The current stock market crash dramatically demonstrates that the value of a stock is only worth what someone is willing to pay for it.  Stocks are purchased for many reasons, some for anticipated growth in stock price, others for expected dividend income, still others for a range of reasons (ecological, political or social).  All told, the buyers have a range of reasons for purchasing a stock.

I don’t know about you, but I don’t know anyone who has bought a stock because of the value of the company’s intellectual capital.  (OK, OK, inevitably a few people will be found who claim this was their rationale for a stock purchase. . . . . but give me a break, it will be a small number!)

The myth associated with all of this is the one that says that the value of a firm’s intellectual capital is equal to the market value of the company (its market capitalization) minus the value of the firm’s tangible assets (found on its balance sheet).

A brief bit of history may be of interest here.  In the early 1990’s two of the pioneers of the intellectual capital movement were Leif Edvinsson and Hubert St. Onge.  Edvinsson was the VP of Intellectual Capital for a Swedish Finance House and St. Onge was the VP of training for a large Canadian Bank.  In thinking about how to convince their respective executive management about the underlying importance of intellectual capital to their firm’s performance, they hit on the idea of equating it to financial value. . . . . . thinking that the financially oriented management would easily comprehend IC if it could be put into financial terms.  At that early stage in the understanding of intellectual capital, this idea had a comforting simplicity and seemed to offer an easy-to-understand explanation for a complex issue. 

As the myth spread throughout the intangibles community it picked up many proponents.  For example, Dr. Margaret Blair, an economist with the prestigious Brookings Institute, conducted an often-quoted study that quantified a shift in two elements, allegedly comprising company value, over a 20-year period.  By comparing Market Cap with Tangible Assets she showed that by the middle 1990’s the value of Intellectual Capital (measured as Market Cap minus Tangible Assets) had grown.  IC had come to comprise over 70% of the value of a firm!

In fairness, I too fell into the comforting trap of this myth, quoting the Blair study in one of my books.

But, if the myth were true, then (among other things) it would suggest that the recent decline in stock prices must be due to a spontaneous worldwide precipitous drop in the value of intangibles to business. . . . . . . . . . . . do you really think so?

Let’s do a brief examination of this formula:

                        Market Cap = Tangible Assets + Intellectual Capital

OK class, sharpen your pencils: 

Market Capitalization (the current share price multiplied by the number of shares outstanding) is determined by negotiations between the current buyers and sellers of the company’s stock in the open market.  Dollar values here are current and are based on market information about the company and expectations of its future performance. 

Tangible Assets: The value of the firm’s tangible assets (found on the balance sheet) is based on the asset prices negotiated by a different set of buyers and sellers from those involved in the stock market, in a different set of asset markets, at a different point in time, and with transaction prices that occurred in the past.

The only attribute shared by these two measurements is that they are denominated in dollars.  Otherwise they are apples and oranges (different buyers and sellers, different assets, different marketplaces, transactions in different time frames). . . . . . . .to use a lovely English word: they are incommensurable. . . . . . they cannot be compared because they are composed of dollars that are not compatible numbers, and cannot be added or subtracted from one another.

If there is anyone out there who still clings to the idea that the value of a firm’s intangibles can be calculated by subtracting the value of a firm’s tangible assets from the value of its Market Cap, I hope the recent vertiginous slide in stock prices will cause you to reconsider. 

While this myth may have a comforting simplicity to it, it is nevertheless a myth and simply not true.