The Great Disconnect: Balance Sheets vs. Market Value

Wriston, Walter B.


"We must measure what is measurable and make measurable what can not be measured." --Galileo

Almost from the beginning of recorded history, man has attempted to take the measure of things: the passage of time, the size of things or the distance to some location. Indeed, some historians have suggested that the eminence of measurement must rank among the major achievements of mankind.

Our reliance on measurement in our daily life is so pervasive that we hardly notice, or even reflect upon, how much we rely on the speedometer in our car, the time on our watch, Government figures on the GDP or an astronomer's discovery of the distance to some newly discovered star.

Because there may be money to be had, many attempts have been made to link one set of data or another with the market value of a given stock. There are those who look at corporate results as revealed by GAAP accounting and compare those stated values with the market value and declare that the market is a huge bubble or even proclaim the market suffers from "irrational exuberance." Corporate CEOs whose corporation reports record accounting earnings, sometimes watch their stock price decline and complain the market is totally unreasonable. There are others who look at return on invested capital and note that the so-called old economy companies usually have to invest large sums in plant and equipment thus reducing their return on capital, while some of the new economy companies have to invest far less and thus their return on capital soars. There are numerous other theories, but they are all spawned by the fact that it is clear that market values do not appear to be based on six-month-old annual reports or even last week's 10Q. Something else is going on. The talking heads on the evening news who explain why the market went up or down add little to our knowledge of economics, but a great deal to the art of creative writing. Some years ago Nobel winner, James Tobin, created what came to be called the Tobin Q in which he indicated that the best yardstick of market value was the replacement book value of a company. In short, the replacement cost of corporate assets should have an equilibrium relationship with their market value. In the height of the Industrial Age, many agreed with Professor Tobin. Since his position was originally put forward, the world has changed and argument can be made that the Tobin Q is no longer a relevant way to measure the reasonableness of a company's market value in the new economy. As Robert Solow once wrote: "...there is a lot to be said in favor of staring at the piece of reality you are studying, and asking just what is going on here?" [1]  When unrecorded intellectual capital becomes the driving force in the economy, it is clear that book value and some of the old rules may not have the same relevance they once had. It is not unlike trying to measure the speed of a computer by the old industrial measures of pounds per square inch or revolutions per minute, both of which were very valid in the machine age. When I was a young lending officer at Citibank, my boss told me always to check the freight car loadings in Chicago which he said represented the best index of how the economy was performing. It was a good index at the time, but not of a great deal of use today. Even though the world has changed, there is a natural desire to hang on to yesterday and to embrace the familiar. Although numbers look and are definitive, few bother to look behind them to see how they are constructed.

We have a mixed bag in this country when it comes to measurements of all kinds. In the physical world, the United States has been an English island in a sea of metric measurement for years. Our corporate accounting also is different from that in other developed countries as are our basic units of measurement. Sometimes we use two different systems in the same sentence or on the same can of soda. We measure our soft drinks in ounces, but the fat in them is recorded in grams. Sometimes this quality produces serious consequences. The confusion between the kind of metrics used in controlling the thruster of a space vehicle caused the loss of a $125 million space craft in September 1999 as it was approaching Mars. The NASA controllers believed that the thrusters used to alter the direction of the craft were calibrated in metric newtons, while the builder had specified that they were calibrated in pounds. The difference was undetected for months and when the final adjustments were made to the flight, the space craft veered off course by 60 miles as it approached Mars. No one knows its fate, but it either crashed or is orbiting the sun. The director of the Jet Propulsion Laboratory which was in charge of the mission said: "The real issue is not that the data was wrong. The real issue is that our process did not realize there was this discrepancy and correct for it." [2]  That statement ranks right up there as world-class spin control. The same could be said for a lot of accounting data: it may be correct as far as it goes, but it may miss that target of useful information by a wide margin. Indeed I do not know a CEO who would attempt to guide his or her company's destiny based solely on the accounting numbers produced by GAAP, even though the dictionary definition of corporate accounting is "to recognize the factors that determine its true condition."

In the scientific world there has been a coming together of nations to produce some standards. This has been a long and divisive process. The modern metric system owes much to the Committee on Weights and Measures of the French Academy of Science in the early 19th century which was headed by the astronomer Jean Charles Borda. Their basic decision was to use a base of ten and that that unit would be used to derive volume and area. The length of the unit, later named the meter, was measured by a fraction of the arc of a meridian.

