quality spends’ on people or physical assets or to improve products – and its spend on commodity supplies. As you push down the trees, keep in mind which costs are which, as that will determine how SIVA treats them.
The core intangible trees
If you push hard enough back through the branches of the tree, you will start to think about the very things that are not easy to quantify: the intangibles. A structured approach to these intangibles is what makes SIVA different to standard financial driver trees. SIVA drills into four core and interrelated intangibles of the business: its brand, its networks, its people, and its capacity for innovation. One or more of them will hit every area of revenue and cost.
How you define these intangibles will be up to you, although there are good models to choose from. The quality and extent of the firm’s relationships and networks are perhaps the simplest of the four core intangibles to break down into component factors. Others take more digging.
For brand quality and value, there are many models on offer globally, from SDR (www.sdr-consulting.com) to Interbrand (www.interbrand.com) and a thousand consultants in between. Dowse CSP uses a model that incorporates some Interbrand- style factors into a model derived from ‘what customers are willing to pay for’ in the telecommunications industry, which can apply to both consumer and business- to-business brands.
Not surprisingly, variations in the quality and productivity of a firm’s people have the greatest impact on the SIVA results. We’re talking here about the extent to which people in a firm have value-creating attributes, and the extent to which they can or will bring those attributes to bear. Again, various firms have their own models for how to measure that quality and productivity. Importantly, these factors include measures of employee wellbeing such as their physical and mental health, skills and experience, values and motivation, the physical and personal work environment and the stability and support of their family and wider community.
Figure 1 lays out a clear breakdown of those factors, with ‘presenteeism’ being similar to employee engagement: the extent to which people are really operating at work, as opposed to playing solitaire.
Innovation capacity is drawn from an organisation’s people, leadership, working environment and culture. The firm’s sectoral, geographic and national settings will also be factors, but for our purposes they are ‘givens’. Again, multiple models of innovation capacity are available.
Finally, far into the leaves of the intangible factors lies the company’s sustainability performance itself. It is trite to say that there are any number of environmental, social, economic and governance factors that contribute to that performance. Measuring and incorporating more than 1,000 potential indices is neither practical nor desirable. Performance measures are useful, and overall ratings from an ESG ratings agency may be incorporated.
But we are more interested in future than past performance. For that, we need to look just as closely at elements of the firm’s future ESG direction – how well sustainability is integrated into the firm’s thinking, how it manages ESG risks, who is responsible for it in the firm, whether environmental and social key performance indicators are integrated into performance management, what issues the company is taking on, who they are partnering with and how they are reporting it.
Converting the conceptual tree to a quantitative model
By this stage, you will have harnessed some expansive thinking from your team to create a thorough, though non- quantitative, conceptual model of how your firm creates value. However, the whole point of the approach is to quantify each of the branches in some way, so that their overall impact on the P&L can be assessed. How?
The SIVA approach breaks the tree into three parts: see Figure 2. On the left are dollar values from full-year management accounts. On the right hand side are the more subjective factors, including the core intangible trees, that together drive revenue and costs. These can also be weighted and scored, and so quantified as scores rather than dollar values. In the middle is where the fun lies: a transition between an accounting-line dollar value, and scored and weighted intangible factors. Let’s take each of the three parts in turn.
1. The management account breakdown
The left-hand side of the model is perhaps the easiest to get a grip on. The most direct route is to use the actual figures for revenue and costs in full-year management accounts, line by line, broken down into their components, to the last line of pure tangible numerics.
This may not, however, always align with your original conceptual tree, so there may need to be some give and take. If your conceptual tree gives you a clearer management view of what drives value, then that’s an argument to realign your management accounts so that they better measure and support value creation for the firm. More likely, though, the thought of reclassifying costs is horrendous, and it’s the conceptual tree which is realigned with the management accounts, more’s the pity.
2. Weighing and testing the subjective factors
The subjective factors may be set out conceptually in the branches, but how do we turn them into numbers? The business has to decide how much weight to give each factor (its potential share of the outcome), and then how strong each factor really is. Together, those two dimensions will make up how much each factor contributes to the outcome.
For each of these dimensions, there are both academic sources and the business’s own experience and knowledge to draw on. For example, a reliable study may suggest that the quality of customer service is determined by the quality of the people hired to give it, the quality of the training and leadership they’re given, their motivation to deliver, the quality of the environment they work in and the systems they work with.
The study may even ascribe the weights of those factors, with the weights necessarily adding up to 100 per cent. There is only a very remote likelihood, however, of the study being in your industry, in your geography, with your technology. But it’s a good start for discussion.
