By Jack Forehand, CFA (@practicalquant)
There has been a major change in our economy going on for a long time now. The days where the largest firms make physical things and need significant physical assets to do that are quickly becoming a thing of the past. Take a look at the current top 5 holdings in the S&P 500.
These 5 companies currently make up over 20% of the index, and producing physical products isn’t the biggest part of what any of them do. Even Apple, which certainly sells many physical products, outsources most of its production to third parties.
Even though the economy has evolved, some of the metrics we use to judge companies haven’t evolved along with it. If you were to look at the valuation of any of these firms relative to their book value on their financial statements, you would likely conclude that they have reached extreme levels of overvaluation.
But that analysis would miss one major point: most of the assets these firms have do not appear anywhere on their financial statements.
Consider Google as an example. What are its biggest assets? Is it the computers that run its website? Is it the buildings it owns? It obviously isn’t either. Google’s biggest assets are things that are much more difficult to measure like its brand and the algorithm that powers its search engine. But despite their importance, you won’t find them anywhere on the company’s balance sheet.
This rise of intangible assets presents a challenge for those who to deploy strategies that utilize the values of a firm’s assets, or the expenses that play a role in generating them.
Does Accounting Need to Evolve?
But before we look at different approaches to value these assets and incorporate them in financial statements, there is an important question to ask first: should they be on financial statements at all?
On one hand, investors rely on data presented within financial statements to value companies, and if that data does not present a fair and reasonable picture of a company and its business then you can argue that we need to change that.
NYU Professsor Baruch Lev has been a leading proponent of this idea. Here is what he said in a 2018 research paper on the subject.
I address below this accounting impasse, and argue, based on empirical evidence, that the major reasons for the deterioration in financial information relevance are: (1) the shift of standard-setters during the 1980s from the traditional income statement approach, aimed at generating high-quality reported earnings by closely matching revenues with real expenses, to the so called balance sheet model, which emphasises assets and liability fair valuation, and, even more damaging, (2) a flawed application of the balance sheet (asset valuation) model during the dramatic shift of corporate value-creating resources from tangible to intangible assets, resulting in an increasing mismatch between revenues and expenses, and the absence of the most important, value-creating enterprise resources from the balance sheet. The result: A largely uninformative balance sheet, except, perhaps for those of financial firms, and an income statement which fails to live up to its major purpose: reflecting enterprise performance and the quality of management.
https://www.tandfonline.com/doi/full/10.1080/00014788.2018.1470138
But on the other hand, intangible assets (for reasons we will discuss next) are very difficult to value. Including them on the balance sheets of firms could lead to more problems than it solves if it isn’t possible to calculate a reasonable value, or if it allows companies to present an inflated picture of their business and its value. University of Toronto Professor Partha Mohanram made this case when he appeared on our Excess Returns podcast.
The Valuation of Intangible Assets
Whether intangible assets are included on financial statements or not, it is still important for anyone analyzing the value of a company to understand their value to the firm.
There are three major ways to approach trying to value them.
For the non-quants out there, there is the traditional method of doing a deep dive into the business and trying to understand what its intangible assets are, and what they are worth.
For quants like myself, there are a couple of methods that can be used.
[1] Using Reported Financial Data
The standard method tries to use reported accounting data to adjust the financial statements to reflect the value of intangibles. The most common method is taking the expenses that generate intangible assets and capitalizing them over time instead of recognizing them in the year they are made. The two expenses commonly used are Research and Development and Advertising (or SG&A since many firms do not report out advertising separately). Using this method, these expenses are turned into assets and depreciated over a 10-year time frame. This causes an increase in total assets to reflect the intangibles and also a change to income statement metrics like earnings per share since they would now include a portion of ten individual years’ worth of these expenses instead of just the current year expense.
While this method is likely to present a more accurate picture of many firms (particularly firms in sectors like technology), it also has its drawbacks. The primary one is that it can be very difficult to tie the value of these assets to the expenses that create them.
Let’s look at advertising as an example. Some firms are very effective at building their brands via advertising, while others are not. Still others engage more in direct response advertising that doesn’t really enhance a brand. If we advertise a subscription to Validea.com, we are typically looking for that to generate immediate sign ups to our website. We don’t really build our brand by doing it. We are looking for a direct response. This type of advertising should likely be 100% expensed. Apple, on the other hand, has built a massive brand over time. Even if you add up all its advertising expense, turn all of it into an asset, and never depreciate one dollar of it, you still likely will come up well short of its brand value. By just taking a general advertising number and turning it into an asset that depreciates over 10 years, we aren’t taking into account the major differences in these situations and the nature and results of the advertising.
[2] Using Alternative Data
Another option some firms use is to look outside the data found on financial statements to try to value intangibles. In his excellent piece Investing in the Intangible Economy, Kai Wu of Sparkline Capital looked at using external sources to measure things like brand value and patents, and he found that this method worked better than using standard financial data (if you would like more detail, you can see our full podcast interview with Kai here) But regardless of which method you choose, measuring intangibles is an inexact science and is very challenging to do accurately.
Value Going Forward
Being a successful investor requires building an investment strategy that is able to evolve over time. Warren Buffett started out as a deep value investor in the mold of his mentor Ben Graham, but he evolved his strategy into one that looks for high quality companies at discounted prices over time when he felt it was necessary. All of us who are value investors are now presented with a situation where our strategies will also need to evolve. Relying on traditional book value in an economy where more than half the assets aren’t on company’s balance sheets doesn’t make sense. The way we look at earnings and the expenses that go into their calculation will also need to evolve.
I am a big believer in value investing. I think the next decade will likely be a good one for traditional value strategies given how cheap value stocks are relative to history. But as we move forward, I think all of us who use value also need to recognize that our strategies need to reflect the world we live in. And that world is one in which intangible assets need to be accounted for.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