This pioneering work furnished the framework on which is built much of modern physical measurement. More than one hundred years later the General Conference on Weights and Measures, met in Paris in October 1960, and gave the name International System of Units to the metric system "based on the meter, unit of length, the kilogram, unit of mass; the second, unit of time; the ampere, unit of electric current, the Kelvin, degree of temperature; and the candelabrum, unit of luminous (light) intensity." [3] 

The system has continued to evolve as more and more nation states join the Treaty. But there is no such Treaty, or agreement, on how to measure the economy, or corporate performance, even though we are inundated with data that purport to tell us how we are doing, and furnish the basis for government action in the economic arena. The numbers we do see are not always a good guide. Nicholas Eberstadt has commented that: "Where unshakable traditional beliefs or passing superstitions played official roles in the past, we now witness overconfidence based on a false precision...Where antique despots surrendered to the temptations of numerology, the modern statesman proudly succumbs to the allure of 'quantophrenia' -- an idolatry of numbers no less unreasoning, and no less poorly suited for promoting the commonweal, than its precursor." [4] 

With the advent of the Industrial Revolution it was necessary for man to devise some kind of record keeping that was more sophisticated than that required for a one-or-two person farm. Merchants in those days had no knowledge of books of account and often recorded transactions on pieces of paper which they stuck on the wall. Historian Fernand Braudel tells us that the first known evidence of an accounts ledger dates from 1211, in Florence, but it was not until 1517 that double entry bookkeeping was in general use. [5]  As economies grew and prospered, first dozens, then hundreds, and then thousands were employed in a single enterprise and an accounting system had to be devised, not only to keep track of what had happened, but also to permit managers to make informed business decisions. Centuries later there is still no accounting system that has total global acceptability either for business or for governments.

In the United States there are thousands of accounting rules, and they are constantly changing. On the other hand, in the physical world, when one says that something is ten meters long, all the world knows that they have received a universally accepted measure. During the great inflation in the American economy when the price level rose more than 12%, major corporations were forced to publish up to five different numbers for earnings per share, so that in the end investors had a plethora of data and little or no information about the business. As inflation abated the number of EPS calculations shrank until we arrived at the current situation.

Matters affecting accounting have never moved very fast. About the time Columbus set sail, a monk named Luca Pacioli published a book on double entry bookkeeping that is often credited with popularizing this practice. Even earlier, one Ragusan Cotrugli had published a similar work in 1458, and a second edition was published 100 years later--the fact that the second edition was unchanged after a century established a precedent of speed in accounting changes that is still the norm today. There were several big firms, by the then standards, that still used single entry bookkeeping well into the 19th century. The Dutch East India Company and the Sun Fire Insurance Office of London were two of these.[6] 

In today's information/network economy, the importance of knowledge workers is raising rapidly, but the measurement of their output has not kept pace with their importance. Measuring productivity of knowledge workers is primitive at best and downright misleading at worst. Huge sections of the economy are left out altogether. So far, we can make rough judgments about the productivity of bank loan officers or insurance underwriters, but we have no real metrics in the service sector. "Work on the productivity of the knowledge worker," Peter Drucker has written, "has barely begun."

"In terms of actual work on knowledge worker productivity we are, in the year 2000, roughly where we were in the year 1900, a century ago, in terms of the productivity of the manual worker." [7] 

The government figures, such as they are, cover less than 50 percent of the service workers in America. So when we read in the papers that productivity goes up or down it does not mean very much, since most Americans work in the service sector and their productivity is either not measured at all, or measured, as bankers were until late in 1999, by assuming that their productivity increase was zero and output rose only as a function of the number of hours worked. This method of computing output solely on the basis of input affects about 25 to 30 percent of the service business. [8]  The people who produced these numbers on productivity in banks walked by, and often used an ATM for their banking needs, but did not make the connection to productivity.

Since knowledge workers constitute more than half of our work force, improving their productivity is the linchpin upon which hangs the future prosperity of the nation. At the end of the day this means we have to find metrics that measure quality as well as quantity.

For example: Is a loan officer who makes a lot of loans and has a few defaults more or less productive than a lender who makes a few loans with no defaults? We have no agreed upon measures. Indeed there is a clear disconnect between what is traditionally measured and what is important. The world simply moves faster than those who measure it.

