Intellectual Capital and its Association with profitability and Market Valuation in Indian IT Sector

 

Dr. Raman Deep Singh¹, Md Rashid Shamim²

¹Assistant Professor, Department: Department of Commerce, College: Sri Venkateswara College,

University of Delhi, New Delhi-110021

²Assistant Professor, Department: Mittal School of Business, College: Mittal School of Business,

Lovely Professional University, Phagwara, Punjab-144111

 

ABSTRACT:

This study examines the relationship of intellectual capital with profitability and market valuation of Indian information technology sector for a period of 10 years from 2006 to 2015 by collecting data from CMIE prowess database. The Value Added Intellectual Coefficient (VAIC^TM) method has been employed for measuring the intellectual capital of the companies. Correlation and panel regression has been applied in this study for analyzing the relationship between variables. It has been found from the study that intellectual capital in IT sector has significant impact on profitability of the companies. The analysis also found that intellectual capital has no role to play in increasing the market valuation of the companies. The findings indicate that investors consider only financial disclosure of the companies regarding their investment decision. The study provides useful knowledge to the researchers and managers regarding IC and its relation with financial performance.

 

 

 

INTRODUCTION:

The world is being rapidly replaced from industrial economy to towards knowledge based technological economy, where intangible assets are considered to be the main determinant of wealth creation. The gap between book value and market value of firms in the stock market, which is often referred to as hidden value is because of intellectual capital (hereafter IC). Companies gain competitive advantage and superior financial performance through the acquisition, holding and efficient use of strategic resources. Knowledge has become the key economic resource and the dominant and perhaps even the only source of competitive advantage (Usoff et al. 2002). 

 

Intellectual Capital:

Intellectual capital is the difference between a company’s market value and its book value.  According to various scholars, IC is considered to be the hidden value that escapes financial statements and the one that leads organizations to obtain a competitive advantage (Chen et al., 2005; Edvinsson and Malone, 1997; Lev, 2001). The Swedish firm Skandia defined IC as “the possession of knowledge, applied experience, organizational technology, customer relationships, and professional skills” (Edvinsson, 1997, p. 368).

 

Classification of Intellectual capital:

Edvinsson and Malone (1997), Bontis (1998) and Sullivan (1998) have adopted the three group categorizations for IC classification termed as:

 

 

 

(1) Human capital; (2) Organizational capital and (3) Customer capital

The human capital constitutes the skills and knowledge of employees which can be further enhanced with the aid of training. Structural capital can be defined as the knowledge that is created by an organization and cannot be separated from the entity. Relational capital is the ability of an organization to create relational value with its external stakeholders.

 

REVIEW OF LITERATURE:

In recent years, many firms have started measuring and reporting their intangible assets. However, voluntary IC disclosure is still in its infancy stage. A brief description of relevant studies is presented here to provide a glance on the existing literature. Deep and Narwal (2014) examined 100 companies in India’s textile industry to assess the relationship between IC and company financial performance, and found IC to have a significant association with company profitability. Mehralian et al. (2012) carried out a study on pharmaceutical industry of Iran to find association between IC components with financial performance and found that IC of the company can explain profitability but not productivity and market valuation in Iran. Komnenic and Pokrajcic (2012) investigated if IC has an impact on organizational performance of MNCs in Serbia. The study concluded that human capital is positively associated with all three corporate performance measures. Pal and Soriya (2011) analyzed association of IC with company performance in Indian IT Industry. It is found that IC efficiency plays a significant role in increasing the profitability of the company. Rehman et al. (2011) carried out a study on Modaraba sector in Pakistan to examine impact of IC on corporate performance. He concluded that human capital and structural capital was positively associated with return on equity (ROE) and earnings per share (EPS) respectively. Ahangar (2011) analyzed the association of IC with financial performance components. It is found that human capital is significantly associated with company’s financial performance. Ghosh and Mondal (2009) analyzed relationship of IC with conventional financial performance of Indian software and pharmaceutical companies. The study found that IC efficiency of a company can explain profitability but not productivity and market valuation of the companies. Tan et al. (2007) examined association between IC and financial performance of companies of Singapore. The study revealed that IC performance is positively related with companies’ performance.

 

Hypotheses Development:

The purpose of this study is to measure the intellectual capital efficiency of Indian information technology sector and to find out its relationship with profitability and market valuation. The following hypotheses have been formulated:

H₀₁: VAIC has a significant impact on profitability (ROA) of Indian IT companies.     

