Anyone who watched dot.com companies appear out of nowhere two years ago with stock values in the billions, and then watched them disappear equally fast in the last six months, doesn’t need convincing that financial markets have become exceptionally fickle and volatile.
One of the most important reasons for the market’s dizzying swings is the huge and growing gap between what corporations report publicly to their investors, and what really counts inside firms today.
Depending on the measure used, at least 50%, and possibly as much as 85%, of the assets and other sources of value in the corporate sector do not appear on the books of corporations. In some firms, the gap between so-called “book” value (what the accountants say the assets of the firm are worth) and the firm’s market value is modest, but in others the gap is as much as 95%. This leaves investors guessing as to what this “unseen wealth” is, and how much it is worth.
Among the known components of unseen wealth are such things as patents, copyrights, trade secrets, brand loyalty, computerized inventory control systems, customer relationships, organizational capabilities and the knowledge, skills, creativity, energy and enthusiasm of employees. Everyone knows such “intangibles” are critically important in business today. To better manage them, firms in every sector of the economy are creating new positions with titles like “director of knowledge management” or “vice president for people.” Consulting and accounting firms are scrambling to sell business clients their latest models for evaluating their “human capital” investments, or for better managing their patent portfolios.
Academics have shown that there are links between stock price performance and such things as spending on research and development, information technology investments, advertising and brand development, workforce training or workplace practices that give workers more control over the day-to-day operations of the firm.
But extracting detailed information from firms about their spending and other practices requires costly survey techniques. Firms, of course, are free not to participate, and many of them don’t.
Why aren’t companies eager to tell us about what makes them so valuable? Some would like to, of course, especially companies that think the financial markets are not valuing them highly enough. But assigning a value to such assets as brand loyalty, or new products in the pipeline inherently involves making some kind of prediction about the future revenues those assets will generate. Under current securities laws, companies can be sued for damages to investors if they make optimistic statements about the future that turn out to be wrong. Meanwhile, companies that have reason to fear that the market may be overvaluing their stock have not been eager to open the black box for investors.
The biggest obstacle to more transparent public reporting by companies, however, is that no one has yet devised a reliable, widely applicable and verifiable system for measuring the value of most intangibles, nor have we even figured out what performance indicators are useful guides to that value, and how we should measure those.
A new Brookings Institution report proposes several new policy initiatives that address the failure of traditional accounting systems to deliver the information needed for the new economy. First, we need a new, large-scale data collection effort. Congress must provide funding to statistical agencies in Washington to collaborate with businesses to collect new data about intangibles. Such data would provide the basis for developing new business reporting models.
We also need a systematic review and reform of intellectual property rights laws to provide greater certainty and clarity about the extent of the protection the law provides for these assets.
Finally, the Securities and Exchange Commission should encourage corporate executives to tell investors what they believe the “value-drivers” in their firms are, and how they are managing them. Our report also asks the SEC to provide additional protection from lawsuits to companies that report nonfinancial performance information, as long as they do so in good faith, and make it clear that such information is experimental, uncertain and unverified.
The information needs of the new economy have already outgrown what traditional accounting systems can deliver. Our next president will have to take steps to close the information gap that is fueling financial market volatility.