Craig Hoyda, senior quantitative analyst, multi asset investment solutions, abrdn, explains why it helps to know a company’s ‘intangible’ value
A balance sheet gives a vital indication of what state a company is in. Debts, assets, liabilities – these are all relatively easy to value. But, increasingly, investors are interested in ‘intangible’ assets, which can be much harder to pin down.
Goodwill, brand value and intellectual property are the kind of non-physical assets defined as ‘intangible’, but nevertheless extremely important for a company. These assets are notoriously difficult to value, but investors need to be fully aware of what they are buying when investing in a company believed to be intangible asset heavy.
Looking at these intangibles in turn, let’s begin with goodwill. Put simply, this is the difference between the price paid and fair market value when one firm acquires another. With merger and acquisition activity soaring in recent years, it’s no surprise that corporate empire-building has led to significant amounts of goodwill building up on balance sheets. Goodwill is a close relation to the next intangible on the list, brand value.
Under accounting rules, brands that are created internally cannot be capitalised (listed as an asset) on balance sheets. However, brands acquired externally can be listed as intangible assets under ‘goodwill’. Interestingly, if a brand has been tarnished, a write-down will likely be recorded, but if a brand increases in stature, there is no provision to revalue it upwards. This means there are many brands whose values are not being correctly reflected, which presents investors with exciting opportunities.
Last, but by no means least, of the intangibles is intellectual property – patents are a good example and of great importance to all kinds of businesses, from drug companies to computer giants. Using, or not using, patents can greatly affect a company’s value. One story often cited is the invention of the computer mouse by Xerox – the mouse wasn’t patented and went on to be fully exploited by Apple. The real story is possibly more complicated; however, the point remains that an invention can be far more valuable than at first imagined and patents provide useful protection if value is realised in the future.
Why does an investor need to understand all this?
Intangibles are becoming an increasingly important part of the corporate environment. It’s critical to understand exactly what you are buying with a share. The classic ‘price-to-book’ (P/B) ratio looks at the price of a company in relation to its net asset base, or the value of assets on the balance sheet, minus the value of liabilities. The market generally assigns higher values to growth stocks, such as younger companies with scope to substantially expand their earnings.
In terms of the book value, an analyst with a true understanding of the value of intangible assets on the balance can assess whether the price the market assigns is fair. For example, if an investor’s forensic valuation of a firm’s balance sheet leads to the conclusion that the company’s patents are overstated in value, then the sensible course of action would be to sell or to short-sell the stock, as supernormal returns may be realised if and when the market reaches the same conclusion. Alternatively, an investor may conclude that a brand is undervalued, due to the inability of a company to record brand value on the balance sheet. Examples of firms with brands that lead to a large amount of sales include Apple and Nike – their global name recognition is reflected in earnings and earnings potential, but doesn’t appear on their balance sheets.
What’s the benefit of intangible exposure?
Diving deep into a company’s balance sheet and identifying mis-valued assets is what an investor hopes to do. But should investors be looking for broad exposure to companies that are heavy on intangible assets? Perhaps the answer is not yet.
If we enter a global recession, companies’ ability to grow earnings will be extremely constrained. This means those intangible assets, which can provide an avenue to generating income in good times, will be less effective when incomes are constrained. However, this does not mean that every firm which is intangibles heavy will underperform. Large corporates won’t be cutting back on their use of Microsoft’s products in the way that consumers might have to hold off upgrading to Apple’s next phone.
In the current environment, the market is likely to prefer firms laden with tangible assets, which can be valued more easily and converted into cash if required. However, consolidation may be a key theme in the coming quarters, as companies try to cope with tougher trading conditions by merging with or acquiring other firms in defensive merger and acquisition moves. In these cases, an investor who can gain an understanding of not just the black-and-white of a balance sheet, but also the more hidden value of the intangibles, may gain a deeper insight into a company’s true value. This is the kind of insightful information that investors need to make successful stock-picking decisions.
