Valuation: Theories and Concepts

support.

Part I

Theories and Concepts

Outline

1 Perspectives on value and valuation

2 Risk and return

3 Efficient capital markets and its implications

4 Estimation of cost of capital

5 Principles of cash flow estimation

6 Discounted cash flow valuation models

7 Relative valuation

8 Mergers and acquisition valuation

9 Real options valuation

10 Valuation of different industry sectors

11 Valuation issues

1

Perspectives on value and valuation

Abstract

In finance, value is the firm value which consists of fundamental value and shareholder value. Firm value can be based on book value or market value. Market value is based on the stock market performance of a company. The strategic relevance of knowledge assets has led to the generation of new concepts and models for managing a company’s knowledge assets. Value creation is often perceived as the future value captured in the form of increased market capitalization. Valuation is used in functional areas of finance like corporate finance, investment analysis, and portfolio management. The three basic approaches to valuation are discounted cash flow valuation, relative valuation, and real option valuation. Value drivers should be directly linked to shareholder value creation. The determination of value drivers is a critical step in business process valuation since these drivers can either increase or reduce the value. The three main financial drivers of value creation are sales, costs, and investments. Earnings growth, cash flow growth, and return on invested capital are specific financial drivers. Profitability, growth, and capital intensity are considered as important drivers of free cash flow and value of a firm. Practitioners often view EPS as the most important part of value creation. Sales revenue and sales growth were also highly rated for measurement of performance. Value-based management focuses on the application of valuation principles. Stock price maximization is one of the significant factors for value maximization objectives. Maximization of shareholder wealth is the main objective of any value creating organization. The main value drivers for shareholder wealth creation are intangibles, operating, investment, and financial. The measures of shareholder value creation are Economic Value, Equity Spread, Implied Value, and CFROI. The major wealth creation measures are total shareholder returns, annual economic return, and market value added. Shared values are policies and operating practices which enhance the competitiveness of a company. In R&D organizations, intangible assets are key drivers of innovation and organizational value. These intangible assets generate shareholder value and corporate growth. The three methods to value proprietary technology are classified as the market approach, the cost approach, and the income approach. The major challenge in valuation is the development of reasonable assumptions for projections based on historical trends and the reasoning for assumption choices.

Keywords

Valuation; value driver; intangible assets; cash flow return on investment (CFROI); shareholder; financial statement analysis

1.1 Introduction

Value has different meanings in functional areas of management. In marketing, value is often perceived as customer value. Strategic management considers value chain as steps a firm performs to provide value for customers. In finance, value is the firm value which consists of fundamental value and shareholder value. Fundamental value is based on the present value of expected free cash flows. Shareholder value is firm value minus the value of outstanding debt. Firm value can be based on book value or market value. Market value is based on the stock market performance of a company. The most widely used practical measure of shareholder value is Total Shareholder Return which is based on stock price appreciation plus dividends. Companies create value by means of investing capital at a higher rate of return when compared to its cost of capital. Companies with higher returns and higher growth are valued more highly in the stock market.

Knowledge assets are organizational resources which are integral for company’s value creation. The strategic relevance of knowledge assets has led to the generation of new concepts and models for managing a company’s knowledge assets. Intellectual Capital has emerged as a key concept to evaluate the intangible dimension of an organization. The modern economic world is based on the foundation of new technologies, globalization, and increased relevance of intangible assets. Alan Greenspan, the former Federal Reserve chief, once remarked that virtually unimaginable a half century was the idea that concepts and ideas would substitute for physical resources and human brawn in the production of goods and services. Modern era is the world of knowledge economy. Organizations create value in totally new ways. In early 2000, Microsoft achieved market value exceeding the combined value of eight US giants—Boeing, Caterpillar, Ford, General Motors, Kellogg, Eastman Kodak Company, JP Morgan & Company, and Sears Roebuck which were built mostly on intangibles (Boulton et al., 2000). Value creation is often perceived as the future value captured in the form of increased market capitalization. The new global economy has led to the emergence of new business models where companies are combining both old and new economy assets. New processes and tools are required to manage the risks on account of new business models. The greatest challenge a company faces today is identification of the combination of tangible and intangible assets which creates the greatest amount of economic value. The complex interaction of a company’s mix of assets termed economic DNA creates or destroys value. In 2000, American Online’s book value was a miniscule 3.3% of its market capitalization.

