Hard facts about soft assets (and real options)
Jeff S. Eder, CPA ValueMiner, Inc.
CAS Seminar on Enterprise Risk Management April 3, 2001
Agenda
• Speaker/Company Background • Importance of Soft Assets & Real Options • “Soft Asset” Myths:
they are not stable, and they are real options
• “Soft asset” impact case studies • “Soft asset” modeling • Conclusion
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Speaker/Company Background
• Jeff S. Eder, CPA, is one of the founders of ValueMiner, a Redmond, WA software company; • ValueMiner’s Enterprise Risk Management offering, the 360Risk™ Suite, features a continuous risk management cycle and the patent-pending, mVaR Squared™ Methodology*; • the mVar Squared™ Methodology* analyzes all enterprise risks that affect market value including the risks associated with real options and soft assets that are the subject of this talk
* multivariate, market Value at Risk™ Methodology 10/30/2008 Jeff Eder, ValueMiner, Inc. 3
Speaker/Company Background
Bank or Insurance Company
Identify 360Risk Map™ System
360Risk™ Cycle
Manage RealTime™ ALM System
Implement 360Risk™ Portal
Strategize Risk Mentor™ System
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Definitions
• • • • • Asset - “an identifiable entity or group that as a result of past transactions has provided and is expected to provide economic benefit to the enterprise”; Capability - “competence that can be extended to multiple markets, that is hard to imitate and that satisfies a customer demand”; Current Operation - “activities supported by assets that are being used to deliver information, products and/or services to a customer today”; Option - “the right to complete a transaction in the future at a specified price”; Real Option - “an investment to change the current operation that is characterized by uncertainty, irreversibility, and the provision for future managerial discretion to exercise timing”;
•
Soft Asset - asset (see above) that is intangible, includes relationships (customer, partner, supplier), legally defined rights (patents, copyrights, trademarks), capabilities (processes, knowledge, systems, infrastructure) and brands.
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Soft Asset Importance
“The success of an enterprise is determined more by a company’s ability to use its intangible assets than by its ability to amass and control the physical ones” that are measured by traditional accounting systems” - from the editorial
“Accounting Systems are Completely Wrong” by William Davidow, former Senior VP Marketing, Intel, Partner, Mohr Davidow Ventures
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Soft Asset Importance
• A group of McKinsey consultants completed a 3 year study (pre-Internet bubble) that confirmed the important role soft assets play in driving profitable growth; • The consultants studied 30 world class companies including: Bertelsmann, Disney, GE, Gillette, Johnson & Johnson, Nokia, SAP and Charles Schwab in 10 industry sectors, in 12 countries on 4 continents;
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Soft Asset Importance
• They reported their findings in a book, The Alchemy of Growth; • Their major conclusion: companies used a well defined mix of “capabilities” (aka soft assets) to drive profitable growth; • The book contains a list of all the elements of the “capability platform” these companies used - some of which are shown on the next page;
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Soft Asset Importance
Capability Platform*
Brands Customers Distribution Financial Management Intellectual Property Partners R&D Management (Real Option Mgmt) Suppliers
*for a complete listing see ValueMiner web site (www.valueminer.com/VFAQ.htm)
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Soft Asset Importance
• Soft asset related problems are also a leading cause of stock market losses; • A recent study by Forrester Research showed that 44% of the major stock drops for Fortune 1000 companies were caused by problems related to soft assets
(source Global Finance, January 2001)
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Soft Asset Importance
“What is the right tool for measuring value and risk in the next three decades? I believe the answer will be found by those who develop the best understanding of what defines income producing assets in a digital world.” Michael Milken, Wall Street Journal, 2/23/99
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Soft Asset Importance
• As important as soft assets are, most experts agree they will only become more important in the future as Technology and the Internet minimize or destroy many traditional sources of competitive advantage including:
– geographic boundaries; – scale economies; and – distribution costs
(from Race for the World, by consultants from McKinsey)
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Soft Asset Importance
• Some have concluded that the only scarce resource in the not too distant future will be “soft” assets “The companies that win in a world of increasing customer choice...will be the companies that make the most of their intangible assets.” from Race for the World, by consultants from McKinsey
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Soft Asset Myths
“It ain’t the things that people don’t know that’s the problem. It’s the things they do know that just ain’t so.” - Will Rogers
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Soft Asset Myths
• There are many myths about “soft” assets, one of the most common is:
“soft” assets are not as stable as hard assets
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Soft Asset Myths
• Reality:
soft assets can be very stable; “hard” assets can be very volatile - accounting conventions tend to hide their volatility; and soft assets have an advantage over many hard assets in that they don’t always depreciate with use and may in fact appreciate in value
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Soft Asset Myths
• One of the best examples of the stability of soft assets is brands; • Many of the most popular brands have been around for over 50 years
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Soft Asset Myths
Age of Brand Over 100 years 50 to 100 years 25 to 49 years 15 to 24 years Under 15 years % of mentions 10 54 4 4 3
Source: Managing Brand Equity, David A. Aaker
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Soft Asset Myths
• Along the same lines, a study by the Boston Consulting Group found that 18 of the 22 leading brands from 1925 were still leading their category 70 years later, the 4 who lost the top spot were still major players in the market
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Soft Asset Myths
• Christmas 1999 showed the power of old brands even in the Internet age. “The big surprise was how well traditional retailers fared compared to their dot com competitors...Media Metrix termed brick-and-mortar stores “one of the biggest success stories” of the holiday season” - Yahoo! News, January 3, 2000
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Soft Asset Myths
• After declining for years, the price of a barrel of crude oil doubled in 1999; • What do you think is more volatile? the economic value of oil extraction equipment or the value of established brands?
