What Secrets Are Hiding Off Your Balance Sheet?

17th in a series of excerpts from the book The HIP Investor (John Wiley & Sons, 2010). See other articles in the series here.

What is your company’s most important asset?  Most of you will say “people.” Many CEOs say this as well. However, one must ask: where are people on the financial statements? People are categorized as an expense on the income statement, not as an asset on the balance sheet. This leads to people being treated as disposable rather than investable – as costs to cut, rather than appreciating assets.

Investors and companies who evaluate these hidden factors can discover new opportunities to create value for shareholders, by measuring invisible assets on the balance sheet – and then acting in a more thoughtful, comprehensive and long-term decision path.

Invisible assets missing from balance sheet

Why is only 30 percent of a company’s market value included in the balance-sheet categories of tangible assets: cash, inventory, plant, real estate, and equipment? More than two-thirds of market value is “intangible,” according to a 2006 Ocean Tomo analysis - 2009, the S&P500 average was 81%. But would you call yourself intangible? Accounting principles do. Despite the traditional economic inputs of “land, labor, and capital,” human labor in accounting is treated primarily as an expense on the income statement, not an asset on the balance sheet. This leads investors and CEOs to think of it as a cost to cut, rather an asset to invest in.

One high-tech company realizes this quandary: the global technology firm Infosys (Nasdaq: INFY) based in India. Read its annual report and you’ll find many interesting aspects. Infosys reports its financial statements in different formats and languages to accommodate shareholders in India, Australia, Canada, France, Germany, Japan, and the UK. In addition to its world-class transparency about nearly every possible number, it goes one further than any other of the hundreds of annual reports HIP has encountered. Infosys calculates the asset value of its people.

Infosys properly identifies its employees as a source of wealth. “The definition of wealth as a source of income inevitably leads to the recognition of human capital as one of the several forms of wealth, such as money, securities, and physical capital,” the company says. In its 2009 annual report, Infosys counts 104,850 employees, of which 97,349 are software professionals, and the remainder are classified as “support” to serve the customer. While physical assets on Infosys’s accounting statements net out to $3.75 billion, Infosys calculates its “human resources value” at $21.5 billion, nearly five times larger. (2010 report showing Infosys’s human resource valuation is here.

New ideas do not come from a machine, factory or even a computer. Innovations are produced by people. Trained talent appreciates over time, becoming more valuable. These fundamentals contribute to the driving forces behind a HIP company: Maximizing human impact internally, along with the factors that solve human needs, can lead to higher profitability and valuations.

Emerging assets: carbon value

Another asset not yet captured on the balance sheet is the value of carbon. Today, much pollution incurs no cost to companies. Some air and water pollution is monitored, regulated, and occasionally fined. In two instances, cap-and-trade systems are already in place—for sulfur dioxide and nitrous oxide emissions. But we expect carbon taxes or cap-and-trade systems will eventually be the norm. When these systems are implemented, companies will need to scramble to systematically account for their emissions. A “credit” for carbon can be created for low-polluting companies that beat the standard. These carbon credits can then be traded from more efficient companies to less efficient companies. According to Bart Chilton, a commissioner of the Commodities Futures Trading Commission, the future market could be valued at $2 trillion, potentially trading more contracts than oil. Imagine the future financial value for forward-thinking companies.

Devon Energy (NYSE: DVN), a $15 billion firm, is holding on to the carbon credits it is generating. “We are concerned about the future value and likely to hold onto them,” says David Templet of Devon’s environmental, health and safety group. Devon is investing in projects to reduce its emissions, including carbon sequestration, selling the gases trapped in the wells, and improvements from upgraded gaskets and valves. “If the price of GHGs rise to $60 to $80 per ton; then those credits will be valuable for our competitive advantage,” says Templet.

The value of carbon reductions is a tradable asset. Companies that are more carbon-efficient today could accumulate higher asset values on their balance sheet when more comprehensive carbon reduction policies are approved and implemented. Leading firms are investing in carbon efficiency now to reduce costs, earn an attractive return on investment, and prepare for a future that includes tradable carbon reductions.

