Stocks have real value because of intangible assets.
What could explain the astronomical success of an IPO from a company with no track record of profitability? Why might a healthy company’s share price plummet due to a little of bad news or an earnings report that just misses market expectations?
The market frequently responds to “information asymmetry” when it ignores a company’s prior financial performance. Traditional financial reporting methods—audited financial reports, analyst reports, and press releases—disclose only a fraction of the information useful to investors, resulting in the asymmetry. Intangible assets, like as research and development (R&D), patents, copyrights, customer lists, and brand equity, account for a significant portion of the information gap.
Important Points to Remember
The market frequently responds to “information asymmetry” when it ignores a company’s prior financial performance.
Intangible assets, like as research and development (R&D), patents, copyrights, customer lists, and brand equity, account for a significant portion of the information gap.
In the information economy, these intangible assets are the fundamental drivers of shareholder value, yet accounting rules ignore this shift in company valuation.
As a result, there is a significant gap between what occurs in the capital markets and what accounting systems reflect.
Why Are Intangible Assets Important?
Any business professor will tell you that the value of a company has shifted dramatically from tangible assets, such as “bricks and mortar,” to intangible assets, such as intellectual capital. In the information economy, these intangible assets are the fundamental drivers of shareholder value, yet accounting rules ignore this shift in company valuation. These assets are not recorded in financial statements made according to generally accepted accounting principles (GAAP). Investors must rely on speculation to determine the correctness of a company’s value when they are in the dark.
However, as the number of intangible assets held by firms has risen, accounting regulations have not kept up. For example, if a pharmaceutical company’s R&D efforts result in a novel medicine that passes clinical testing, the financial statements do not reflect the value of that discovery. It doesn’t appear until after sales have been made, which could take several years. Consider the worth of an e-commerce store. Almost majority of its worth is derived from software development, copyrights, and its user base, according to some estimates. While the market reacts quickly to clinical trial findings or client attrition at online shops, these assets are lost in the financial accounts.
As a result, there is a significant gap between what occurs in the capital markets and what accounting systems reflect. Accounting value is based on previous costs of equipment and inventory, whereas market value is based on expectations about a company’s future cash flow, which is largely based on intangibles like R&D activities, patents, and the complexity of its staff.
Why Is It Difficult to Trust Intangibles?
It’s not surprising that investors are concerned about valuation. Consider investing in a company with a market capitalization of $2 billion but only $100 million in sales to date. You’d definitely guess that the value picture has a lot of gray areas. Perhaps you’d enlist the help of analysts to fill in the gaps. However, experts’ measurements can only go so far. The factors that tend to fill the information space are rumor and innuendo, public relations and the press, speculation, and hype.
Many firms value their patents and branding in order to better milk them. However, these figures are rarely available to the general public. They can be inconvenient even when utilized internally. A management team’s miscalculation of future revenue flows generated by a patent, for example, could lead to the construction of a plant that it cannot afford.
Investors might, without a doubt, benefit from more transparent financial reporting. Brand recognition as a balance sheet asset is already permitted in a dozen or more nations, including the United Kingdom and France. A study was conducted by the Financial Accounting Standards Board to see if intangibles should be included on the balance sheet. The topic was dropped from the research agenda due to the huge difficulties of accurately valuing intangibles and the high danger of erroneous measurements or surprise write-downs. Investors shouldn’t hold their breath for a change in that decision any time soon.
Intangibles: How to Value Them
Despite this, it pays for investors to try to grasp intangibles. Much accounting research is devoted to devising methods for valuing them, and procedures are, thankfully, improving. While perspectives on appropriate tactics continue to differ sharply, investors should take a look.
Try determining the overall value of a company’s intangible assets as a starting point. Intangible value is calculated using one approach (CIV). The market-to-book approach of valuing intangibles, which essentially subtracts a company’s book value from its market value and labels the difference, has several flaws. The market-to-book figure cannot provide a fixed valuation of intellectual capital since it fluctuates with market mood. CIV, on the other hand, analyzes earnings and pinpoints the assets that generated those earnings. CIV also emphasizes the enormous unrecorded value in many cases.
CIV looks somewhat like this, using Intel (INTC) as an example:
- Calculate your three-year average pre-tax earnings (for this example, the years are 2006, 2007, and 2008). That’s $8 billion for Intel.
- Get the average year-end tangible assets for the same three years from the balance sheet. It’s $34.7 billion in this scenario.
- Divide profits by assets to get Intel’s return on assets (ROA): 23% of the population
Find the industry’s average ROA for the same three years. The semiconductor industry’s average profit margin is roughly 13%.
- Calculate the excess ROA by multiplying the company’s tangible assets ($34.7 billion) by the industry average ROA (13 percent). Subtract that from the $8.0 billion in pre-tax earnings in step one. Intel has a $3.5 billion surplus. This shows how much more Intel profits from its assets than the average chipmaker.
- Make a payment to the taxman. Calculate the excess return by multiplying the three-year average income tax rate. Subtract the result from the excess return to get the premium attributable to intangible assets after taxes. That calculation is $3.5 billion – $1.0 billion = $2.5 billion for Intel (average tax rate 28%).
- Calculate the premium’s net present value. Divide the premium by a suitable discount rate, such as the company’s cost of capital, to arrive at this result. Using a 10% discount rate, the total value is $25 billion.
That is all there is to it. Intel’s intellectual capital has a computed intangible value of $25 billion, which does not appear on the balance sheet. Assets of this magnitude surely ought to be seen.
While intangible assets may not have the same visible physical worth as a factory or equipment, they are nonetheless valuable. In reality, they can be extremely beneficial to a company and even crucial to its long-term success or failure.