Valuation of human capital

 

After an interesting discussion regarding how to do valuation of companies and how to analyze financial ratios of the companies very interesting discussion regarding valuing human capital came up. Professor rightly pointed out that the financial statements are designed to capture assets such as plant and machinery, land, inventory and liabilities such as loan payable, accounts payable etc. But what about the human capital. Peter Drucker said 40 years ago that World is moving towards knowledge economy where people will be most valuable assets of the company. And he was spot on we are living the world where people make or break companies. Software giants such as Microsoft, Google, Facebook do not have assets in form of huge machineries, land and equipment but they have human talent, brightest engineers from across the world working for them. How to value the company with such assets then.

The world has changed a lot, few people from basement office can create company with sales of more than billions of dollars so balance sheet of these companies will be asset=negligible, liabilities= negligible, revenue=astronomical and profit=you can’t believe. So if you do the same ratio analysis that you do for say steel company, airline or big retail company then you will never invest in other companies. That is a big problem and often causes overvaluation of technology companies.

So how to value human capital. I can think of only sport to look for answers. Footballers are sold and bought by clubs and valuation is done based on goals scored, previous performance, merchandise selling potential etc. But still they can not put that value on the balance sheet as accounting rule do not allow it. Some other form of statements have to be started some parameters to be defined for such companies. I was thinking of Human capital index or Human resource index a measure of IQ of the employees or Standard test scores, something to tell potential investor what they are buying.

I can not think of any perfect solution as beauty of we humans is that each one of us is unique. So it’s a big challenge to all accountants to value the company correctly.

Signing off

Nikhil Parchure

Disclaimer : The thoughts above are directly influenced by Class discussions at Drucker school MBA class. Examples used are directly taken from class discussion. Company names used are only for the sake of example.