Intangible Assets: Why Now?

Intangibles: You Can't Touch Them, Smell Them, Or See Them. So Why Bother With Them?

It's Annual Report Season again in America. For the next several weeks your mailbox, seemingly whenever you open it, is going to contain at least one colorful, bulky, beautifully-printed, costly publication telling you - it swears - how a company in which you own stock fared last year.

As far as that company and its auditors know, they're telling the truth. But unless you open that annual report and see detailed accounting of "intangible assets," you're not seeing the whole picture.

The valuation of intangible assets will hold profound implications for your investments for the foreseeable future. Regrettably, those intangible assets are still missing from the vast majority of financial statements, which greatly handicaps analysts, corporate officers, and of course investors.

Thus this introduction to intangible assets, and future stories on the topic. While you won't have access to all of the information you would need to do your own intangible analysis, you'll still want to have some notion of what it's all about. Without at least a nodding acquaintance with intangibles - such things as brand names, franchise agreements, new processes, corporate talent, products in development, patents, copyrights, proprietary software, reputation, customer lists, long-term contracts, and perhaps above all, ideas - and some notion of how they affect stock prices, you could be inaccurately valuing virtually every stock in your portfolio.

Where is it?

Entities like steel mills, textile factories, railroads and energy companies, own plants, equipment, and natural resources, which are relatively easy to value. But the old accounting methods, which worked fine when valuing those tangible production functions, can't deliver useful information when dealing with a knowledge-based company. (No wonder, since those accounting methods were developed in the 15th century.)

However, we're still using that old system to make critical decisions in this complex new environment where the assets that create value often bear no resemblance to plants, equipment, and natural resources. It's not a good fit. That accounting system was based entirely on transactions for resources, manufactured goods, and services; indeed, "transactions" are the key to a tangible-asset-based economy. However, since the beginning of the 20th century, tangible assets and their transactions have constituted an ever-shrinking portion of the U.S. economy.

As proof, look at this change in the ratio of tangible to intangible business capital in the last 70 years, according to John Kendrick, an economist who studies the determinants of economic growth: In 1929 the tangibles-to-intangibles ratios was 70% to 30%. In 1990 it was 37% to 63%.

Dancing in the dark

Today's economy contains a great deal more non-transactional value than it did 100 years ago. For example, when a software program passes a beta test there's no transaction and nothing changes hands, but it suddenly becomes valuable. Similarly, when a highly-anticipated drug completes a final clinical trial there's no transaction, but value is undeniably created . . . a manufacturer moves its operations offshore, potentially saving millions in costs . . . a CEO with a brilliant record leaves one company and joins another . . . a company extends its successful patent for another seven years. Leaving these potential values off a financial statement is like forgetting to mention operating revenues.

But generally accepted accounting principles (known as GAAP) still have no hard-and-fast provisions for how to value those situations. Consequently, a knowledge-based company can't properly quantify its intangible assets, and so is forced to give its shareholders a blinkered and inaccurate view of its operations and prospects.

Here's another example: GAAP mandates that you treat in-process research and development without a current product as an expense. So what happens when you acquire a company that's largely involved in R&D? You have to expense all or most of the acquisition, take a big (needless) one-time hit, and probably watch your company's stock price plunge while hardly any trace of an asset remains.

Few investors know how to determine the real value of a knowledge- based company, so they trade on momentum, news, or rumor, often applying industrial-age fundamental analysis techniques to evaluate their holdings - which could explain much of the recent Nasdaq disaster. What we are dealing with is the exact opposite of transparency.

Old accounting plus new economy equals faulty valuation and almost certain stock-price volatility.

Baruch Lev, the Philip Bardes Professor of Accounting and Finance at NYU's Stern School of Business, is widely considered the "father" of intangible analysis. Even he recognizes that it's hard to come up with a comprehensive definition of intangible assets, but he's managed to group them into four categories:

First are assets related to product innovation, such as those that derive from a company's research and development efforts. Then there are assets associated with a company's brand, which can allow a company to successfully sell its products or services at a higher price than its competitors. Third are structural assets, which are markedly more efficient and productive ways of doing business. Finally come monopolies: companies with a solid franchise, an effective (legal) barrier to entry, or substantial "sunk costs" that any would-be competitor would have to match.

Pick a number. Any number.

"Intangibles illiteracy" can affect corporate financial officers and stock analysts in a very big way. In the last eight or 10 years, how many impressive sounding companies with no earnings, dot-coms and otherwise, have been acquired for more money - embarrassingly more money - than they were really worth? Dozens, if not hundreds. How many wildly touted tech IPOs turned out to be mere flashes in the pan? Too many, as we now know.

But intangibles illiteracy can affect everyone in an economy: Employees don't know how to accurately value their contributions to their companies. Managers don't know whether to back a project, or if they back it, how to properly monitor it. Investors - including many sorrowful investors in the above- mentioned IPOs and acquiring companies - don't know whether the stock prices of some knowledge-based companies are inflated. They could even be deflated.

If nothing else, an understanding of intangible assets can protect you from getting too many nasty shocks.

Professor Lev is also Director of the Project for Research on Intangibles and has pioneered the development of a Knowledge Capital Scoreboard, which assigns hard numbers to intangible assets. In future Education Center columns for the Alert, Professor Lev will be discussing intangible assets in detail, including their effects on stock prices.

Beginning this month, Professor Lev will contribute a series of essays to the 21st Century Education Center. This special arrangement is part of a yearlong investor education initiative that will:

• Explain the impact intangible assets have on stock market valuations

• Teach you the common language of intangibles

• Examine the role of knowledge management practices and the nature of intellectual capital

• Identify measurement models that you can use to more accurately assess your investments

In the future, transparency will return to financial statements, and the balance sheet will include all of the details you need to accurately value your investments. Until then, we will help you acquire the knowledge and provide you the tools needed to make educated investment decisions.

* Baruch Lev's participation is strictly educational. He is not involved and bears no responsibility for 21st Century's recommendations and products.