Valuing human and social capital

Seminar Paper 2004 33 Pages

Business economics - Investment and Finance



Table of Abbreviations

Table of Symbols

1 Introduction
1.1 Problem and Objectives of the Paper
1.2 Methodology of Analysis

2 Conceptual Principles
2.1 Definition of Human Capital
2.2 Definition of Social Capital

3 Valuation Methods of Human and Social Capital
3.1 Methods for Appraising Human Capital
3.1.1 Company Value Method
3.1.2 Weighted Cost of Human Resource
3.1.3 Value of Future Earnings
3.1.4 Human Resource Accounting
3.1.5 Human Assets and Human Capital - A Relationship
3.1.6 Real Options
3.2 The Appraisal of Social Capital
3.2.1 The Capital Side of Social Capital
3.2.2 The Role of Intrafirm Networks
3.2.3 Interfirm Networks

4 Human and Social Capital within the System

5 Conclusion



Table of Abbreviations

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Table of Symbols

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1 Introduction

1.1 Problem and Objectives of the Paper

Industries and countries experience a shift from manufacturing to service and techno l- ogy based systems. Intangible assets like human and social capital become relatively important drivers of value.1Furthermore, new accounting standards create a need for a standardized valuation of intangibles. The raise of hidden values develops into an important issue especially in business combinations.2Financial statements provide very few information about human or social capital, but shareholders and stakeholders become more interested in these information.3

When a company acquires another, a single price is paid for a bundle of assets. The price reflects the firm value as a whole at a specific date, but the particular values of the individual assets are seldom transparent.4Furthermore, intangibles receive 50% to 70% of an average firm’s annual investment s5, but the possible achievements are not shown in the balance sheet. Thought, it is crucial to company success.6

This paper will analyze different methods for valuing human and social capital. Different approaches will be described and the suitability for valuation will be evaluated. The focus will be on a company’s human and social capital, because the value of personnel human and social will not contribute to the problem solving.

1.2 Methodology of Analysis

The structure of the paper follows the research objectives. Chapter 2 defines human and social capital and serves as the basis for the following analysis. Chapter 3 presents the different valuation approaches. Human and social capital appraisal methods are exa m- ined individually. Every method is analyzed, described and evaluated. Chapter 4 illustrates the influence of human and social capital on companies and the effects of their combined impacts. Chapter 5 summarizes the findings and draws a conclusion. In addition, an outlook is given and proposals for future research are made.

2 Conceptual Principles

2.1 Definition of Human Capital

Many studies are done about human capital, but the definitions still vary. “It is often referred to as the “hidden value” of an organization. It is hard-to-define property that everyone knows is worth a great deal but finds difficult to express in monetary terms”.7 Human capital is the qualities one brings into the job, one’s capability to learn and the motivation to share information and knowledge.8Human capital embraces the effects of schooling and education as well as on-the-job training and off-the-job training.9Fur- thermore, the ability to migrate and physical health are characteristics of human capital. It also contains individual and collective skills and expertise, creativity and innovation, learning and knowledge, and competencies and capabilities.10Thus, it is the people’s continuous capacity for providing customer-value outcomes. Figure I11illustrates the position of human capital within an organization and brings out the crucial linkages.

Some authors also distinguish between firm-specific human capital, industry-specific capital and individual-specific capital.12The focus in this paper is on the first type of human capital.

2.2 Definition of Social Capital

The definition of social capital is relatively philosophical, differs across studies, and is always addicted to the purpose of the study. Social capital is described as a conne ction among ind ividuals in social networks.13It also includes a willingness to live by norms and an arising trustworthiness. Cooperation is a key element of social capital. A virtu- ous ‘group’ of isolated individuals is not rich in social capital.14Social capital has two characteristics: social structure and the ability to facilitate certain actions of individuals within this structure.15It is a relation, which is embedded in crosscutting ties, which are useful for growth.16Social capital also enables to gather market and non- market returns because of interaction with others.17Social capital can be productive and makes achievements possible, which in its absence would not be achievable or would only be accomplished at higher expenditures.18VAN DETH also distinguishes between structural and cultural aspects of social capital.19Figure II20summarizes the aspects and components of social capital. Figure III21illustrates how shared beliefs can create (alternative A) and destroy social capital (alternative B).