On another front, everyone from Main Street to Wall Street watches the inflation numbers. If the number is going up, we assume the Federal Reserve will take action. With so much riding on the veracity of the numbers, it was vital that a full review of their accuracy be instituted.

Accordingly, a Congressional Advisory Commission on the Consumer Price Index, chaired by Michael Boskin, was formed and after study reported that the CPI overstated the change in the cost of living by about 1.1 percent per year. This number seems small, but compounded over time, the effects are enormous.

For example, instead of falling by 13 percent, real hourly wages have really risen by 13 percent from 1973 to 1995. This is a mind-bending change that affects millions of people.

With about one-third of Federal budget outlays indexed to the cost of living, as are income tax brackets, the distortion between the numbers reported and the real world is huge.[9]  Another example of how the public data conceal reality is America's savings rate or lack of one.

Many analysts look at a nation's savings rate in predicting how its economy will unfold. For example, a low savings rate may foretell a scarcity of capital that could cramp the growth of the economy, while a larger rate portends ample money capital for expansion.

Many commentators have deplored that Americans don't save enough money and that our savings rate is said to be low as compared to other nations. Sometimes the savings rate is said to be negative. While the official numbers seem to confirm this story, it is the way these numbers are put together that assures the result. Until last year, government employee pensions were counted as government savings instead of being, like private pensions, in the household savings column.

The press reports on the lack of savings in America often run in juxtaposition to a story that the inflow of money to mutual funds has just hit an all time high, that the purchase of new homes (many peoples' principal asset) continues apace, that the IRAs and 401Ks are bulging with cash and that many corporate pension funds are over funded.

All of these events, plus the purchase of consumer durables represent savings by Americans and constitute a direct disconnect from the official savings number which is derived by computing savings as the proportion of disposable income individuals set aside.

Measurement in the private sector is little, if any better. The companies in the Industrial Age that spawned our current accounting rules had huge sums invested in hard assets--things that you could feel and touch and count -- like buildings, factories and inventory. In the new economy, intellectual capital is far more important than money capital, but so far it goes mostly uncounted in the balance sheet of our corporations because it is largely ignored by the writers of accounting standards. Examples abound, but to cite just one example, the value of patents is nowhere to be seen on our corporate balance sheets. This is not a trivial number. The best estimates of the value of these patents range from $115 billion to one trillion, and the number of patents filed each year is exploding. Ten years ago, Microsoft had one patent, while today it has somewhere around 800 while the other companies in the Valley like Intel, Dell, Novell, Sun and Oracle have increased their patents by more than 500%.[10] 

While the American accounting profession has now produced about five thousand pages of accounting rules, Robert Elliott, a partner of KPMG, has pointed out that:

"At best, today's financial statements are an obsolete product. Relatively unchanged over the last 100 years, financial statements were designed to describe industrial-era assets inventory, machinery, buildings and land. Post-industrial enterprises run on intangible assets, such as information, research and development, brand equity, capacity for innovation and human resources...Yet none of these appear on the balance sheet."[11] 

Today there is a debate about how to handle "goodwill" among the various accounting authorities of the world. One school holds that it should be written off against earnings, which is another way of saying intellectual capital or the worth of a brand name like Citibank or Coca-Cola has no value. On the other side of the debate is the marketplace. And the verdict of the market is loud and clear. Microsoft, for example, which has trivial fixed assets, has a market cap exceeding that of the big three automobile companies put together. This being so, it becomes increasingly hard to argue that intellectual capital has no value.

The old guard will say that this view is just a way of measuring hot air and not real assets, even thought many of the so-called real assets are rusted hulks in the scrap yards of history, while the firms based on intellectual capital like AOL are propelling companies into the new economy.

As bad data produce bad results, both the public and the private sector are in need of new metrics for a new economy. So far there has been little progress in this direction as there is a huge vested interest in the familiar and the known. But reality is beginning to sink in and there are scattered efforts to come to grips with the need for new metrics.

There is no doubt that an essential factor in the success of the Industrial Revolution was the use of accounting to permit the management of huge corporations, but the old rules measure yesterday and usually only a point in time. Like the number of car loadings in Chicago, their usefulness has come and gone.

