Quantifying the intangible
As non-physical assets grow in importance, so do the role of ESG standards.
Business titans of the late 19th and early 20th centuries controlled critical industries of the day, including transportation, commodities and manufacturing. They also dominated America’s capital market, laying the foundation of the Dow Jones Industrial Average. Accounting frameworks focused on the quantifiable: physical inventory, equipment, property and so on. A company’s intrinsic worth was reflected by “book value” on a balance sheet.
Over the past half century, we have witnessed a revolution in the understanding of what really drives business valuation. As the global economy shifted away from an industrial base to one marked by services and knowledge, intangible assets increasingly have been recognized as a vital component.
Today’s investors are moving beyond traditional financial analysis, emphasizing intellectual property and incorporating what many are defining as pre-financial or extra-financial disclosures. Shareholder value, while still vital, is slowly being superseded by an emphasis on stakeholders. Many large domestic manufacturing companies have pivoted to these considerations as a result of concern about outsourcing production around the globe. Apple is a prominent example. While its products are designed in California, the assembly shops it uses in China have been criticized over the years. In 2020, it responded with a Supplier Code of Conduct, in which its suppliers "are required to provide safe working conditions, treat workers with dignity and respect, act fairly and ethically."
As globalization and a focus on services continue to grow, a greater portion of a corporation’s assets have become intangible in nature. In 1975, less than 20% of the S&P 500’s market value was derived from intellectual capital such as patents or proprietary technology. Today, approximately 90% of the index is considered intangible, according to a study by Ocean Tomo.
A defining result of this process is the weight it gives to relevant and material environmental, social and governance (ESG) factors. These quickly are becoming recognized as vital to the evaluation of a company, adding a new lens to see how an entity is managing its entire spectrum of resources. Returning to Apple: its new code also demands its suppliers "use environmentally responsible practices wherever they make products or perform services."
Evaluations should be further improved as accounting standards evolve to paint a more complete picture of how a company generates long-term value. Human capital, intellectual property and the efforts to ensure their sustainability are identified as material ESG issues in many industries, but you won’t necessarily find them on a line item in a financial statement.
Another hurdle is the lack of standardized ESG disclosures. At present, various entities have cluttered the landscape with different guidelines, creating more confusion than clarity. But frameworks are converging. The most significant is merger of the Sustainability Accounting Standards Board and the International Integrated Reporting Council to form the Value Reporting Foundation. A global coalition of regulators, investors, companies, academics and accounting experts working toward a set of guiding principles would offer much-needed harmonization. As business models have evolved from a physical to a virtual dimension, corporate disclosure and valuation will soon reflect the modern age.
A version of this commentary appeared in Forbes.