In May 2004 the UK government issued draft regulations to make operating and financial reviews (OFRs) a statutory requirement for quoted companies. Clearly, financial statements are no longer thought to tell enough of a business's story on their own.
Many resources used in the value-creation process are generated from intellectual capital (in the form of human, structural or relational capital). These knowledge assets don't appear on the balance sheet because they cannot be identified and quantified reliably. You can roughly gauge just how incomplete a company's financial statements are by considering the relationship between its market value and its balance sheet value, which is known as the market-to-book ratio.
Economic theory suggests that highly informative business disclosures improve the market's understanding of a firm's value-creation process and the economic risks it faces. This reduction in "information asymmetry" decreases the company's cost of capital by lowering the information risk premium. It follows that the lower the firm's cost of capital, the higher its market value, because the latter is the present value of expected future cash flows, discounted at the cost of capital. Looking at it the other way, deficiencies in disclosures about intellectual capital result in systematic undervaluation by investors.
Numerous studies have shown that the theoretical link between the cost of capital and the quality of disclosure applies in practice. The costs of both equity capital and debt capital are negatively associated with high levels of disclosure. Other empirical research has shown the value-relevance of voluntarily disclosed non-financial information.
Lev, a leading intangibles researcher in the US, has documented the market-to-book ratio of the Standard & Poor's 500 over the past two decades or so. The average figure rose from just over one in the early eighties to a peak of six by 2000, falling back to 4.5 by late 2003.
We looked at the market-to-book ratios of the FTSE 100 using the latest accounts available in early 2004. After excluding companies with negative book values arising from negative reserves, we found that the average ratio for the remaining 92 firms was 2.52. This meant that around 60 per cent of the firms' value was not reflected in the balance sheet. But, given the wide range of individual values we observed, it was the distribution of these ratios that was most revealing (see chart, above). The market values of 17 companies were lower than their book values--ie, they had ratios of less than one--while 12 firms had ratios of more than five.
There was a clear link between the market-to-book ratio of a firm and the industry in which it traded. The average ratios for the pharmaceutical and media companies in the sample were relatively high (5.6 and 4.4 respectively), which is not surprising given the knowledge-intensive nature of their industries. GlaxoSmithKline had the highest ratio we observed, with 10.94.
Firms operating in the financial sector generally had ratios at the lower end of the range, while the book values of all the insurance and real-estate companies were higher than their market values--ie, their ratios were less than one. Intellectual capital isn't of great significance to the value-creation process in these industries.
The size of the market-to-book ratio can be influenced by intellectual capital in two ways. Primarily, the ratio reflects the importance of intellectual capital in a company's value-creation process, but the quality of disclosure about its intellectual capital also has an impact. A low market-to-book ratio can be attributed to the relative unimportance of knowledge-based assets to a company and/or the fact that the company is bad at explaining the importance of such assets. …