1.2 Application of valuation

Valuation has significance in different areas of finance. It has relevance in portfolio management, mergers and acquisitions, corporate finance, legal and tax purposes. Valuation plays a vital role in corporate finance. The wealth maximization principle of corporate finance is embedded in the objective of maximization of firm value. The value of a firm is directly related to the firm’s financing, investment, and dividend decisions. Valuation also plays a critical role in corporate finance for financing decisions to raise funds for investment purposes. The pricing of IPOs are basically determined by the valuation process. Valuations of private companies are basically done for tax or legal reasons.

In portfolio management, the role of valuation is integral in fundamental analysis in which the true value of any firm can be related to the financial characteristics of its cash flows in terms of growth, riskiness, and timings. The fundamental value of a firm can be derived to understand whether it is under- or overvalued in order to facilitate long-term investment strategy. Valuation is also useful for technical analysis.

Valuation plays a pivotal role in merger and acquisition (M&A) analysis. Determining the value of target firm for acquisition is an important step in the due diligence process of M&A. The bidding firm has to decide on a fair value for the target firm before making the bid, and the target firm has to decide a reasonable value for the offer. The value of target from the bidder’s point of view is the sum of the pre bid standalone value of the target and the incremental value that the bidder expects to add to the target’s assets. The incremental value may arise from improved operations of the target or the synergy between the two companies. Valuation of the target requires valuation of the totality of the incremental cash flows and earnings.

1.3 Approaches to valuation

There are basically three approaches to valuation. Discounted cash flow valuation is based on the fundamental idea that the value of any asset is the present value of expected future cash flows on that asset. Relative valuation estimates the value of any asset by analyzing the pricing of comparable assets relative to a common variable such as earnings, cash flows, sales, etc. The contingent claim valuation employs option pricing models to measure the value of assets which have option characteristics. Discounted cash flow valuation consists of equity valuation and firm valuation.

In another perspective valuation can be broadly classified into earnings-based valuation, market-based valuation, and asset-based valuation. The earnings-based valuation (also known as discounted cash flow valuation) takes into account the future earnings of the business. The value of business depends on projected revenues and costs in future, expected cash outflows, number of years of projection, discount rate, and terminal value of business. Market-based valuation for listed companies and comparable listed companies are based on market multiples such as market capitalization to sales or market price to earnings. The asset-based value is based on the book value of assets net liabilities. The value of intangible assets like brands and copyrights are valued independently and added to the net asset value to get the business value.

In other words, valuation methods can be categorized as direct valuation method and indirect (relative) valuation methods. The direct valuation methods provide an estimation of a company’s fundamental value. The analyst, through direct valuation method, can compare the fundamental value of the company with the market value of a company. The direct valuation method consists of discounted cash flow valuation method and nondiscounted cash flow models like real option analysis. The company can be said to be fairly valued if the market value of the firm is equal to its fundamental value. If the market value of firm is lower than the fundamental value then it is said to be undervalued. If the market value is higher than the fundamental value then the firm is said to be overvalued. Relative valuation basically identifies whether a company is fairly valued relative to some benchmark group of companies in the same sector. In other words relative valuation method doesn’t give a direct estimate of a company’s fundamental value. Relative valuation is also known as comparable approach as the process involves identifying a group of comparable companies in the same sector.

The basic factor that determines a company’s fundamental value is its expected future cash flows. Relative valuation methods give a quick and simple way for analysts to understand the valuation of a company. Relative valuation methods are based on multiples which is a ratio between two financial variables. The numerator of the multiple is primarily the firm’s market price or enterprise value. The enterprise value is equal to market value of equity and debt net of cash.