3 Valuation Methods of Human and Social Capital

3.1 Methods for Appraising Human Capital

3.1.1 Company Value Method

This method appraises human capital under the assumption that any above-average re- turn relating to the industry is caused by off-balance-sheet items.22HERMANSON dis- tinguishes two categories of assets. First owned assets, which could be transformed and used to pay off any debt or liability and second operational assets (i.e. highly trained labor), which are non-owned resources but operating in the entity. Both types contribute to the realization of any profits.23The owned assets are responsible for the achievement of the average return of the industry operating in. Consequently, the operating assets, which mainly consist of labor and efficient organizational structures, donate the above- average return. Thus, the human capital of a company is the capitalized value off the above-average return.24

The first step of va luation process is, to identify the average return of the industry by dividing the average industry profit, based upon the admitted profits from the previous fiscal year, by the average owned assets, calculated at market price, of the industry. Secondly, this calculation is repeated on company level. The standardized profit of the company is calculated in step three, by multiplying the average industry profit with the company owned assets. This calculation equals in the rate of return of the company owned assets. Finally, the difference between the actual company profit of the previous year and the standardized profit is capitalized with the average return of the industry. This perpetuity is the value of the human capital of the company.

The formula can be written as followed:25

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This method is very straightforward and allows for verifiability. However, it also carries some weaknesses. It is not clarified whether the quantity of the owned assets should be valued at the date of balance or on an annual average. The industry average return re- quires a clear classification of the industry, which will definitely differ and will depend on individualistic evaluations. The main deficiency is the allocation of the human capi- tal to the operational assets, which are the only source for the above-average return of the company. However, many more factors drive and contribute to the success of a company. Finally, the value of the human capital can only be interpreted as a relative value, because it is linked to the industry average.26Hence, this method should not be used for valuation purposes.

3.1.2 Weighted Cost of Human Resource

HERMANSON also developed another, more future-orientated method. This method discounts the future salary of the human resource and weights it with an efficiency rate. Step 1 makes a forecast of the salaries, which might occur in the coming five years for an employee or a homogenous group of employees. These amounts are individually dis- counted at the weighted average cost of capital (WACC) and added together.27 The formula of the present value of the future salaries looks as followed:28

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Step 2 determines the efficiency rate by weighting the company return of the past five years with the average-return of the industry. Younger returns are weighted much stronger in the equation than older ones. Consequently, the formula looks as fo l- lowed:29

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Finally, the value of the human capital is the product of the efficiency rate (ER) and the present value of future salaries (PV). The excess worth created by relatively efficient human resource is calculated by subtracting the future value of salaries from the value of human capital and indicates whether the company utilizes its human capital efficiently (positive excess worth) or not.30

This method bears some of the weaknesses already mentioned. Furthermore, the forecast horizon of the salaries is not justified and can be seen as a random pick. Any biases in the forecast of the salaries itself will adulterate the value of human capital. Thus, this method is an inappropriate tool for valuing a firm’s human capital. Both approaches have to be seen as a contribution for further discussion of this problem.31

3.1.3 Value of Future Earnings

LEV/SCHWARTZ’s human capital is an accumulation of the remaining future earnings of every employee. The human capital of a single employee is calculated by discounting the future earnings until retirement, which are represented by the individual salaries.32 The formula is:33

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Only an ex post valuation can determine the annual salaries without bias. Therefore, future salaries can only be forecasted, so the value of human capital is just an estimate.34The formula gets more precise if the probability of death of an employee is included, which would end an employment.35

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LEV/ SCHWARTZ than recommend to create “homogenous groups of employees such as unskilled employees, semi- skilled, skilled engineers of different kinds, salesmen, managerial staff, etc.”36. The value of a firm’s human capital is determined by adding single values of human capital or the human capital value of the homogenous groups. This method of discounting future cash flows is a widely accepted technique. Neverthe- less, one major weakness of this approach is to equal future salaries for the employees with future earnings of every employee to the company.37The individual perspective of the employees is integrated into the firm. Employees gain salaries as a reward for their labor. This reward cannot be transformed into a utility gain for the company. Further- more, human capital increasing activities, e.g. on-the-job training, are ignored.38Hence, this method of valuing a firm’s human capital is an unsuitable instrument.

3.1.4 Human Resource Accounting

The human resource accountings focus is, to support any strategic human resource deci- sion.39It also is the most mature theory for valuing a firm’s human capital. Amongst many supporting strategic tools for decision-making and a cost-based appraisal theory, FLAMHOLTZ developed an approach to determine a firm’s human capital based on future profits.40

The human capital is calculated at five steps.41First, an employee can occupy different value-added positions (service states) during the employment.42These service states have to be identified and allocated to the employee. Second, value s for every single service state must be defined. Third, the period the employee stays with the company is necessary for the calculation and must be forecasted. Fourth, a probability for the employee reaching a specific position is allocated to every service state. Finally, the present value of the employee is computed by discounting the forecasted profits.43The formula, including a dropout probability, looks as followed:44