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Soft Asset Myths
• In a related example, what do you think happened to the value of the billions of dollars of hard assets that were tied up in the nuclear industry in the days following the incident at Three Mile Island?
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Soft Asset Myths
Brands aren’t the only “soft” assets with enduring value
Customers Relationships can easily generate increasing value for the life of a company While the life of individual patents is limited, they can be improved upon indefinitely
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Patents
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Soft Asset Myths
• In some ways soft assets are superior to many hard assets because the may increase in value with the passage of time and/or with increased use - exception may be real estate/property
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Soft Asset Myths
Expected impact on asset value Soft Asset Increase Varies Hard Asset Decrease Generally a decrease
Increased use Passage of Time
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Soft Asset Myths
• Another myth about “soft” assets that appeared during the height of the Internet bubble was:
“soft” assets are real options
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Soft Asset Myths
• There are two problems with saying that soft assets are real options • First, this tends to ignore the value soft assets create with their positive impact on the current operation;
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Soft Asset Myths
• For example, a strong brand can allow a company to:
– lower selling costs; – increase selling price; and – increase customer loyalty
all of which increases the value of the current operation - this portion of brand value, therefore, derives from its impact today - not the future.
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Soft Asset Myths
• The second problem is that calling soft assets real options confuses cause and effect; • A brand, customer relationship or employee capability have value only in the context of an activity that will increase revenue, lower expenses or reduce the need for capital - for example brands enable line extensions
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Soft Asset Myths
• Without the activity or the prospect of an activity there is no value associated with having a soft asset/capability that isn’t fully utilized, in fact the opposite may be true;
“the organizational value of capabilities depends on the potential uses of flexibility in future but uncertain states” - “Capabilities as Real Options”, Bruce Kogut, Wharton
School, Nalin Kulatilaka*, Boston University
* co-author of Real Options: Managing Strategic Investment in an Uncertain
World, 1999, Harvard Business School Press
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Soft Asset Impact Case Studies
• Soft assets are intimately related to the value of real options and business ventures as shown in the two case studies
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Soft Asset Impact Case Studies
• Johnson & Johnson selected contact lens manufacturing as an area for growth • Problem - how to distinguish itself? • Answer - build soft assets • Result - profitable, rapidly growing $600M business
source: The Alchemy of Growth
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Soft Asset Impact Case Studies
Johnson & Johnson Soft molding process Leverage existing brand and channels Advanced Manufacturing Process Exclusive supplier relationship - leading injection molder Intellectual property new lens technology
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Soft Asset Impact Case Studies
• Soft assets can also explain the valuation acquirers place on “strategic” acquisitions
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Soft Asset Impact Case Studies
Valuation $8M
Brand sounds like a movie
Customers - zero
Real Option to lead web authoring tool market
Patents several pending
Employees - who? Investors - 2 vc firms
Partners none
Soft Asset Impact Case Studies
10 months later Valuation = ?
Brands - now part of Microsoft Office
Customers - the world
Real Option to lead web authoring tool market
Patents pending patents added to portfolio
Employees - Bill Gates, Paul Allen, etc.