Economic income or residual income method is an alternate model of valuation. Economic income models rely on earnings to estimate a firm’s fundamental value. This model is based on the premise that positive economic income leads to shareholder value creation.

1.4 Steps in value creation

Arzac (1986) suggests four steps for valuation of business units within a strategic framework:

1. Estimate the basic data for each unit—cost of equity and debt, debt capacity and tax rate, and the turnover, sales margin, ROI, and asset growth expected.

2. Set performance standards (required sales margin and ROI) and compare them against projected performance.

3. Estimate the value creation implications of the current strategy. Use return on investment (ROI) and financial leverage data to express the unit’s performance in terms of return on equity (ROE) and cost of equity and to estimate the unit’s contribution to the value of stockholder equity.

4. Evaluate strategic decisions having to do with the units, such as changes in production and marketing, alternative investment and growth rates, and harvest and liquidation options.

1.5 Value drivers

Every asset, financial as well as real, has value. The key to fundamental aspect of investing and managing assets lies in understanding of not only what value is, but also the sources of value. A value driver is a performance variable which impacts the results of a business such as production effectiveness or customer satisfaction. The metrics associated with value drivers are called key performance indicators (KPIs). Value drivers should be directly linked to shareholder value creation and measured by both financial and operational KPIs which must cover long-term growth and operating performance.

The three commonly cited financial drivers of value creation are sales, costs, and investments. Earnings growth, cash flow growth, and return on invested capital are specific financial drivers. Profitability, growth, and capital intensity are considered as important drivers of free cash flow and value of a firm (Miller et al., 2004). The key performance indicators also include financial measures such as sales growth and earnings per share as well as nonfinancial measures. The nonfinancial performance measures include product quality, workplace safety, customer loyalty, employee satisfaction, and customer’s willingness to promote products.

The determination of value drivers is a critical step in business process valuation since these drivers can either increase or reduce the value. Many researchers consider value driver as any variable influencing enterprise’s value. Value drivers include both external and internal value drivers (Jennergren, 2013). Value drivers are crucial for value maximization. The classification of value drivers are most frequently related to the analysis method of shareholder value and the concept of value-based management (Kazlauskiene and Christauskas, 2008). The major value drivers included by researchers consist of sales increase, margin of activity profit, tax rate, working capital, expenses of capital, costs of capital, period of competitive advantage, and return on capital. Relative indicators like turnover of capital, margin of gross profit are also called drivers.

The value drivers for a fast food chain consider customer satisfaction as key to profitability. The acquisition of new customers is an important performance metric for new subscription businesses like wireless telephone provider. As the company matures, the focus of these companies would be on managing the existing customers by providing them additional services. Increasing shareholder value is the primary goal of business. Corporations seek to maximize the value of shares over the long term. It is often observed that the market value (in terms of share prices) of many firms exceed the book value of firms. There are also firms in the market which trade below book value both in bull and bear markets.

Companies which cannot create fundamental value through operational efficiency and increase of cash flow cannot be successful in the market in the long run. Stock markets recognize those strategies of firms which are directed toward value creation. Shareholder value enhancement is possible through acquiring knowledge about sources of value creation and destruction in an organization. Basically value is created or destroyed at business unit level for a company. For instance, in the eighties, the tobacco business of Philip Morris consistently created value for the company while the beverages unit performed below the expectations. Companies often consider divestment of loss-making units in order to recover loss of shareholder value. SCM had to halve its investment in typewriter business due to years of value destruction on account of persistent losses and shrinking of market share.

Any value creation model must synthesize the link between strategy and shareholder value. The key determinants of value creation are present values of free cash flows, expected return on equity, cost of equity capital, expected growth rate and period in which company creates positive spread between return on equity and cost of equity. Companies create value when positive spread is generated between its return on equity and cost of equity. Growth opportunities through investments in assets at positive spread are also sources of value creation. On the other hand companies destroy value when the spread between return on equity and cost of equity is negative. It is often observed that many companies evaluate business units in terms of return on investment and pretax margin on sales rather than ROE Arzac (1986).