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The procedure of calculating the human capital can become very complex. Especially, the identification of the service states and the assignment of values to every service state can turn out to be extremely time consuming and expensive. Furthermore, it is hard to predict how long an employee will stay with the company, and when he will gain specific positions. Thus, this approach is not suitable for intern human capital valuation, thought it is a method which is relatively close to reality.45FLAMHOLTZ himself sees his work as a contribution for discussion about human capital.46

3.1.5 Human Assets and Human Capital - A Relationship

MORSE acknowledged the weaknesses and the potentials of FLAMHOLTZ’s and LEV/ SCHWARTZ’s methods, and developed an approach by combining both techniques. The combined formula looks as followed:47

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MORSE defines the first two parts of the formula as “the present value of the gross services rendered […] by all employees”48and the third part as the currently employed human capital. Setting part one and two asRand part three asC, MORSE finds the value of human assets to a company (AV).49

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The dilemma of this idea is that it is based on two other methods with extreme deficie n- cies. Using this approach, maximizingAcould end in reducingC. Furthermore, the ef- fects of an investment into the employees (e.g. on-the-job training) which increasesC are not implemented into the formula. This method combines rather than eliminates the boundaries from its two basis formulas. Thus, this method is not useful for valuing hu- man capital.

3.1.6 Real Options

The theory of real options is a further technique to value human capital. This dynamic method allows including several future alternatives.50The expanded human capital (HCe) is calculated by adding the static human capital (HCs) to the value of the option (VO).51

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1See Persch (2003), P. 1.

2See Foster / Fletcher / Stout (2003), P. 50.

3See Lev (2003), P. 17; Kaplan / Norton (2004), P. 52.

4See Flamholtz / Geis / Perle (1984), P. 11; Beutel / Ray (2004), P. 35.

5See Schmidt (2002). P. 3; O’Haver (2003), P. 16.

6 See Lev (2004), P. 109.

7Bukowitz / Williams / Mactas (2004), P. 43.

8See Smart (1999), P 60; Barthel / Gierig / Kühn (2004), P. 5.

9See Persch (2003), P. 40; Light (2004), P. 146.

10See Rastogi (2000), P. 193 et seqq..

11See P. 17

12See Dakhli / De Clercq (2004), P.109.

13See Nahapiet / Ghoshal (1997), P 35; Light (2004), P. 146.

14See Durlauf (2002), P. F460.

15See Robinson / Schmid / Siles (2002), P. 2.

16See Tsai / Ghoshal (1998), P. 464.

17 See Glaeser / Laibson / Sacerdote (2002), P. F438.

18See Nahapiet / Ghoshal (1997), P. 35.

19See Van Deth (2003), P. 82.

20See P. 18.

21See P. 19.

22See Aschoff (1978), P. 180; Shaikh (2004), P. 442.

23See Hermanson (1964), P. 5.

24See Hermanson (1964), P. 14.

25 See Persch (2003), P. 124.

26See Persch (2003), P. 127.

27See Hermanson (1964), P. 15.

28 See Persch (2003) P. 129.

29See Persch (2003), P. 131, Aschoff (1978), P. 185.

30See Aschoff (1978), P. 186.

31See Persch (2003), P. 133; Aschoff (1978), P. 187.

32See Lev / Schwartz (1971), P. 105.

33 See Lev / Schwartz (1971), P. 105; Persch (2003), P. 134.

34See Lev / Schwartz (1971), P. 106.

35See Lev / Schwartz (1971), P. 106; Flamholtz / Searfoss / Coff (1988), P. 1 et seqq.; Persch (2003), P. 136.

36Lev / Schwartz (1971), P. 107.

37See Persch (2003), P. 141.

38See Persch (2003), P. 142.

39See Flamholtz (1974), P. 45 - 46; Persch (2003), P. 143.

40 See Flamholtz (1972), P. 259; Flamholtz (1982), P. 74.

41See Persch (2003), P. 162.

42See Flamholtz / Searfoss / Coff (1988), P. 4.

43See Flamholtz (1974), P. 56.

44See Flamholtz (1999), P. 182

45See Persch (2003), P. 176.

46See Flamholtz (1974), P. 61.

47 See Morse (1972), P. 590.

48See Morse (1973), P. 591.

49See Morse (1973), P. 591.

50For a deeper inside into the method of real-options, see Hull (2003), pp. 660 et seqq..

51 See Hommel / Pritsch (2001), P. 11, Pertsch (2003), P. 184.


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European Business School - International University Schloß Reichartshausen Oestrich-Winkel
Valuing Seminar Finance Banking



Title: Valuing human and social capital