New Math for a New Economy

It's extremely difficult to come up with a comprehensive definition of intangible assets. I've tried to group them into four categories. First are assets that are associated with product innovation, such as those that come from a company's R&D efforts. Second are assets that are associated with a company's brand, which let a company sell its products or services at a higher price than its competitors. Third are structural assets -- not flashy innovations or new inventions but better, smarter, different ways of doing business that can set a company apart from its competitors. And fourth are monopolies: companies that enjoy a franchise, or have substantial sunk costs that a competitor would have to match, or have a barrier to entry that it can use to its advantage.

What is it about intangible assets that creates value -- value that is more significant than that of tangible assets?

The best way to answer that question is to use another example -- and here I'm intentionally steering away from the Web-based and high-tech companies that people usually point to, such as Cisco Systems and Amazon.com. Let's look at American Airlines, or, more accurately, its parent company, AMR Corp.

In October 1996, AMR Corp. sold 18% of its computer-reservations system, called SABRE, to the public. It held on to the remaining 82%. That one transaction provides a beautiful way of evaluating tangible and intangible assets. When I recently checked the market, SABRE constituted 50% of AMR's value. This is mind-boggling! You have one of the largest airlines in the world, with roughly 700 jets in its fleet, nearly 100,000 employees, and exclusive and valuable landing rights in the world's most heavily trafficked airports. On the other hand, you have a computer-reservation system. It's a good system that's used by a lot of people, but it's just a computer system nonetheless. And this system is valued as much as the entire airline. Now, what makes this asset -- the computer system -- so valuable?

One big difference is that when you're dealing with tangible assets, your ability to leverage them -- to get additional business or value out of them -- is limited. You can't use the same airplane on five different routes at the same time. You can't put the same crew on five different routes at the same time. And the same goes for the financial investment that you've made in the airplane.

But there's no limit to the number of people who can use AMR Corp.'s SABRE system at once: It works as well with 5 million people as it does with 1 million people. The only limit to your ability to leverage a knowledge asset is the size of the market.

Economists call physical assets "rival assets" -- meaning that users act as rivals for the specific use of an asset. With an airplane, you've got to decide which route it's going to take. But knowledge assets aren't rivals. Choosing isn't necessary. You can apply them in more than one place at the same time. In fact, with many knowledge assets, the more places in which you apply them, the larger the return. With many knowledge assets, you get what economists call "increasing returns to scale." That's one key to intangible assets: The larger the network of users, the greater the benefit to everyone.

So that's how intangible assets can create extraordinary value. But is there a downside to knowledge assets?

As my former teacher and colleague Milton Friedman used to say, "There's no such thing as a free lunch." Knowledge assets are very expensive both to acquire and to develop. And they're extremely difficult to manage.

Look at the extremely high prices that high-tech companies are paying to acquire smaller companies, as they look for knowledge assets that they can leverage. On November 1, 1999, Cisco announced that it had acquired Cerent Corp. for $6.9 billion. For the first six months of 1999, Cerent's sales totaled roughly $10 million. That's what it can cost to acquire a knowledge asset. Or look at the high cost of developing a knowledge asset: In the world of pharmaceuticals, it costs close to $500 million to develop a new drug. One last example is America Online, which spent nearly $1.5 billion on customer acquisition when it was creating its franchise. That's what it can cost to create a high barrier to entry.

There's another downside of knowledge assets: Property rights are fuzzy. When it comes to a tangible asset, such as an airplane, American Airlines doesn't have much to worry about. No one is going to steal an airplane. But American Airlines definitely has to worry about someone stealing its software. The proliferation of thousands upon thousands of very costly patent-infringement lawsuits attests to the difficulty of defining and keeping property rights when you're dealing with knowledge.