The Effect of Intellectual Capital on Firms' Valuation: An Empirical Investigation with Reference to India

By Tripathy, Trilochan; Sar, Ashok Kumar et al. | IUP Journal of Applied Economics, July 2014 | Go to article overview

The Effect of Intellectual Capital on Firms' Valuation: An Empirical Investigation with Reference to India


Tripathy, Trilochan, Sar, Ashok Kumar, Sahoo, Debadatta, IUP Journal of Applied Economics


(ProQuest: ... denotes formulae omitted.)

Introduction

Firms' valuation approach differs across the stakeholders. The promoter, economist, accountant, trader and investor perceive firms' value differently. However, the persistent difference between the firms' book value and market value has been a fortified field of inquiry queuing from Ohlson (1995). The increasing gap between firms' market and book value across the markets has drawn a wide research attention to explore the invisible value omitted from financial statements (Lev, 2001 ; and Lev and Radhakrishnan, 2003). Examining over a period of 24 years, data on US firms listed in S&P 500, Lev (2001) reported that book value only captures 20% of firms' market value. Against this backdrop, it is understood that the firms' valuation is an important consideration for investors, practitioners and regulators. Further, market value has a more meaningful implication than the book value. The investor has to pay the price to the firm to own a part of the business regardless of what book value is stated. Thus, high market value of a firm provides liquidity, high growth, high market capitalization and profitability.

Financial analyst, investors and managers sought to identify the proxies that predict firms' value. A wide array of parameters have been used in the literature to measure the firms' value (Basu, 1977, Campbell and Shiller, 1988; Pastor and Veronesi, 2003, 2005 and 2006; and Fink et al, 2010). However, the Market-to-Book Value (MTBV) ratio is used as one of the most accepted standard measures in valuation literature. The present study attempts to fill the gap in the existing literature by empirically examining the relation between intellectual capital efficiency and firms' market valuation in India.

Literature Review

The MTBV ratio is widely used in the valuation literature in two very distinct ways, strategy and finance. The strategy literature views this ratio as an indicator of firms' performance, where it reflects the value that the market attaches to the common equity or net assets of a company (Ceccagnoli, 2009; and Lee and Makhija, 2009) and it also reflects the efficiency in asset utilization and future growth potential (Goranova et al, 2010). The MTBV ratio incorporates both historical accounting and forward-looking market indicators of firm performance; this provides a theoretical rationale for using the MTBV ratio as a measure of firm performance valuation (Lee and Makhija, 2009). On the other hand, finance literature emphasizes MTBV ratio as a proxy for risk measurement (Liew and Vassalou, 2000; and Griffin and Lemmon, 2002) and risk-reward linkage (Malkiel, 2003; and Fama and French, 2006).

MTBV offers a more tangible measure of a company's value than earnings do and hence it is evaluated by most conservative investors. A lower MTBV ratio usually means that the stock is undervalued or something is fundamentally wrong with the company. This ratio gives you an idea if you are paying too much for what would be left if the company declared bankruptcy. The persistence of excess returns earned by firms with lower price to book ratio indicates either that the market is inefficient or that the price to book ratio is a proxy for equity risk. In other words, if lower price to book ratio stocks are viewed by the market as riskier than firms with higher price to book ratios, the higher returns earned by these stocks would be a fair return for this risk. In fact, this is the conclusion that Fama and French (1992) reached after examining the returns earned by lower price to book stocks.

The high market value, compared to book value, suggests the presence of some unmeasured or unrecorded assets of the firm, which could be tangible or intangible in nature. There are a wide array of factors within and outside the firm influencing the market value of a firm over and above the book value. For instance, the deployment and efficient usage of intellectual capital in the firm is responsible for the firms higher market valuation. …

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