Today, investors and credit grantors want, need and can get an almost constant stream of useful information. Audited financial statements have their place in the stream of data, but the current accounting rules now prevent a company from publishing a cash flow per share number, data which many managers believe is vital in running a business. As Robert Elliott observes:

"Financial statements are assembly-line Model T's when what is needed are instruments designed to client-specific management criteria and performance indicators, such as measures of customer satisfaction, product and process quality, innovation, new technology skills, and global business know-how."[12] 

The pace of change is now so swift that no bureaucracy, public or private, can keep up. As the huge disconnect between markets and accounting results becomes obvious, efforts both in the public and private sector are beginning to attack the problem of metrics.

The Government has made a few modest changes in establishing a retail index to take partially into account and measure the explosion of e-commerce. The new index, initiated in March of 2000, measures products sold on the Net, but omits services such as on-line brokerage and travel bookings where much of the action is. But the complexity of attempting to measure the new economy is enormous. The players change, the rules change, and the output changes. Despite all the mergers that have taken place, there are far more players in the game than ever before. In Michael Boskin's words: 'Back when we had very few products being made by a small number of manufacturers, we needed a lot less detailed information, and it was easier to come by."[13] 

In the private sector there are many initiatives designed to create new metrics to measure the economy. One is a joint effort of Forbes, Ernst and Young's Center for Business Innovation and the Wharton Research Program to create some kind of a value index. With intangible assets apparently playing such a huge role in stock valuation, research is needed to try to determine what factors are driving our stock values.

Although the project is in its infancy, many of the tenets of conventional wisdom are falling by the wayside. One of the leaders of the project reported that: "Perhaps the most amazing result of our research is that two intangible asset categories--use of technology and customer satisfaction--had no statistical association with market value."[14] 

Another group consisting of the Sloan School of Management at the Massachusetts Institute of Technology and the consultants of Arthur Andersen are working to find a way to value intangible assets. The scope and pervasiveness of the problem is now becoming evident to all. As the co-chair of the effort put it: "Even the Coca-Colas and Disneys of the world are actually creating most of their value from assets that don't appear on their balance sheets."[15] 

Another initiative in creating new measurements for business was undertaken by Professor Baruch Lev of New York University. In his scenario, he has devised a way to measure the earnings impact resulting from knowledge-based activities.

Using his metrics, Professor Lev has constructed a chart showing knowledge capital of dozens of firms derived by computing the discounted present value of future knowledge earnings.[16] 

As the methodology gets refined, more and more companies will recognize that measuring knowledge capital will become even more important than measuring physical capital. This will apply to every occupation. All of the farmers growing produce, people driving trucks or making durable goods will be supported and enveloped by the network/information revolution, so that the urgency of new metrics for both the old and new economy is manifest across the board.

Many accountants are far from comfortable with these new concepts. They like things that they can touch and feel, things that have a clear cost that can be verified. One can count physical inventory, one can dig back through the records to find what an asset cost, but the concept of value raises huge questions because value is an intangible concept. Every sector of society is impacted.

Banks, for example, which like to have collateral for their loans, are increasingly faced with the dilemma of what constitutes good collateral. Some major banks such as BT Commercial, now part of Deutsche Bank, have lent hundreds of millions of dollars to companies and taken as collateral the firm's trade names and patents.

The law has progressed to the point where the banks are able to obtain a perfected security interest in these intangible assets.

This new kind of lending spawns a new kind of appraiser: value appraisers, who give the banks an appraisal of the value of intangible assets so the loan officers can make a judgment about the size of the loan.[17] 

BT Commercial is not alone, and some of these loans are syndicated with many other banks. All of this moves such valuations from the conference rooms of "think-tanks" to the real world of corporate finance.

Efforts to come to grips with the value of intellectual capital are not confined to the United States. The Swedish consulting firm Celemi has developed what they call the Intangible Assets Monitor. Their approach is somewhat different, but aims at the same result as other efforts, that is to put a value on intangible assets.

One big Swedish insurance company, Skandia, is now using, both internally and with the public, a set of metrics they call the Business Navigator. The company now publishes a report on its intellectual capital as a supplement to its regular annual report.

It took centuries for a universal system of measuring to evolve in the physical world. Measurement moved from using various parts of the human body from the foot to the fingers until the metric standard was in general use. From the late 18th century until the middle of the last, France was the custodian of a specially constructed bar of metal kept at zero centigrade bearing two engraved fine scratches exactly one meter apart. By 1960, a meter was defined by wavelength of radiation produced by atoms of krypton-86.

