The Stock Market is Not the Best Way to Value Intangibles

In the Value Networks discussion group here, someone recently asked the question about the value of intangibles now that the stock market has declined so precipitously. Many of us in the field have used the shorthand formula: market cap – tangible book value = intangibles.

This got me started and I posted the following answer. Most of these themes have been explored in previous posts but this one pulls a lot of it together…

The use of market capitalization minus book value to arrive at an intangibles valuation was never a scientific exercise. Even so, we all use it because it is a good shorthand way of pointing to the fact that corporate value is no longer driven by what a company OWNS (tangible assets) but, rather, by what it KNOWS (intangible knowledge assets including people, process, IP and, of course, networks.

Analysts do not arrive at the corporate value by looking at the intangibles as assets, they arrive at it by making judgments about future earnings. Over time, there is lots of room to educate analysts about how to improve their judgments of earnings using analysis of intangibles.

The state of the art for valuation of intangibles is a discounted cash flow based on the known and established uses of the intangible. This, by the way, is the method used to value intangibles acquired in a merger—and to put them on the balance sheet where they are mixed in with assets valued at cost. When there is a downturn, these assets get written down faster than the tangible assets, not because they have lost more value but because it makes sense in current accounting paradigms.

The accuracy of valuations will be improved once we have more market data on individual intangibles transactions (this already exists but at a low level of activity). But even then, the market will only be able to value the intangible based on the current understanding of its value. Paul Romer taught us that knowledge is an infinite asset and, as such, its value is limited only by the potential use of that knowledge. But infinite doesn’t mix well with business.

In business, we have to appreciate the infinite value of knowledge but we have to operate by looking at cost and return. Most companies do not know how much they spend on intangibles because the “cost” hits the income statement and is not segregated. I advocate calling this “intellectual capital expenditure” and tracking it separately.

Here’s the logic: If you were going to build a factory, you would want to know how much it would cost to build, maintain and operate—and then calculate the potential return. Intangibles should be no different. Analysis of intangible investments should ask, “What is the cost and what is the return on this investment?”

Although he has been a great promoter of the field of intangibles, Baruch Lev has convinced even the accounting regulators that we cannot use cost because of the infinite nature of intangibles (I had this confirmed to me just this week). In some ways, he is doing the field a disservice, making it more complex than it is.

The investment perspective was used at a macroeconomic level by Leonard Nakamura at the Fed in his estimates that the steady state US investment in intangibles is roughly $5 trillion, which is about one half of market value. Other data from the OECD shows that U.S. national investments in intangibles now exceed investments in tangibles.

So the bottom line on intangibles is that they represent at least (and probably much more than) half of corporate “assets.” If you want more on this discussion, use the search term “intangible cost” in the upper right hand corner of this page.