1.6 Empirical evidence on value drivers

The term value has attracted the interest of many researchers and economists. In scientific literature, value is referred as the best indicator of a firm’s performance results which integrates the drivers reflecting enterprise’s internal as well as external environment.

Executives often believe that EPS is the most important part of value creation. A survey of executive compensation by Frederic W Cook and Company found that EPS is the most popular measure of corporate performance used by companies. Another study by researchers at Stanford Graduate school of Business based on survey of 400 financial executives found that nearly two-thirds of companies placed EPS first in a ranking of most important performance measures reported to outsiders. Sales revenue and sales growth were also highly rated for measurement of performance. EPS growth is good for company which earns high returns on invested capital. At the same time EPS growth is not good for companies which have returns below the cost of capital. Mauboussin (2012) finds that the two popular measures of performance—sales growth and EPS have limited value in predicting shareholder returns since neither is both persistent and predictive.

The CEOs of companies must focus on objectives and rules to promote long-term value creation for shareholders. A US study (Carrott and Jackson, 2009) based on companies managed by CEOs with 4–8 years of service and having returns greater than 20% during the period 2003–2008 suggest that these CEOs focused on actions for value creation. Nordstrom focused on improvement of gross margin return on inventory investment as a driver for value creation. The company spends approximately $200 million on an improved inventory system. During the period 2000–2004, the inventory per square feet dropped from $63 to $52 while the sales rose from $5.5 billion to $7.1 billion. Adobe holds managers responsible for long-term performance by linking compensation to long-term stock performance of the company. During the period 2005–2009, the company achieved an average annual compound return of 28% to shareholders. But the top executives’ salaries were only 10–25% of the total compensation. The rest in terms of stock option and bonuses were linked to long-term value creation. John Deer improved the operating return on operating assets to a range of 22–26% by reducing working capital investments in receivables and inventory from 58% to 35% of sales. As a result the share price of Deere quadrupled. McDonald was able to improve performance by improved service and menu items.

Rappaport (1986, 1998) presented the model of relationship between value drivers and common goals of an enterprise within the framework of general enterprise management system. This study divided drivers into three groups: operational, investment, and financial. Scarlet (1997) classified value drivers into four categories of intangible, operational, investment, and financial. Research studies by Kaplan and Norton (1996) classify value drivers into financial, purchasers, employees, operational, quality, alliances, supply, environment, innovations, and society. Damodaran (1994, 2002) introduced the value creation model which highlights cash flow, capital cost, and expected growth period as the main value drivers. Value drivers can be divided into internal and external; financial and nonfinancial.

Pratt (1989) suggests that the analysis of qualitative drivers as well as the determination of their impact on value requires highest skills of a valuer which form up during many years of practical and research work. McKinsey value driver formula (Copeland et al., 2000; Koller et al., 2000) can be split into two parts, one for existing operations and one for growth projects. The return on new invested capital (RONIC) which refers to the rate of return on growth projects can be lower than the return on invested capital (ROIC) which is the rate of return on the existing operations.

1.7 Strategic models of valuation

Value-based management focuses on the application of valuation principles. In value-based management system, the components of the employees’ work should be identified and linked to profitability, growth, and capital intensity. The actual performance should be measured, evaluated, and rewarded in terms of targets for profitability, growth, and capital intensity.

Value creation is traditionally considered as a chain of activities. The field of corporate finance was revolutionized by introduction of mathematical models of capital asset pricing model and the Black Scholes Merton option pricing model. Value-based business strategy adapted by A. Brandenburger and Harborne Stuart applied mathematics to the evaluation of strategic decisions through mathematical linkages. Value capture model (VCM) defines competition in an industry as a tension between the value generated from transactions that a firm undertakes with a given set of agents and the forgone value it could have generated from transactions with other agents. Cooperative game theory could be applied effectively in studying competitive dynamics. VCM model of competition allows a firm to identify potential payoffs to investments in resources and capabilities supported by big data. The resources and capabilities which influence value are deployed with competitive intent (Ryall, 2013).

