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Intellectual Capital

Moving beyond a broad-brush approach to dissecting the relationship between patents and innovation marks a big step forward. But patents certainly don’t tell the whole story. In today’s knowledge economy, many innovations are simply not patentable. Some of the most creative manufacturing and distribution companies-think Dell-won’t appear on any yardstick that tracks intellectual property. As a result, a lot of attention is shifting to other scales. Perhaps most notable is what’s often called “intellectual capital”-the sum total of the seemingly “intangible” knowledge, processes, culture, customer and supplier networks and other factors that can ignite industrial creativity.

Intellectual capital might be the hot zone of gauging innovation today. NYU’s Lev notes that in the manufacturing economy of the 1970s, the market-to-book ratio of S&P 500 corporations ran about 1:1. These days, it’s around 6:1, while high-flyers like Microsoft come in around 25:1-largely on the basis of their intellectual capital.

“It’s really mind-boggling when you think about this whole accounting machinery that ends up with a balance sheet that explains less than one-sixth of a company’s real value,” says Lev. “So we are talking here about an enormous asset which really is the engine of the success of companies and growth.”

Earlier this year, Lev compiled a Knowledge Capital Scoreboard for CFO magazine ranking 47 large chemical and pharmaceutical firms. He and portfolio manager Marc Bothwell of BEA Credit Suisse Asset Management analyzed each firm’s earnings for the past three years, as well as its projected earnings for the next three years. From the weighted average, or “normalized” earnings, they subtracted expected returns on tangible assets such as bond portfolios and physical equipment; the remainder, they assumed, represented knowledge-capital earnings.

For companies that are knowledge-rich, this kind of capital is a huge part of their success. Take Merck, considered one of the scientific leaders in drug development. In this analysis, Merck’s normalized earnings were $5.5 billion. Its physical assets were expected to generate $343 million annually, while some $624 million in financial assets were projected to earn $28 million. That left a whopping $5.1 billion a year attributed to knowledge earnings. According to Lev’s formula, this represents the return on intellectual capital assets totaling nearly $50 billion-which moved Merck to the top of the pharmaceutical pack, ahead of others with greater sales.

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