Accounting’s Mistreatment of Intangible Assets Distorts Equity Market Valuations
Intangible assets comprise some four-fifths of S&P 500 companies’ total value, but they don’t show up in balance sheet and valuation analysis unadjusted. About that growth-to-value market rotation…
If the recent speculation about a growth-to-value stock rotation was reinforced in September, when value-classified stocks outperformed growth stocks both in the U.S. and globally, investors now tempted to try and time a leadership shift between the two factors might first consider whether other dynamics may be undermining the strength of the signals reflected in traditional valuation metrics such as price-to-book and price-to-earnings ratios.
After all, a more accurate assessment of a company’s total investment and the potential return on that investment is crucial to gain a better understanding of the company’s earnings potential and return prospects for its shareholders and creditors alike.
The S&P 500 Value Index and the MSCI ACWI Value Index shed 2.3% and 3%, respectively, in the last month of the third quarter, beating their S&P 500 Growth and MSCI ACWI Growth index cousins’ 5.9% and 4.5% losses in the period. Whether an inflection point in index-level style leadership has been reached or it’s yet another headfake, sharper bottom-up analysis can greatly enhance the appraisal of an individual stock’s intrinsic value. That, in turn, improves portfolio construction, regardless of the factor benchmarks into which index providers assign underlying stocks.
Adjustments for anachronistic accounting treatment of investment in both “asset light” new economy stocks and old economy cyclicals can give a far better sense of what nowadays actually constitutes the scale of a company’s investment, the potential return on that investment and greater visibility into future profitability.
To Ensure Against Undervaluing Intangibles, Recognize Value from Investment in Intangibles
The key, says Thornburg Portfolio Manager Sean Sun in a new podcast, is adjusting for investment in intangible assets such as software code, customer lists, licenses, wireless spectrum or other rights, brand equity and sundry types of intellectual property protected by patents and copyrights. While tangible assets are easy to appraise and insure, and show up on the balance sheet, intangibles are harder to measure, insure and show up on the income statement, he points out.
“P/B is what traditional value investors focus on, yet it really only captures tangible assets,” Sun says. “But our economy and our world have been evolving more toward value being embedded in stuff like intellectual property…(and) more digital goods as opposed to physical stuff. When you’re valuing a company purely on tangible book, you’re really missing a whole lot of embedded value.”
Optically Pricey P/B Still Comes Up Short
The estimated value of intangible assets of S&P 500 Index companies runs at roughly $24 trillion, far greater than the approximately $5 trillion in tangible assets of the blue-chip index constituents.
The Intangible Growth of Real Market Value
Source: Bank of America, AON
Smart private equity firms, Sun adds, certainly adjust for intangible value in acquiring software companies, which often produce extremely valuable streams of cash flow against which leverage can be applied for buyout deals. Indeed, about $121 billion of software deals were done in 2019, he notes.
A corollary is evident in the pharmaceutical industry with Gilead Sciences’ $21 billion acquisition bid for Immunomedics, book value of which runs less than $600 million. Immunomedics, Sun points out, has a cancer drug that can potentially generate between $4 billion and $5 billion in peak sales. The transaction illustrates the nature of “rival” goods, which can only be used by one party at a time, and “non-rival” goods, which can be used by multiple parties simultaneously. A cancer drug, for example, can treat a wide swath of people at the same time while benefitting from patent protection. That “excludability” alongside its non-rival status makes it extremely valuable in a way that traditional book value doesn’t capture, Sun says.
Expensing Intangible Investment on the Income Statement? Sharpen Your Pencil
It also illustrates the value of research and development, which is recorded on the income statement rather than the balance sheet, where capital expenditure shows up. “We all agree that capex is an investment for growth,” Sun says. “We all generally agree that research and development (R&D) is also an investment for growth. But the problem…is that it’s expensed on the income statement as it’s incurred; thus, it doesn’t generate a tangible asset, but it is clearly generating these intangible assets like software code, or patents, or drugs or whatever the case may be, that generate cash flows over time.”
The problem is bigger than most investors may realize, given the sheer scale of investment in R&D compared with capex. According to the Bureau of Economic Analysis, U.S. R&D spending over the last 20 years has been growing at a 4.5% compound annual growth rate, nearly double the 2.4% CAGR in non-financial capex growth.
Growth Drivers in Slow and Fast Lanes
Source: U.S. Bureau of Economic Analysis, St. Louis Federal Reserve
And it’s not just R&D that conventional accounting is failing to count as an asset. Aspects of sales and marketing and even general and administrative (G&A), which also fall on the income statement, contribute to brand development and customer acquisition. In this respect, they aren’t all just costs but to degrees investment in intangible assets as well. In “SaaS” (software as a service), this is reflected in the customer lifetime value-to-customer acquisition cost ratio. “When lifetime value exceeds the customer acquisition cost by quite a bit, that’s the sign of a really healthy software company,” Sun says.
Network effects on social media, gaming and other types of online platforms create both economies of scale on the supply side and increasing returns on the demand side as the user base grows and monetization opportunities expand. That combination creates a powerful dynamic. But beyond servers, the tangible assets of these companies pale in comparison to their intangible assets.
Active Fund Managers Make Reasonable Adjustments to Clarify Value of Future Cash Flows
Yet for all firms, including old-industry cyclicals, unadjusted P/B ratios can be misleadingly low. “I think it’s important as a fundamental investor to not just look only at the optical metrics but to dig a little deeper,” Sun says. “Make adjustments where it makes sense to capitalize R&D or capitalize parts of sales and marketing or G&A in your pro-forma analysis to get you to what a company is really worth.”