1.8 Stock price maximization

Stock price maximization is one of the significant factors for value maximization objectives. Stock prices are the most observable of all measures which can be used to judge the performance of a listed company. Stock prices are constantly updated to reflect new information about a firm. Thus managers are constantly judged about their actions with the benchmark being the stock price performance. Book value measures like sales and earnings are obtained only at the end of year or in each quarter. Stock prices reflect the long-term effects of a firm’s business decisions. When firms maximize their stock prices, investors can realize capital gains immediately by selling their shares in the firm. An increase in stock price is often automatically attributed to management’s value creation performance. At the same time, the stock price might have increased due to macro-economic factors.

1.8.1 Shareholder value and wealth creation

The concept of measuring and managing shareholder value is of paramount importance on account of the increasing relevance of capital markets and corporate governance. In the era of globalization of markets, investors have easy accessibility to raise funds. The shareholders of the company desire transparency in the operations of the company and place much significance to the corporate governance practices. Today no underperforming company is safe as always there is the threat of hostile takeovers. Hence the managers of firms have to perform to improve the value of the company. The criticism with accounting measures such as earnings per share (EPS) and profit or growth in earnings is that they do not consider the cost of investment made for running the businesses.

Shareholder is the main pivotal stakeholder or fulcrum of the business activity. Firms which don’t create value for shareholders faces challenges like risk of capital flight, higher interest rates, lower efficiency and productivity and threat of hostile takeovers. Maximization of shareholder wealth is the main objective of any value creating organization. The value perspective is based on measurement of value from accounting-based information while wealth perspective is based on stock market information.

Economist’s viewpoint suggests the firms create value when management generates revenues over and above the economic costs to generate these revenues (Armitrage and Jog, 1996). The economic costs are attributed to sources like employee wages and benefits, materials, economic depreciation of physical assets, taxes and opportunity cost of capital. Value creation occurs when management generates value over and above the costs of resources consumed, including the cost of using capital. A company which loses its value faces the daunting task of attracting further capital for financing expansion as the declining share price becomes a detrimental factor for value creation. In such a scenario, the company is compelled to pay higher interest rates on debt or bank loans.

Wealth creation refers to changes in the wealth of shareholders on a periodic (annual) basis. In the case of stock exchange listed firms, changes in shareholder wealth occurs from changes in stock prices, dividends, equity issues during the period. Stock prices reflect the investors’ expectation about future cash flows of the firm. Shareholder wealth is created when firms take investment decisions with positive NPV values.

The real or true value of a stock or intrinsic value includes all aspects of company in terms of both tangible and intangible factors which affect the value of a company and subsequently the perceived value of a share of stock.

1.8.2 Value drivers for shareholder wealth creation

Value drivers are variables which affect the value of the organization. The main value drivers for shareholder wealth creation are intangibles, operating, investment, and financial. Increase in shareholder value results from improvement in cash flow from operations. Value enhancement can also result from minimizing the cost of capital by focusing on optimal capital structure decisions. The value drivers for increase in cash flow from operations are higher revenues, lower costs and income taxes and reduction in capital expenditure. No company can maintain their operation and produce great wealth for its shareholders without stable and rising revenue which comes from customer.

The strategic requirements for higher revenues consist of patent barriers to entry, niche markets, and innovative products. The strategic requirements for lower costs and income taxes are scale economies, captive access to raw materials, efficiencies in processes of production, distribution and services. The strategic requirements for reduction in capital expenditure are efficient asset acquisition and maintenance, spin offs, higher utilization of fixed assets, efficiency of working capital, and divestiture of nonperforming assets.

The value drivers for reduction in capital charge are reduced business risk, optimization of capital structure, reduction of cost of debt, and cost of equity. The strategic requirements for reduced business risks are superior operating performance and long-term contracts. The strategic requirement for optimal capital structure involves maintaining a capital structure that minimizes the overall costs which optimizes tax benefits. Companies often adopt different strategies for value creation. Companies like Sony, Apple, and Microsoft often introduce new products for enhancing shareholder value creation.