The business will know better what actually works for it. In some cases, it will actually know – it’s looked at the evidence, run it through some regressions, and knows just how much those factors are influencing the results. In others, there will be no such evidence, but the responsible managers will have good feel for the levers that deliver for them.
It makes for a great discussion on what those factors are, how strong they are in the business, how strong they could reasonably be – and perhaps which of them should be better measured.
The next part of that discussion is to assess how strong the factors actually are in the firm. A scale of 1 to 10 is conceptually and mathematically easiest. In practice, most self-assessments (or third-party reviews), will score a firm’s qualities at between 4 and 10 out of 10, so a generic average is typically a 7. Multiplying out the scores and weights for sub-factors (for example, quality of people, quality of training, employee engagement, quality of working environment), gives you a score for the overall factor (customer service).
3. The transition
A number of techniques can be used to translate what is actually a quality score or identified factors into a financial outcome that the responsible manager would agree with, and that is objectively reasonable.
The first technique is to assess the firm’s current transactions against the maximum cost or price that the market will bear for a particular good or service. For example, a firm supplying engineering equipment to oil and gas companies will know the price boundaries — the maximum price the market will bear — for most if not all of its inventory items, by drawing on industry data and the firm’s own knowledge. There will usually be a gap between that price, and the price the firm currently charges. The current quality of its service is valued at its current price. If it wants a higher price, it will have to improve its value proposition, or negotiating skills, so that the price limit is reached when all of the contributing factors are as strong as they can be. Any further value from the transaction will need to come from accompanying services, which will have another limit to what customers are prepared to pay, no matter the benefits.
A similar technique is to assess how much a line item of costs and revenues could conceivably change from year to year. Again, the current year’s price and performance is known, and the maximum change would align with a perfect score for the factors. Aligning the two allows you to suggest a pro-rata financial change for any change in factor performance.
A third analysis is to assess how good a particular factor could logically be, how much it would cost to get it there, and what difference it would make to cost or revenue if that investment were made.
To take a simple example, a routine task might be done to the same effect whether you paid for unskilled labour or for the finest engineering graduates. The quality of sound on an airline headset might be improved with a modest investment, but what difference would that make to a traveller’s airline decision?
Working with SIVA
SIVA is a ‘live’ model of the firm’s profitability, the value of its intangibles, and the value of its efforts (including sustainability) to strengthen those intangibles.
Though it is possible to build a ‘black box’ SIVA model, doing so would overlook the benefits of working through each branch with the managers responsible for its real operation – they will understand the factors best, and will in many cases appreciate the depth of analysis that SIVA offers. Many will also gain a better understanding of the impact of sustainability or people initiatives, those who own and manage companies often throw metaphorical darts to work out how much their ‘intangibles’ are worth how they might affect their own accountabilities, and how they link to long- and short-term value.
Once a model is in place, its uses are many. Most importantly, it becomes an agreed platform for systematic analysis within the firm and by its investors. If the firm is considering any soft or hard investment to improve productivity, innovation, brand or financial performance – and that will be most of them – SIVA will offer an objective and systematic view of its many impacts. If people have differing views on the value of that investment, they will have an existing, agreed platform to explore those differences.
For the sustainability head of the firm, SIVA is particularly useful to help determine how to get the most bang for their sustainability buck. It will help compare initiatives vying for a share of the sustainability budget. It will help identify which are the biggest intangible drivers of value for the firm, and therefore where to best target a sustainability strategy. Most importantly, it will make conversations on sustainability of direct significance for quarterly performance measures, and so very much more real than they may be now.
For the investor, SIVA would be integrated with the investor’s own analytic model of the firm. It will help identify those ESG issues that matter most to the firm, and help provide a sensitivity analysis for the firm’s ESG performance, overall or on specific issues, as well as for its core intangibles.
From data to insight
ESG data is now relatively easy to come by. It is not immediately apparent what significance they all have. The links between ESG performance and the firm’s operations, strategy and financial performance have long been listed in shopping-list, conceptual form. SIVA helps make those links transparent and concrete.
It is not a generalised model, but one that must be built for each firm. It assists in discussing ESG factors with operating managers and investors in a focused and numeric way, offering a shared understanding of how ESG factors relate to performance.
It’s an understanding much in need.
For further information, see www. dowse-csp.com.au.
This article was first published in the July 2013 issue of ‘Keeping good companies’, the journal of Chartered Secretaries Australia. reprinted with kind permission of the publisher.