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Past Issue • Oct-Dec 2013

Calculating Intangibles: Drivers of Firm Performance

The research featured in this issue is drawn from papers presented at the Summer Research Conference in Corporate Finance organised by the Centre for Analytical Finance at the ISB and the Wharton School of the University of Pennsylvania. Shedding new light on aspects as diverse as corporate boards, corporate philanthropy, political speech and innovation, together these four articles illuminate the intangible drivers of firm productivity and performance, and the economy at large. Professor Krishnamurthy Subramanian of the Indian School of Business, and the organiser of the conference, connects the dots.

In developed economies, production not only requires traditional factors such as capital and labour, but also involves skills, organisational structures, know-how, information, and other factors that are collectively referred to as “intangible assets.” Detailed investigation of these types of assets has found that they are often large and have substantial productivity benefits. For example, an article in the October 20, 2005 issue of The Economist estimated that “as much as three-quarters of the value of publicly traded companies in America came from knowledge-based intangible assets, up from around 40% in the early 1980s.” Jorgenson and Fraumeni (1995) found that the stock of “human capital” in the United States (US) economy dwarfs the stock of physical capital and has grown substantially over time. Hall (1993), Griliches (1981) and Lev and Sougiannis (1996) have found that research and development (R&D) assets bring benefits in the form of positive market valuation. Results from analyses of market-to-book values of firms have shown that the stock market valuation of firms has increasingly diverged from their measured book value (Chan, Lakonishok and Sougiannis, 1999; Hall, 1999).

As India attempts to progress into the league of developed economies, intangible assets will be critical to enhancing the productivity of firms, and thereby, that of the economy. Given this important backdrop, in this issue, we examine the effect of various intangible assets in creating firm value. The articles discussed in this issue examine different facets of intangible assets and how they impact firm value. These papers were presented at the annual Summer Research Conference in Corporate Finance organised by this author and Krishna Ramaswamy of
the Wharton School of the University of Pennsylvania under the aegis of the Centre for Analytical Finance (CAF) at the Indian School of Business (ISB). The CAF Conference is the premier conference in finance in the Asia-Pacific region with top quality researchers from all over the world congregating to present and discuss cutting-edge research in the area of corporate finance. The acceptance rates for papers presented at the conference in the topmost finance and economics journals is significantly higher than the acceptance rates of papers presented at the two flagship conferences organised by finance academics, specifically, the annual conferences of the American
Finance Association and the Western Finance Association. This year marked the 10th successful year of the conference.

Governance Matters? Political Speech, Corporate Boards and Giving

The articles we discuss touch upon four different aspects of intangible drivers of enterprise value.

The current election year in India provides the backdrop for the first of our articles. Assembly elections will take place in many important states, followed by elections to the Lok Sabha, the lower house of Parliament. As election fever heats up, political rhetoric could also ratchet up a notch or two. “Political Speech and Economic Outcomes: Running the Numbers,” is rather topical in this regard as it discusses the value of political rhetoric to firms and their investors. The authors, Professors Art Durnev, Larry Fauver and Nandini Gupta, conduct a textual analysis of speeches by state governors in all 50 American states and find a positive association between the level of optimism expressed in a speech and abnormal returns to firms headquartered in that state. They also find that a more optimistic gubernatorial speech is associated with an increase in investment and employment by firms located in that state, whereas a more pessimistic speech is associated with a decline in investment and employment. Moreover, they observed that political rhetoric was more informative during the recent economic crisis, when the impact of government policy was greater.

The context for our second article comes from family-owned firms, which are an important component of the Indian corporate landscape. A key corporate governance phenomenon that manifests in family-owned firms relates to the tussle between promoters and other shareholders for control of the board. The recent events at Yes Bank offer an example of such jostling for power in the boards of family-owned firms. In this instance, a deceased promoter’s wife, Madhu Kapur, has raised corporate governance issues at Yes Bank Ltd in an affidavit filed in the Bombay High Court after the management and the board rejected her daughter’s nomination as a director. The article “Family Firms and Boards of Directors,” examines family and nonfamily board characteristics and their impact on firm value. The authors of this paper, Professors Huimin Li, Harley Ryan, Lingling Wang and Baozhong Yang, argue that board tenures and board characteristics are quite substantially different between family and non-family firms. More importantly, they find that these differences affect firm value and performance. Their study extends our understanding of the mechanisms that govern family firms and has important implications for founding families, investors and policy makers.