1.8.3 Measures of shareholder value creation

1.8.3.1 Economic value

Economic Value (EV) as a performance measure has been popularized by multinational companies like Coca Cola, AT&T and Kellog. EV is calculated as net operating income after taxes (NOPAT) minus the capital charge. The sequential steps for EV calculation are as follows:

• Calculation of NOPAT

• Estimation of Capital Employed

• Estimation of Weighted Average Cost of Capital (WACC)

• Calculation of capital charge and EV.

Format for calculation of EV

Revenues−cost of sales=Gross Profit−Other Operation (income/loss)−Depreciation=Profit Before Interest and Tax−Income Tax=NOPAT

Capital Employed=Net Working Capital+Net Fixed Assets

Capital Employed*WACC=Capital Charge

NOPAT−Capital Charge=EV

1.8.3.2 Equity spread

Equity Spread is a variation of the EV measures. Equity spread is the difference between the ROE and the required return on equity (cost of equity) as the source of value creation. Mathematically, the equity spread is expressed as:

Equity value creation=(Return on equity in percent−Cost of equity in percent)*Equity Capital

1.8.3.3 Implied value

The implied value measure is similar to discounted future market value. This method is closely related to the DCF (discounted cash flow) framework. If the difference between implied value at the beginning of the year and end of the year is positive, then the management would have created value. Value would be created if the management’s decisions generate cash flows over and above the cost of capital and is able to sustain this performance over a long period of time. The implied value measure is based on forecasts of future by making proforma income and balance sheet statements over a period of time.

1.8.3.4 Cash flow return on investment (CFROI)

CFROI represents the sustainable cash flow a business generates as a percentage of the cash invested in the business. This measure can be interpreted as the internal rate of return (IRR) over the economic life of the assets. The difference between this IRR and cost of capital represents the value creation potential of the firm. The calculation of CFROI involves conversion of income and balance sheet items into cash and calculating cash flows after adjusting for inflations and adjustments for monetary or near monetary assets such as inventories. The estimation of the normal life of assets is made. The value of the nondepreciating assets at the end of the horizon is also calculated.

NOPAT+Depreciation=Real Gross Cash Flow.

The capital employed is considered as the initial investment. Then IRR is calculated.

1.8.4 Measures of shareholder wealth creation

Wealth creation measures are based on stock market and don’t require analysis of the financial statements of the firm. Hence these measures are applicable only to exchange listed firms and cannot be used for privately held firms. The price of a share of any company is basically considered to be the market’s expectation about the firm’s value creation potential. The higher the potential, higher will be the share price relative to the capital invested. Companies which create fundamental value in the operating performance are expected to create value in the market through rise in the stock prices.

The two major wealth creation measures are

a. Total Shareholder Return (TSR)

TSR is the rate of return earned by shareholder based on capital appreciation through price changes and dividends received. TSR enables measurement of a firm’s contribution to the overall capital gain and dividend yield to investors. Return on Investment (ROI), free cash flow, and growth in invested capital are the key value drivers of capital gains. Companies with higher returns on the invested capital are able to achieve stock price increases as these companies are able to invest more capital at high ROIs.

The annual TSR is calculated as the change in price plus any dividends divided by the initial price.

Mathematically, TSR can be expressed as:

TSR=(Pricet+1+dividendst+1–Pricet)/Pricet

b. Annual Economic Return

Annual Economic Return (AER) is based on a firm’s annual wealth creation performance. AER calculation is based on dividends and its timings and externally raised capital. The AER method involves estimation of the cost of equity based on the riskiness of the firm.

AER is calculated as a return by the firm after adjusting for dividends paid and external dividends paid and external capital.

1.8.5 Hybrid wealth creation measure

This measure involves measuring both the book value of equity and market value of equity. The difference between the market value of equity and book value of equity is called the net wealth created.

1.8.5.1 Market value added (MVA)

The most commonly used hybrid value or wealth creation measure is market value added. MVA involves adjusting all debt and equity to reflect capital market expectations about the firm’s future value creation performance.

