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Introduction
Intellectual capital represents a collection of intangible assets also known as knowledge assets. These assets, distinguished from physical assets such as property, plant and equipment (PPE) or stock and financial assets such as receivables, investments and cash, have become increasingly important as key resources of firms in their competitive strategies. In today's complex and turbulent business environment companies are required to be flexible, highly innovative and able to develop pro-active strategic approaches. To reach these aims many organisations have realised that knowledge (underlying capabilities) represents a crucial factor in creating economic value that underpins a firm's value creation performance.
Paul Krugman argues that in the past, businesses primarily invested in the tangible means of production. The value of a company was at least somewhat related to the value of its physical capital. But now businesses increasingly invest in intangibles and these assets make "it extremely hard to figure out what that company is really worth" (New York Times , 22 October 2000). Krugman's observation reflects the phenomenal growth in the market values of some of knowledge driven Internet companies in the 1990s and the subsequent, spectacular crash of 1999-2000. Bio-technology companies that sought to exploit new advances in bio sciences to create new drugs had been similarly overvalued only to experience dramatic falls in their values.
The merger of AOL the internet service with a more mature media company Time Warner in 2001 provides a cautionary tale. When the friendly merger of equals was announced in January 2000 the combined market capitalisation of the two entities was $288bn. By the middle of 2003, the merged firm, AOL Time Warner, was valued at just $74bn - 74 per cent of the value of the two firms had been wiped out. While part of the decline was due to the general stock market decline, an analysis of the valuation metrics used at the time of the merger shows that they were based on wildly exuberant optimism ([2] Applegate, 2002). It is starkly apparent from cases like the AOL Time Warner merger that tools for valuation of knowledge-based companies are woefully inadequate.
The traditional valuation tools such as relative valuation multiples, e.g. price earnings ratio (PER) or enterprise value to EBITDA do not fully capture how...