Surprise liabilities: lawsuits

New liabilities can emerge when businesses ignore the true costs of their actions. Gun manufacturers have been sued for lack of safety controls on weapons. Tobacco manufacturers lost a $206 billion lawsuit related to the health impacts of their products. Auto manufacturers creating unsafe vehicles, like the historic Ford Pinto, also are pursued in court.

The chance of new legal liabilities increases when a company ignores human impacts and lifecycle costs. For example, future lawsuits might emerge around companies selling food with high-fructose corn syrup, which can contribute to obesity and diseases like diabetes.

Leading companies think ahead about the full impact of their products, operations, and ultimate actions. Well-managed firms engage customers early on to address their concerns about products and navigate potential hurdles with care. The least-HIP companies tend to have higher-than-average liabilities, in dollar value and gravity of offense. Judgments against companies can deplete accumulated cash; hurt the brand image, affecting sales; and distract top management from looking forward instead of backward—all of which affect profit and valuation.

New liabilities: payment for eco-services?

In 1997, environmental economists from Argentina, Netherlands, and the United States estimated the value of Nature’s services. Since many of these services, like soil formation and nutrient recycling are free, some companies treat them as having no cost. The total annual value of ecosystem services – provided for free today -- at that time was set at $22 to 37 Trillion, or up to nearly double the global GDP of $18 trillion (PDF).

Since nature can manage natural resources more effectively than humans, preservation of ecosystems can be worth more than the human-made approaches. For example, the City of New York calculated that it could avoid building new water treatment plants for $6 to $8 billion, and instead protect the upstate New York watershed that purified the natural water systems at a cost of only $1.5 billion.

Will companies have to pay for Nature’s services in the future? Governments can institute limits in usage or set a market-pricing mechanism to ration resources for the common good. Companies that proactively manage their Earth metrics and look ahead long term will better manage the risk of new liabilities or expenses.

The last element of the balance sheet is equity, how a company calculates its net worth, or book value.

Equity: spread it around

Companies that share equity and ownership with employees more readily benefit from staff loyalty and productivity. Hewlett Packard (NYSE: HPQ), Google (Nasdaq: GOOG), and Whole Foods (Nasdaq: WFMI) all spread the equity ownership across all levels of the firm. This tends to not only increase employee satisfaction but also creates a more stable shareholder base, whose decisions on behalf of the company are vested with the long-term appreciation of the stock.

Companies that match employees’ savings for the future (an excellent example of a HIP Wealth metric), particularly with discounts in company stock, contribute to longer-term stability and less volatility related to trading. Well-managed companies have broad-based ownership and make it easy for employees to contribute as co-owners.

In summary, there are multiple sources of value that are ignored on the income statement and balance sheet. However, investors and companies can be blind to these new fundamentals of investing. Will you be a more HIP investor and incorporate those drivers of financial value in your decisions?

In our next feature, we will explore how leading companies and investors are communicating by incorporating these sustainability metrics in their financial reporting.

To navigate this series, please use this table of contents.

***

HIP Investor supports Spring of Sustainability.  For three months, the Spring of Sustainability will feature 100 “stars” of sustainability, from Jane Goodall to Bill McKibben to Van Jones, in free interactive teleseminars throughout the spring of 2012. Live events will also be held in cities across the globe.

***

R. Paul Herman is CEO and founder of HIP Investor Inc. Herman is the author of “The HIP Investor: Make Bigger Profits by Building a Better World,”  published by John Wiley & Sons in 2010. Herman is a registered representative of HIP Investor Inc., an investment adviser registered in California, Washington and Illinois.

NOTE: This feature, excerpted and adapted from the HIP book, is not an offer of securities nor a solicitation. The information presented is for information and education purposes, and is not an investment recommendation. Past performance is not indicative of future results. All investing risks losing your principal. The author may invest in the companies mentioned above, and several are included in the HIP 100 Index portfolio. Details and full disclosures are at www.HIPinvestor.com

Follow on Twitter @HIPInvestor