Market value added represents the wealth generated by a company for its shareholders. It equals the amount by which the market value of the company’s stock exceeds the total capital invested in a company (including capital retained in the form of undistributed earnings).

Adjustments are required for negative changes to equity. The market value of a firm’s equity is obtained by multiplying the number of shares outstanding times the price per share. The market value of firm is calculated as the sum of the market value of all outstanding securities which consists of common shares, preferred shares, and debt. This measure is calculated by comparing the market value of capital (equity) with the adjusted value of capital (equity).

Market Value Added (MVA)=Market Capitalization–Total Common Shareholders’ Equity=Total Shares Outstanding*Current Market Price–Total Common Equity

Market Value Added for Investors=Market Value of the company–(Book value of equity+book value of debt)

1.9 Linkage between strategic management and shareholder value

The study by Bigler and Hsieh (2013) posits that the five elements of competitive strategy, innovation, profitable growth, strategy execution, enterprise wide risk management are necessary and sufficient strategy and management factors affect shareholder value.

The ultimate test of corporate strategy is to analyze whether strategic decisions creates economic value for shareholders. Value-based management (VBM) is used to assess firm value and shareholder value. According to the basic VBM model, the present financial value must be equal to the discounted future free cash flows from operations using the firm’s weighted average cost of capital as discount rate.

1.9.1 Value-based management

VBM is an approach to management whereby the company’s overall aspirations, analytical techniques, and management processes are aligned to help the company maximize its value by focusing management decision making on the key drivers of shareholder value (Ittner, 2001). Coca Cola is one of the pioneering companies with VBM principles.

1.9.2 Significance of shared value

Shared values are policies and operating practices which enhance the competitiveness of a company. In this concept, businesses have to focus on value with a societal perspective. Value is defined as benefits relative to costs. The approach to value creation has undergone transformational changes. Value creation is not just optimizing short-term financial performance. Companies like GE, Google, IBM, Intel, Johnson & Johnson, Nestle, Unilever, and Walmart aim to create shared values by focusing on the interaction between societal needs and corporate performance. The next wave of innovation and productivity growth in the global economy will be based on shared value creation. Porter (2011) suggests three key ways that companies can create shared value opportunities: (i) By reconceiving products and markets, (ii) By redefining productivity in value chain, and (iii) By enabling local cluster development. The concept of shared values focuses on societal needs instead of economic needs. Societal harms or weaknesses create internal costs for firms such as wasted energy or raw materials.

Societal needs in terms of basic needs like housing, nutrition, help for aging, financial security are the greatest unmet needs in the global economy. Innovative new companies like Water Health International use innovative water purification techniques to distribute clean water at minimal cost to more than one million people in rural India, Ghana, and Philippines. Excessive packaging and greenhouse gases are costly to environment and businesses. By means of reducing its packaging and cutting 100 million from the delivery routes of its trucks, Walmart lowered carbon emissions and saved $200 million in costs. British retailer Mark and Spencer’s overhaul of its supply chain with steps like stoppage of purchase of supplies from one hemisphere to ship to another is expected to provide cost savings of £175 million by year 2016 thereby contributing immensely to reduce carbon emissions (Porter and Kramer, 2011). Coca Cola had a goal of reducing its water consumption by 20% in the year 2012. Dow Chemicals reduced consumption of water by one billion gallons and had a cost savings of $4 million. This amount of water was enough to supply water to 40,000 households in US. Nespresso emerged as one of the fastest growing division of Nestle (over 30% since 2000) by redesigning procurement. The company redesigned procurement by working with growers, providing advises on farming practices, guaranteeing bank loans and securing fertilizers and pesticides for farmers. Johnson and Johnson through its employee wellness programs saved $250 million in healthcare costs. Hindustan Unilever through its Project Shakti Program is empowering underprivileged female entrepreneurs with microcredit and training.

