Management of public corporations has had a rough decade. Between recent corporate scandals, financial crashes and lingering volatility in public markets, and mass layoffs occurring seemingly every week, public companies seem to have lost some of their luster. Why is this? More importantly, how do public companies in today’s market move past this? The answer, surprisingly, may lie on the corporate balance sheet – or, rather, just off of it.
If you peruse the 10-Ks and public statements of many of the world’s largest companies, you’re likely to hear a common refrain: “Our most important asset is our people.” This seems obvious on the surface. No matter what kind of business you are in, your company is helpless without employees – oil doesn’t pump itself for ExxonMobil, Facebook doesn’t code itself, Apple’s products don’t develop and sell themselves. Even in this increasingly automated and digitized modern economy, no company can operate without the human component.
How well do companies recognize this fact? Here’s a challenge: take a look through a given 10-K and count the number of times “people” appear in it. Despite the pervasive statement that “people are our most important asset,” ‘people’ don’t appear as assets on the 10-Ks of any public company in the US. If anywhere, they appear on the liability tab: payroll, pension liabilities, etc.
People do not appear as assets on the balance sheet because accounting, as a rule- and tradition-bound pursuit, has never had a reason or rule for doing so. Corporate accounting is largely governed by the Generally Accepted Accounting Principles (GAAP), a set of rules and process for the valuation of corporate assets for disclosure in public financial reports. The GAAP is largely a product of the early 20th century, when most large companies (for whom public disclosure was required) were heavy industrials. For these companies, the bulk of their value was located in physical assets: production plants, mines, trains, ships, etc. Labor was typically interchangeable and performed relatively simple tasks (shoveling coal, operating a train, etc.). As such, companies could base their value fairly accurately upon the total value of their physical assets.
As the 20th century came to a close, the rise of personal computing, the internet, and the slow but steady shift in the US from output to services complicated the process of valuation. By 1980, services made up 80% of the US economy’s “value added.” By 2012, the service sector (things like finance, entertainment, and health) made up more than three quarters of all economic activity in the US, and employed more than 80% of all US workers. Meanwhile, manufacturing and other capital-intensive industries declined.
As manufacturing and heavy industries declined relative to services, the traditional approach to corporate valuation has lost its relevancy. The GAAP focuses on physical assets and capital goods; in a service or knowledge economy, physical assets make up and increasingly tiny share of the actual value of a company (what capital goods does Google possess?). More importantly, as the shift from heavy industry to services occurred, the source of company value shifted from physical assets to employees themselves. The advisory firm Ocean Tomo estimates that in 1975, 80% of the value of the S&P 500 lay in firms’ physical assets; by 2010, however, 80% of the value in the S&P 500 was tied to intangible assets. This is crucial. Unlike physical assets, intangible assets (intellectual property, brands, research and development, marketing, etc.) are created by and stay within the human component of the business.
Unfortunately, the accounting profession has not kept up. Despite the wholesale shift in value drivers, accountants continue to 20th century accounting methods, overstating the value of physical assets while ignoring the positive contributions people make to a company’s value.
The lack of human-focused metrics on a balance sheet has had a variety of negative impacts on the modern business environment. If Ocean Tomo is to be believed, and up to 80% of a given company’s value exists off balance sheet, then investors and financial traders are forced to fly 80% blind. This can create huge swings in share prices for very little reason. If managers only see employees valued as a liability they are more likely to cut costs through layoffs and restructurings, ignoring (or blind to) the loss in employee assets. This results in atrophied workforces, slower recoveries, and unnecessarily high unemployment.
A large part of this is due to the lack of valuation of “human capital” in traditional accounting methods. However, an equally important challenge lies in the technical challenge of quantifying the value individual employees bring to a firm. How exactly does one value the human component of a business? While things like “brands” and “intellectual property” can be roughly quantified (there being active markets for both), how does one value an R&D or marketing function?
Academics, accountants, and company executives have been struggling with this problem for years. Recently, a handful of international companies have begun to systematically work their people into their balance sheets. Infosys, a major Indian software company, has been systematically quantifying and publicly reporting its human capital for four years. Their method, known as the Lev-Schwartz model, calculates today’s value of future compensation to employees at various ages and experience levels. In addition to publicly reporting the value that Infosys places in their employees, this allows managers and investors to track metrics such as “return on human resource investment” and “HR value per employee. While imperfect (relying upon compensation rather than value-added), this approach is a great step forward for public companies.
Investors have begun to take notice as well. Researchers at the Wharton School recently determined that companies listed on Fortune Magazine’s “100 Best Places to Work” routinely outperformed standard benchmarks. A number of funds, including HIP Investor, have begun to explicitly identify and screen for companies that place a premium on developing their human capital. Whether this marks the beginnings of a major shift in investing and management remains to be seen, but the benefits of a more careful accounting of human capital should be obvious.
By putting the true source of a knowledge-based company’s value on the balance sheet under assets (rather than solely under liabilities), both managers and investors can have a more transparent view of a company’s value. This can lead to a more efficient and less volatile financial system, better decision-making from managers, and a more human-centric market overall. The technical and systemic challenges to achieving this are significant, but companies like Infosys have shown that they are not insurmountable.