No such precision will ever be possible in the economic world as the conditions to be measured change over time. Despite that difficulty it is becoming increasingly evident that nations need a whole new chart of accounts and that business needs new methods to measure the new economy.

Since it took centuries to get a generally accepted system of measurement in the physical world, and even then one that is largely ignored by many people in the United States, it seems clear that there is little hope of conforming our official accounting system to the realities of the information/network economy before the next phase of our economy occurs. What to do? There is clearly a massive disconnect between corporate accounting and the value the market puts on a corporation's stock. Even if you do not believe in the efficient market theory, it is clear that the market is creating real time values at odds with the conventional measures used by analysts. In this situation Carver Mead's famous admonition to "listen to the technology" could be paraphrased to say "listen to the market." The market is saying that our current GAAP accounting while useful, is far from reflecting current reality in the network/information economy. While regulators and CPAs continue to debate new rules, it is clear from past history that if corporate managements want to get their story out of how value is being created some kind of supplement detailing the company's intellectual capital is needed. Unlike the Scandinavian example which is basically concerned with the environment, this would have a different emphasis. Since intellectual capital is the driver in the new economy, this information must be given equal prominence with the GAAP financials, so that analysts and the public will get more of the data they need to make value judgments. Such tabulation, while different for each company, might cover some of the following points:

1) Last year we filed for 78 patents, had 15 prior filings granted and were able to license out eight patents to others creating a stream of income of $230,000.

2) Since constant learning is the only road to survival in this economy, we conducted 10,000 hours of training for our staff. Some 37% of all employees got some form of new training last year.

3) To keep the new ideas flowing, we hired 350 new people last year. Some 62% of the new hires had a master's degree or its equivalent and almost 50% had had prior business experience.

4) Some 40% of all our products and services have been introduced during the last five years, so that the output of our R&D continues to be good.

5) So far 60% of our departments have gone through the six sigma process and we will complete the rest of the departments next year.

6) Our personnel turnover rate fell to a new low.

This is just a sample of what a page might look like and clearly can be expanded and tailored to specific companies. Whatever the content of the list, one thing is clear: It is intellectual capital that drives the new economy. It follows from this that successful corporate managers must know that the company's real competition in the marketplace is not the ones they have been familiar with for years, but the vital competition now is for the men and women with brains to survive and prosper in the new economy. If all the brains go to one segment of the economy, or to one company in your industry, but not to yours, then it does not really matter who your nominal competitors may be, you will already have lost the race. This being so, corporate reports should reflect this reality.


[1] Solow, Robert M., "How Did Economics Get That Way and What Way Did it Get?," Daedalus, 126:1, Winter, 1997, pp 39-58, p 56

[2] Pollack, Andrew, The New York Times, October 1, 1999

[3] Klein, Herbert Arthur, The Science of Measurement, Dover Publications, 1974, p. 24-25.

[4] Eberstadt, Nicholas, The Tyranny of Numbers, AEI Press, 1995, p. 2-3

[5] Braudel, Fernand, The Wheels of Commerce, Harper & Row, 1979, p. 572-3

[6] Braudel, Fernand, The Wheels of Commerce, Harper & Row, 1982, p. 574-75

[7] Drucker, Peter F., Management Challenges for the 21st Century, Harper Collins, 1999, p. 142

[8] See National Research Council, Information Technology in the Service Society, National Academy Press, 1994, for a full discussion.

[9] Wall Street Journal, December 5, 1996

[10] Rivette, Kevin G. and Klein, David, Rembrandts in the Attic, Harvard Business School Press, 2000, pg 4

[11] Newsletter of Stan Ross Department of Accountancy of the Zicklin School of Business, Baruch College, Vol. 1, No. 2, Spring 1999

[12] IBID, Newsletter

[13] Wall Street Journal, March 2, 2000, pg. A2

[14] Forbes, ASAP, April 2000, pg. 142

[15] Boulton, Richard, as quoted in Business Week, Feb., 7, 2000, pg. 6

[16] See the magazine CFO, Feb. 2000, pgs 52-62 for Prf. Lev chart and description of methodology.

[17] See the November 2000 issue of Strategic Finance, an article by Alfred M. King, pg. 3

  • The document was created from the speech, "The Great Disconnect: Balance Sheets vs. Market Value," written by Walter B. Wriston for the Cap Gemini Center for Business Ernst & Young Innovations Conference on 2 October 2000. The original speech is located in MS134.001.014.00012.
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