H₀₂: VAIC has a significant impact on market valuation (MB) of Indian IT companies.     

 

RESEARCH METHODOLOGY:

Research Objectives, Sample Size and Data Collection:

Value added intellectual coefficient (VAIC^TM) method has been used to measure the intellectual capital efficiency of the companies. VAIC is used as a measure to reflect the efficiency of intangible assets. It is a composite of three indicators such as human capital efficiency, structural capital efficiency and capital employed efficiency respectively. VAIC has been used as independent variable and return on asset (ROA) and market valuation (MB) has been employed as dependent variables. Two control variables i.e. debt equity ratio (DER) and SIZE has been used in the study to control their effect on dependent variables. The top 50 companies of Indian IT sector have been chosen for the study. The data has been collected from CMIE Prowess database for a period of 10 years i.e. from 2005-06 to 20014-15. Selected companies are listed on both NSE and BSE. Panel regressions have been applied to check the effect of IC on the financial performance.

 

Definition of Variables:

Independent Variables:

For measuring the intellectual capital efficiency of the company, first of all value added is measured as

VA= W + I + T + NI………………………………. (1)

 

Where, W = Wages and salaries; I = Interest expenses; T = Taxes paid and NI = Profit after tax.

In the second step, human capital efficiency (HCE), structural capital efficiency (SCE) and capital employed efficiency (CEE) being calculated:

•HCE = VA/HC

•SCE = SC/VA

•CEE = VA/CE

Where, HC = wages and salary; SC = VA-HC; CE = Capital employed of the company.

Finally, VAIC and its three components are being calculated as:

 

VAIC = HCE+SCE+CEE

 

 

Dependent and Control Variables:

For conducting the analysis, two traditional accounting performance measures namely, return on asset (ROA) and Market valuation ratio (MB) has been applied as dependent variables. Apart from this, one control variable has also been used in the study. A brief explanation of their calculation is given next:

ROA = Net Income/average total assets

ROA is an indicator of how profitable a company is in relation to its total assets.

 

MB = Market capitalization/ Book value of common stock

MB reflects the market to book value of the companies indicating market valuation of the company.

 

DER =Total debt/ total equity

DER measures what proportion of equity and debt is used by company in financing its assets.

 

SIZE = Total assets = Log (Total assets)

Size of the firm as measured by the natural log of total assets, is used here to control the impact of size.

 

Regression Models for Analysis:

In order to achieve the research objectives, the following models have been developed for carrying out the analysis:

 

ROA = α_it +β₁VAIC_it + β₂DER_it + β₃SIZE_it + ε_it.............................. (2)

MB=    α_it +β₁VAIC_it + β₂DER_it + β₃SIZE_it + ε_it…............................. (3)

 

Where, α = Constant term; VAIC = Value Added Intellectual Coefficient; ROA = Return on Assets; DER = Debt Equity Ratio; SIZE = Market Capitalization and ε = Error term.

 

RESULTS AND DISCUSSIONS:

Descriptive Statistics:

The descriptive statistics shown in Table 1 shows that the average value of VAIC is 4.877 which indicate that Indian IT companies created 4.87 rupees for each rupee employed in intellectual capital. The average value of ROA is 0.065 indicates that the companies of this sector are not getting a fair return on its assets. The average value of MB ratio is 2.817 which show that Indian IT sector companies’ market value is higher than its book value. The average value of DER is 1.354 indicates that there is more use of debt in comparison to its equity capital.

 

Table 1: Descriptive analysis of all variables:

	VAIC	ROA	MB	DER	SIZE
Mean	4.877	0.065	2.817	1.354	1376.12
Std. Dev.	0.167	0.202	3.604	0.253	4264.24
Median	0.044	0.126	1.727	0.572	178.15
Minimum	-2.94	-0.64	0.106	0.009	0.117
Maximum	0.617	1.271	30.22	0.95	57866.85

 

Regression Analysis:

The results of the regression analysis are shown in Tables 2 respectively. Table 2 exhibits the result of the regression models where ROA and MB are taken as dependent variable and VAIC is taken as independent variable. Both fixed and random effect model have been used for the analysis. Hausman test has been used to check which model should be used for analysis. In case, if Hausman X² result found significant, fixed effect model is used and when it is found insignificant then Random effect model is preferred for the analysis. From the table 2, it is shown that for both ROA and MB, Result of Hausman test statistics is found significant, indicating that fixed effect model is more appropriate. From the table 2, it is found that VAIC is playing a significant role in increasing the ROA of the companies. The control variables, DER and SIZE showed a significant negative relationship in increasing the return on asset. Hence, in the light of the results, H₀₁ is accepted means IC is having a significant impact on profitability of the company. Table 2 also found that VAIC is not playing any significant role in increasing the market value of the IT companies. It indicates that investors do not consider the value of IC efficiency regarding their investment decisions. The control variable size is contributing significantly in increasing the marker valuation of the companies. Hence, in the light of the results, H₀₂ is rejected means IC is not having any significantly associated with MB of the company.

 

 

Table 2: Regression Results of IC and Performance of IT companies

Note: * and ** represents Significance at 1%, and 5% respectively

 

 

 

CONCLUSION:

In this study, the relationship between intellectual capital efficiency and financial performance was analyzed using ROA and MB as indicators of financial performance. It is found from the study that intellectual capital has a significant effect in increasing profitability. In other words, the profitability is positively influenced by efficiently using the intellectual capital. The results also came up with the finding that intellectual capital is not playing any significant role in increasing the market valuation of the companies, which indicates that Indian investors do not pay attention to intellectual capital at the time of evaluating the company.

 

In the view of the above, it is advisable for academics, managers and government officials to take a more active role in encouragement of development of IC. Managers are needed to give more considerations to human resources and structural resources for increasing profitability and market valuation of the company. Disclosure of IC may be made a mandatory requirement for the companies which will allow IC statements to be included in the annual reports of every listed company.

 

REFERENCES:

1.        Ahangar, RG. The relationship between intellectual capital and financial performance: an empirical investigation in an Iranian company. African Journal of Business Management, 2011; 5(1): 88-95.

2.        Bontis, N. Intellectual capital: an exploratory study that develops measures and models. Management Decision, 1998; 36(2): 63-76.

3.        Chen, M, Cheng, S, Hwang, Y. An empirical investigation of the relationship between intellectual capital and firms’ market value and financial performance. Journal of Intellectual Capital. 2005; 6(2):159-176.

4.        Deep, R, Narwal, KP. Intellectual capital and its association with financial performance: A study of Indian textile sector. International Journal of Management and Business Research, 2014; 4(1): 43-54.

5.        Edvinsson, L. Developing intellectual capital at Skandia. Long Range Planning. 1997; 30(3): 366-373.

6.        Edvinsson, L, Malone, MS. Intellectual Capital: Realizing Your Company’s True Value by Finding Its Hidden Brainpower. Harper Business, New York, NY. 1997.

7.        Ghosh, S, Mondal, A. Indian software and pharmaceutical sector IC and financial performance. Journal of Intellectual Capital, 2009; 10(3): 369-388.

8.        Komnenic, B, Pokrajcic, D. Intellectual capital and corporate performance of MNCs in Serbia. Journal of Intellectual Capital, 2012; 13(1): 106-119.

9.        Lev, B. Intangibles: Management, and Reporting. Brookings Institution Press, Washington, DC. 2001.

10.     Mehralian, G, Rajabzadeh, A, Sadeh, MR, Rasekh, HR. Intellectual capital and corporate performance in Iranian pharmaceutical industry. Journal of Intellectual Capital, 2012; 13(1):138-158.

11.     Pal, K, Soriya, S. Financial reporting of intellectual capital and company’s performance in Indian information technology industry. International Journal of Asian Business and Information Management, 2011; 2(2): 34-49.

12.     Rehman W, Rehman C, Rehman H, Zahid A. Intellectual capital performance and its impact on corporate performance: An empirical evidence from Modaraba sector of Pakistan. Australian journal of business and management research, 2011; 1(5): 8-16.

13.     Sullivan, PH. Profiting from Intellectual Capital, Extracting Value from Innovation. John Wiley, New York, NY. 1998.

14.     Tan, HP, Plowman, D, Hancock, P. Intellectual capital and financial returns of companies. Journal of Intellectual Capital, 2007; 8(1): 76-95.

15.     Usoff, C, Thibodeau, JC, Burnaby, P. The importance of intellectual capital and its effect on performance measurement systems. Managerial Auditing Journal, 2002; 17(1/2): 9-15.

 

 

 

 

Accepted on 19.04.2017          © A&V Publications all right reserved