The lofty prices of certain stocks (i.e. FAANG) present a challenge for value investors, according to an August article in CFA Institute that delves into the subject of intangible assets and presents a proprietary metric—called the Franchise Quality Score—intended to evaluate the benefits such intangibles can offer.
The article explains that current accounting standards were created during the industrial era when businesses were primarily engaged in manufacturing. “These standards have not kept pace in an increasingly services-based economy characterized by rapid technological and financial innovation,” the article notes, underscoring the need for investment professionals to “come up with a logical approach to incorporate intangibles into their decision making; otherwise they risk being relics in the age of information.”
Offering background information on the evolution of intangible assets, the article points out that this class has grown from 9% to 14% of national gross value added (GVA) between 1977 and 2014, while investment in tangible assets has dropped from 15% to 9% during the same period. “This trend,” the article states, “has exacerbated the impact of the inconsistent accounting treatments” of the respective asset categories.
The CFA Institute created the Franchise Quality Score—defined as “the ability of a firm to consistently and repeatedly earn excess return…without inviting competition that would eliminate that excess return”– to focus on the upside of intangibles. The score is calculated by assigning a value to eight component factors (on a scale of 1 to 5):
The article explains, “We derive the composite Franchise Quality Score from this framework and apply it as an independent variable in a regression model that uses valuation, quality and growth factors to identify undervalued stocks.” It concludes that, while it is challenging to accurately assess this category of assets, “the perfect should not be the enemy of the good,” and that “even a basic, logical attempt to incorporate intangible assets is better than none at all.”