IT Value: Capturing The Intangibles

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September 22, 1997

IT Value:
Capturing The Intangibles

The value of technology investments has always been more difficult to gauge than other types. But that needn�t be the case.
By Anandhi Bharadwaj and Benn R. Konsynski
IW 500 slug ow do organizations place a value on enhanced customer relationships, improved brand image, quick response to demand for new products, and knowledge of market shifts and competitor moves? Though many organizations attempt to relate these goals directly to revenue, asset deployment, and costs, these are poor surrogates for the real implications. As the song goes, we may be lo oking for value "in all the wrong places."
While managers struggle to relate IT investments to profit measures, there is growing evidence that IT investments are creating substantial intangible value for companies, such as customer orientation and service, quality improvements, flexibility, and speed to market-all key strategic goals of users' IT investments.
Unfortunately, methodologies that link IT value to accounting measures of performance, such as return on investment, capture only IT's tangible value components, with little consideration for intangible worth. Though these measures may have worked well for typical industrial-age companies, they don't work for new knowledge-based companies, where IT-based processes and services are the primary value drivers.
One problem with the accounting measures: They look only at a company's past performance; they don't consider future profit potential. IT investments, however, are often made with a view to protecting a company's strategic options and to h aving the flexibility to rapidly introduce products and services in today's hyper-competitive markets. Focusing exclusively on the size of IT investments' returns ignores their more important contribution, namely, their effects on the risk of a company's income stream.
To get a true picture of IT's contributions to the bottom line, managers must focus on risk avoidance, growth potential, and strategic flexibility-all made possible by IT. For example, financial-services and insurance firms often invest in IT control systems that help prevent potential losses from things such as fraudulent claims or other misappropriations. Though these investments may be critical to a company's survival, they're seen only as costs.
To date, IT investment studies have focused mainly on relating IT spending to current profit levels. However, the contribution of capital investments must be assessed by considering their association with the level and risk of current and future profitability.
Because of the substantial learning curve associated with the uses of information systems, IT investments often take years to add value to a company and are more likely to be reflected in future profit streams. In the past, benefits from IT were measured strictly in terms of cost reduction, such as in reduced labor and increased throughput. Though cost-related advantages are still a major factor in IT investment decisions, users are focusing on IT's less-tangible benefits.
According to J.B. Quinn, professor of management at the Amos Tuck Business School at Dartmouth College in Hanover, N.H., decision making for IT investments has begun to resemble investment decisions in R&D projects, where engineering or quality metrics are often used with financial measures. As with other technological breakthroughs, information systems take several years to achieve payback, and company and industry indicators may show low or negative returns. Even when IT benefits accrue, it can be difficult to separate out IT's contributions because improve d results are typically achieved by pairing IT's benefits with supporting investments in such programs as reengineering and total quality management.
Frustrated by similar problems in evaluating R&D and other knowledge-based initiatives, economists and financial analysts have turned to market-based measures of performance for evaluating such investments.
True Worth
Unlike a balance sheet, which reflects a company's tangible assets only, the market value of a company's securities is the best indicator of profit potential, since it provides an unbiased estimate of future cash flows attributable to all the company's assets.
For example, integrated customer databases and data mining capabilities are the most valuable assets for direct marketers, but they don't figure as corporate assets. According to a report prepared by Arthur Andersen and Co. in 1995, "In successful companies, the value of such assets is growing as a proportion of total shareholder value." Thus, any premium over the balance-sheet valuation that the stock market places can be a reflection of the company's intangible resources.
As with R&D, if investments in IT serve as another source of intangible value, then new measures capturing the intangible value contributions of IT must be considered in evaluating IT projects. We recently conducted a study that attempted to measure the intangible value attributable to IT by using a market-based measure called Tobin's q.
Yale economist James Tobin introduced the q ratio in 1969 to be used as a predictor of a company's future investments. It compares a company's market value to the replacement value of all its physical assets. Since its introduction, academics and financial analysts have used it to explain a variety of phenomena, such as to gauge a company's intangible value. Researchers have exploited the relationship between q and intangible value to examine the effects of such factors as R&D, advertising, and brand equity on company performance.
The use of q f or measuring intangible value is based on the assumption that a company's long-term equilibrium market value must be equal to the replacement value of its assets, giving a q value close to unity. Deviations from this relationship (where q is significantly greater than 1) are interpreted as signifying an unmeasured source of value, generally attributed to a company's intangible value.
The use of q as an outcome measure for IT investments is appealing mainly because it better reflects IT's true contribution to business value. With rapid globalization and increasing competition, past IT investments are quickly losing their value, whereas inexpensive but focused IT investments are far exceeding their initial costs.
Forward-Looking Measure
Any evaluation of IT investments must be oriented toward future revenue-generation potential and associated risks, which a forward-looking measure such as Tobin's q is better able to capture. Our study examined the association between IT investments and Tobin 's q, using InformationWeek 500 data from 1989 to 1993. From this database, we selected those publicly traded firms for which data on other relevant variables was available from the Compustat database.
Results from our study showed that after we controlled for industry characteristics and other company-specific factors that could potentially affect q values, IT expenditures had a statistically significant positive association with q for each of the five years we analyzed.
The study also showed that over the five-year period, a 1% increase in IT investment was associated with a 0.37% increase in the q value, if all other factors were equal. Though academic research on this point has focused on linking IT solely to tangible value components, our study explored the neglected dimension of intangible value.
Chances are this will not end the ongoing debate about IT's value. Managers focusing on IT capital value may continue to be disappointed by their inability to reconcile the fully burdened investment with historic measures. Market measures of company performance reflect the impact of the investment against a goal of maximizing shareholder wealth.
Perhaps with the help of similar studies, IT managers may be better able to discuss IT investments' value with the shareholder community, explain expectations to the capital market community, spell out the impact of IT investment, bring a broader discussion to proposed IT investments, and improve the governance of timing and expectations of true benefits and realized value. Also, introducing into IT investment decisions the intangible value that IT adds to the technology's tangible value should help organizations further align investment in IT with strategic needs.
IT transforms strategic options and organizational practices, and the investment is profound when properly executed. So, too, are the tangible and intangible implications. As such, it's important that CIOs represent the implications of their organizations' IT investment and then convey to sen ior managers the systems' full capabilities. Only then will companies begin to value IT's true worth.
By Anandhi Bharadwaj and Benn R. Konsynski Anandhi Bharadwaj is an assistant professor and Benn R. Konsynski is the George S. Craft professor of business administration at the Goizueta Business School of Emory University in Atlanta.
See related story: " Buyer-Supplier Relations "

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