How Intangible Assets Provide Value to Stocks

What explains the runaway success of an initial public offering from a company with no earnings history? And how does a poor earnings report that misses market expectations send a healthy company's share price plummeting?

When the market ignores a company's historical financial performance, there is "information asymmetry" because traditional reporting methods, like audited financial reports, analyst reports, and press releases, disclose only a fraction of the information. The value of intangible assets such as research and development (R&D), patents, copyrights, customer lists, and brand equity are not represented.

Why Intangible Assets Matter

The value of companies has slowly shifted from tangible assets, or "bricks and mortar" assets, to intangible assets, like intellectual capital. These invisible assets are the key drivers of shareholder value in the knowledge economy, but accounting rules do not acknowledge this shift in the valuation of companies. Statements prepared under generally accepted accounting principles (GAAP) do not record these assets.

Although the percentage of intangible assets has increased, accounting rules have not kept pace. If the R&D efforts of a pharmaceutical company create a new drug that passes clinical trials, the value of that development is not found in the financial statements. It doesn't show up until sales are made. The value of an e-commerce retailer comes from intangibles like software development, copyrights, and its user base.

There is a disconnect between what happens in capital markets and what accounting systems reflect. Accounting value is based on the historical costs of equipment and inventory. Market value comes from expectations about a company's future cash flow, represented by intangibles such as R&D efforts, patents, and workforce.

Investors and Intangibles

Investor wariness is common when considering intangibles. A company may have a $2 billion market capitalization but with revenue of only $100 million. Analysts' metrics can only provide a limited snapshot. Rumor and innuendo, PR and the press, speculation, and hype tend to fill the information space.

To better milk their patents and brands, many companies measure their worth. But these numbers are rarely available for public consumption. Even when used internally, they can be troublesome. Miscalculating the future cash flows generated from a patent could prompt a management team to build a factory it cannot afford.

Investors could benefit from financial reporting that includes improved disclosure. Countries, including the U.K. and France, allow recognition of a brand as a balance sheet asset. The Financial Accounting Standards Board in the U.S. has only considered whether to require intangibles on the balance sheet.

How to Value Intangibles

One method to value intangibles is calculated intangible value (CIV). This method overcomes the drawbacks of the market-to-book method of valuing intangibles, which simply subtracts a company's book value from its market value and labels the difference. Because it rises and falls with market sentiment, the market-to-book figure cannot give a fixed value of intellectual capital. CIV, on the other hand, examines earnings performance and identifies the assets that produced those earnings. In many cases, CIV also points to the enormity of the unrecorded value.

Using microprocessor giant Intel (INTC) as an example, CIV goes something like this:

1. Calculate average pretax earnings for the years 2006, 2007, and 2008. For Intel, that's $8 billion.
2. Go to the balance sheet and get the average year-end tangible assets for the same three years. In this case, it is $34.7 billion.
3. Calculate Intel's return on assets (ROA) by dividing earnings by assets: 23%
4. For the same three years, find the industry's average ROA. The average for the semiconductor industry is around 13%.
5. Calculate the excess ROA by multiplying the industry average ROA (13%) by the company's tangible assets ($34.7 billion). Subtract that from the pre-tax earnings in step one ($8.0 billion). For Intel, the excess is $3.5 billion. This tells you how much more than the average chip maker Intel earns from its assets.
6. Pay the taxman. Calculate the three-year average income tax rate and multiply this by the excess return. Subtract the result from the excess return to find an after-tax number, the premium attributable to intangible assets. For Intel (average tax rate 28%), that figure is $3.5 billion - $1.0 billion = $2.5 billion.
7. Calculate the net present value of the premium. Do this by dividing the premium by an appropriate discount rate, such as the company's cost of capital. Using an arbitrary discount rate of 10% yields $25 billion.

The calculated intangible value of Intel's intellectual capital, which doesn't appear on the balance sheet, amounts to $25 billion.

The Bottom Line

While intangible assets don't have the obvious physical value of a factory or equipment, they are significant to investors. Intangible assets can prove valuable for a firm and can be critical to its long-term success or failure.