The Effects of Economic Value Added and Intellectual Capital on the Market Value of Firms: An Empirical Study

Abstract

Roos et al. (1998) maintain that firm value is composed of financial capital and intellectual capital. According to current Generally Accepted Accounting Principles (GAAP), however, intellectual capital is seldom capitalized in financial reports, and the cost of equity capital has been neglected in deriving accounting earnings. This study extends Ohlson's model by adopting Economic Value Added (EVA®) for excess earning abilities and adding intellectual capital for firms listed on Taiwan Stock Exchange. The research sample comprised 14 firms in traditional industries (42 observations) and 23 firms in the electronic industry (67 observations), with a total of 37 firms (109 observations). The research results show residual income based on EVA® is no better than that based on current GAAP in its capacity to explain variations in a firm's market value. Moreover, we also find intellectual capital does provide incremental information for the evaluation of stocks. Introduction The participants in capital markets are deeply concerned with the performance and valuation of firms. The development of the knowledge economy coupled with rising globalization, market liberalization and increased competition has pushed many firms to invest in innovation and in value creation activities (such as research and development, manpower training, new technology acquisition or advertisement, etc.) in order to sustain their leadership in the market. However, intangible assets that result from these valueadded investments, such as brand loyalty, human resources, sales channels, etc., are seldom recognized in balance sheets. Under current Generally Accepted Accounting Principles (GAAP) much of those expenditures are immediately expensed, since their economic benefits are highly uncertain and are difficult to measure. Such accounting procedures cause traditional accounting measurements to deviate from the 'real economic situation' and consequently to reduce the usefulness of the information provided by such financial statements (Lev & Zarowin, 1999). Bradley (1997) found that many firms which engage heavily in knowledge-based innovation activities tend to have clear gaps or differences between their book values and their market values. According to Morgan Stanley the investment bankers, among others, stock prices tend to be twice book values on average for the stock markets of the world, and it is much higher for the American markets (Edvinsson & Malone, 1997), a disparity (gap, difference) which again implies that some important financial aspects (values) of firms are not reflected in their financial statements. Ohlson (1995) proposed a residual income valuation model, in which the market value of a firm can be determined by its book value, by the discounted value of its expected future abnormal earnings, and other information. The Stern Stewart Company has argued maintains that the aim or goal of Economic Value Added (EVA ) is to evaluate a firm's market value directly in a way similar to residual income; that it is a financial performance measure integrating accounting and economic concepts. According to this concept, some accounting items in the financial statements are adjusted to present the firm's whole economic value, and shareholder's value is increased only after its earnings exceed its cost of capital. Roos, Edvinsson, and Dragonetti (1998) argued that a firm's value is determined by its traditional physical capital, its financial capital and its intangible intellectual capital. Lev (2001) suggested that the physical and financial assets of firm can only generate normal earnings; abnormal earnings are created through the development of intangible assets. Lev stated that if the intellectual capital of knowledge-intensive firms is not properly accounted for in the financial statements, their cost of capital will be over charged and their value systematically undervalued, which will hinder the investment and growth of those firms. …