Partners 10,000+ VARs Investors - MS
Soft Asset Modeling
• Summarizing what we have seen so far:
– soft assets are increasingly important to corporate growth and profitability and they are expected to become more important as time goes by; – soft assets are major source of enterprise risk; – soft assets can be stable and they can increase in value; and – soft assets enable real options and can transform a real option for growth in to a profitable business
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Soft Asset Modeling
• Any system that models soft assets would have to account for the observations on the previous page, it would also have to account for other “hard facts” about soft assets
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Soft Asset Modeling
1) A soft asset modeling system needs to account for the fact that soft assets have an impact of the market value of equities.
Researchers from UC Berkeley and the University of Wisconsin found that customer-perceived quality correlated positively with stock market performance and that “brand building (for the 34 companies studied) did pay off for the shareholder.”
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Soft Asset Modeling
2) A soft asset modeling system needs to identify and measure the different intangible assets that drive value for different businesses.
In their study “Measures that Matter” Ernst & Young identified a wide variation in the relative significance of given “soft” assets for firms in different industries. For example, the assets that drive value for steel companies are different than the assets that drive value for a software company.
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Soft Asset Modeling
3) A soft asset modeling system must adapt to changes in markets and the economy.
Dr. Baruch Lev, Director of the Intangibles Research Center at NYU, has identified the inability to handle change as one of the major weaknesses of traditional accounting systems.
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Soft Asset Modeling
4) A soft asset modeling system needs to account for the fact that the value impact of soft assets depends on how they are put together (the recipe, if you will) in addition to the ingredients.
Researchers from MIT's Sloan School of Management documented a 4X multiple on market value impact for the same soft asset investments when the right "recipe" was used.
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Soft Asset Modeling
5) A soft asset modeling system needs to account for the fact that soft assets have an impact on short term financial performance.
Researchers from Rutgers University have documented a link between corporate HR policies and short term financial performance, they have also identified a link from HR policies to stock market performance.
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Soft Asset Modeling
6) A soft asset modeling system should help you take advantage of the fact that understanding “soft” assets improves your ability to forecast stock market performance.
“When non-financial factors (aka soft assets) were taken into account, earnings forecasts were more accurate…The message is clear: non-financial factors can be used as leading indicators of future financial performance” “Measures that Matter”, page 7
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Soft Asset Modeling
Soft Assets: affect short term financial performance enable real options affect the market price of equity impact is “recipe” dependent impact varies by industry and over time can be used to improve forecast accuracy
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Soft Asset Modeling
• ValueMiner has developed and patented systems for measuring and managing the value and risk associated with all facets of enterprise value; • The real option and soft asset segments of these systems meet all the criteria listed in the preceding slides (and several criteria that weren’t listed).
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Soft Asset Modeling
• One of the principles behind the operation of these systems is best illustrated by an example from the physical world - electricity.
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Soft Asset Modeling
Electricity flows when there is a potential difference between two bodies connected by a conductor. The electric current consists electrons flowing from the more negative body to the more positive body.
Question is how to measure the flow?
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Soft Asset Modeling
• How do you measure electricity?
– If you are an accountant:
• you calculate the cost per electron (including overhead); and • count the electrons (after all that is the only way to know for sure just how many electrons were used by the customer)
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Soft Asset Modeling
• How do you measure electricity?
– If you are an engineer:
• you look for a relationship between electric current and other effects that more easily measured (magnetic field or heat) and measure the other effects
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Soft Asset Modeling
• ValueMiner’s systems take an engineering approach; • It turns out that measuring indirectly using “impacts” is fairly common - temperature, magnetic field, radiation, etc. are all measured in this way; • Accounting systems attempt to measure assets by tracing inputs - a fundamentally different approach
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Soft Asset Modeling
Forbes ASAP: Why is intellectual capital so hard to pin down? Esther Dyson: It's like impressionism. You can't see it up close. You measure it by what it does.
Source: Forbes ASAP, Intellectual Capital Issue
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Soft Asset Modeling
• Summarizing what we’ve discussed - soft assets derive their value from improving current operations and enabling real options.
“the fundamental basis of the value of the firm is its organizational ability to exploit current and explore future opportunities” - “Capabilities as Real Options”, Bruce Kogut, Wharton School, Nalin Kulatilaka*, Boston University
*
co-author of Real Options: Managing Strategic Investment in an Uncertain World, 1999, Harvard Business School Press
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Conclusion
• Soft assets are increasingly important drivers of enterprise value and enterprise risk; • The information ValueMiner’s systems provide on soft asset and real option values can be used to power new families of risk transfer products; • Now that you know you have a choice, why use anything less than a complete model?
Note: links to most books and articles referenced in talk can be found at http://www.valueminer.com/RLinks.htm
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