1.9.3 Intangibles

In R&D organizations, intangible assets are a key driver of innovation and organizational value. The allocation and deployment of intangible resources is an important strategic decision for organizations (Pike et al., 2005). Intangible assets are identified as key resource and driver of organization performance and value creation. Researchers like Itami (1987) articulated the idea that intangible assets such as technology, accumulated consumer information, brand name, reputation and corporate culture are critical resources of firms and sources of competitive advantage. Hall (1992) divides intangible assets into intangible properties and intangible resources. Intangible property consists of knowledge related to legal ownership like patents, trademarks, copyrights, trade secrets, registered designs, brands, computer software, contracts, and databases. Intangible resources are formed by an individual’s experience, organizational processes, relational resources such as reputation, client loyalty as well as firm’s relationship. Intangible assets can be classified into human capital, process capital, and innovation capital. Intangibles are important value drivers in the R&D process.

The intangible assets consist of patents, skilled workforce, software, know-hows, strong customer relationships, brands, unique organizational skills. These intangible assets generate shareholder value and corporate growth. These soft assets provide competitive advantage for modern companies. Intangibles account for over half the market capitalization of public companies. Intangible assets absorb trillion dollars of corporate investments every year. Markets sometimes overvalue or undervalue the intangibles of a company. In case of undervaluation of intangibles, firms have to deal with high cost of capital which could lead to underinvestment in intangibles in future. The research by Federal Reserve economist Leonard Makamura finds that US Companies expenditure annually on intangibles is equal to the total corporate investments in physical assets. Financial service firms often invest substantial resources in product and service innovation.

The intangible assets can be categorized as follows:

Marketing-related intangible assets: Trademarks (Brands), trade names, service marks, internet domain names, noncompetition agreements.

Contract-based intangible assets: Licensing and royalty agreements, advertising, construction, service or supply agreements, lease agreements, employment contracts.

Technology-based intangible assets: Patented technology, computer software, unpatented technology (know-how), databases, trade secrets.

Customer-related intangible assets: Customer lists, order or production backlogs, customer contracts and customer relationships including noncontractual relationships.

Artistic-related intangible assets: Plays, books, magazines, newspapers, pictures and photographs.

Brooking (1996) identified market assets, intellectual property assets, human-centered assets and infrastructure assets as constituents of intangible assets. Sveiby (1997) suggested that the core components of intangible assets are internal organization structures, external organization structures and the competence of its personnel.

In the modern era of knowledge economy, the value of companies have shifted from the tangible assets of bricks and mortar to intangible assets such as patents, customer clients and brands. During the last few years, the brand value of Apple equaled a huge 80% of its market capitalization.

Pharmaceutical companies have spent huge amounts to create new brands. Regulatory changes have speeded up the process of branding in financial service sectors. Branding had played a key role in the reinvention and growth of IBM computers. During the dotcom crash period, IBM was well positioned as a voice of reason. A strong brand helps customers understand an organization and imparts a sense of mission inside the company. Free cash flows are the very blood of a corporation but intangible assets are its nervous system. The four core intangible assets are firm’s brands, relationships, productivity, and innovation capacity of its people.

1.9.4 Valuation of intangibles

The general techniques used for valuation consists of brand valuation, human resource valuation, valuation of research and development costs and valuation of patents and copyrights. The general methods used for brand valuation include market value of company’s shares, the difference between market value and book value, brand replacement value, difference between values of branded company and value of company selling generic products and present value cash flow method. The methods frequently used for valuing human resources mainly include balanced scorecard, competency models, benchmarking, business worth, and calculated intangible value. According to International Financial Reporting Standards, the cost involved in R&D has to be expensed in the same year in which it has been incurred. In the case of valuation of patents and copyrights, the full acquisition costs consisting of purchase consideration and related expenses are required to be capitalized. International guidelines direct companies to go through a more rigorous process of identifying and valuing acquired intangible assets. The International financial reporting standards (IFRS-3) advocates identification of more intangible assets, rigorous and detailed annual impairment test and requirement of purchase price allocation. The financial role of intangibles has become relevant as reflected in the valuation of brand and valuation of intellectual property