A more optimistic gubernatorial speech is associated with an increase in investment and employment by firms located in that state, whereas a more pessimistic speech is associated with a decline in investment and employment.

The relevance of the third article emerges in relation to the new Companies Bill recently passed by both houses of the Indian Parliament. The bill requires firms to allocate a fixed proportion of their revenues for activities related to corporate social responsibility. The article “Corporate Philanthropy and its Effects on Firm Value,” examines the sagacity of such a move. Although corporate charitable contributions are frequent and often substantial, there is no clear evidence as to whether these expenditures have positive effects on firm revenues, performance or on shareholder wealth.

Proponents assert that corporate giving is consistent with shareholder value maximisation since it is a channel for firms to promote their image to customers and to enhance their standing with regulatory agencies and legislators. Counterarguments suggest that corporate giving can often reflect conflicts of interests between shareholders and managers, where managers support their personal preferences toward charities with corporate funds or enhance their personal reputation and social networks. Since it is difficult to measure the benefits that accrue to a firm from charitable contributions, these decisions can reflect the personal preferences of corporate managers, and thus, substantially depart from firm value and shareholder wealth maximisation.

Given this ambiguity surrounding the benefits of corporate giving, an understanding of why firms make charitable contributions and what implications such contributions have on shareholder wealth is critical in today’s world.

Valuing Innovation
The final article “ Valuing Innovation: Evidence from Cisco’s Acquisitions,” pulls together the themes of this issue by examining intellectual/ knowledge capital as an intangible asset. This article, which I have authored with researchers Chandra Sekhar Mangipudi and Rajkamal Vasu, estimates the intrinsic value of the innovative assets of private, vanguard firms.

As Indian information technology, business process outsourcing, Information Technology and other allied services, biotechnology and pharmaceutical firms move up the value chain by creating more intellectual/ knowledge capital, they will have to rely, at least partially, on acquisitions to fill their knowledge gaps. The study conducted in our paper is, therefore, quite germane to acquiring companies when
attributing appropriate values to the intellectual/knowledge capital of potential targets, thereby ensuring that they do not overpay for acquisitions.

The relevance of the third article emerges in relation to the new Companies Bill recently passed by both houses of the Indian Parliament. The bill requires fi rms to allocate a fi xed proportion of their revenues for activities related to corporate social responsibility.

Our paper focuses on young, private firms because they are the primary drivers of mouldbreaking innovation. Our novel approach uses the
price paid in the market for acquisitions of young, private targets and combines it with unique data handcollected from Google Patents. By comparing across deals undertaken within the same year by the serial acquirer Cisco Systems, which has well-defined and fine-tuned processes for acquisitions, we minimise systematic biases.

We address concerns regarding the validity of our results outside of our focused sample by crosschecking the estimates obtained using Cisco’s acquisitions with those of Yahoo and Google. The value of a granted patent equals US$158 million, which in order of magnitude is higher than the value estimated in existing studies. one standard deviation increase in technological expertise (over and above intellectual property rights), as measured using the citations to patents, increases value by about US$500 million. Finally, the value of the target’s innovative assets increases when there is greater overlap between these assets and the acquirer’s assets and/ or the assets of the acquirer’s competitors. Ours is the first study to estimate the intrinsic value of the innovative assets of private, innovative firms and to value innovative assets in mergers and acquisitions.

Further Reading
Chan, Louis K C, Josef Lakonishok, and Theodore Sougiannis (1999). “The Stock Market Valuation of Research and Development Expenditures”, Working Paper 7223, National Bureau of Economic Research (NBER), Cambridge, Massachusetts.

Griliches, Zvi (1981). “Market Value, R&D, and Patents”, Economic Letters, 7(2): 183–87.

Hall, Bronwyn H (1993). “The Stock Market’s Valuation of R&D Investment during the 1980s”, American Economic Review, 83(2): 259–64.

Hall, Bronwyn H (1999). “Innovation and Market Value”, Working Paper 6984,  National Bureau of Economic Research, Cambridge, Massachusetts.

Jorgenson, Dale W, and Barbara M Fraumeni (1995). “Investment in Education and U.S. Economic Growth”, in Dale W. Jorgenson (ed): Productivity, Volume 1: Postwar U.S. Economic Growth (Cambridge, Massachusetts: MIT Press).

Lev, Baruch, and Theodore Sougiannis (1996). “The Capitalization, Amortization, and Value-Relevance of R&D”, Journal of Accounting and Economics, 21(1):107-138.

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