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.