Education: Value Investing

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Factoring in Intangibles

When determining the value of a company, it is fairly straightforward when it comes to getting our arms around its tangible assets. These can include equipment, land, buildings—basically anything of physical existence. But what about assets that are not physical in nature? These are referred to as intangible assets and can hold a great deal of value for a company.

Common Types of Intangible Assets

Unfortunately, investors are only able to obtain a fraction of pertinent information needed before deciding whether to buy or sell a particular stock. Financial statements are easily accessible, analysts covering the stock frequently make buy and sell recommendations, company web sites provide a plethora of information, etc.

However, beyond all of this lies a vast amount of additional information that is usually out of reach of the common investor and, to make matters worse, are extremely difficult to put a price tag on. These are referred to as intangible assets and statements prepared under generally accepted accounting principles (GAAP) do not disclose this type of information. Some of the most common include:

Copyrights: How is one to value the legal right granted to a company to exclusively publish, produce, sell, market, or distribute certain works or information?

Patents: When a company is granted a patent by the government, it is given the exclusive right to make use of an invention or process for a fixed period of time. Other companies are prohibited from producing, using or selling the claimed invention.

Trademarks: A trademark consists of a distinctive name, symbol, motto or design of some kind which is used by a company to uniquely identify itself and its products and services to its prospects and customers. Other companies can be prevented from using identical or similar marks.

Goodwill: This is usually something that provides a company with a competitive advantage. Perhaps a strong brand name or maybe a great employee base. Since these are abstract concepts, goodwill is very difficult to value.

Trade Secrets: These are commonly referred to as “confidential information.” Client or prospect lists are great examples of a trade secret.

Valuing Intangibles

After reading the various intangible assets mentioned above, you can see why it is awfully difficult when it comes to their valuation. Nevertheless, these items remain crucial components when an investor is trying to determine whether or not a company is currently trading below its fair value.

A great deal of research in this area has been conducted over the years. While improvements continue to be made, opinions on which approach to take or which model to implement varies across the business valuation industry.

One approach that seems to be mentioned rather frequently is the calculated intangible value (CIV) model. This approach puts a dollar amount on intangible assets by examining a company’s ability to outperform an average competitor with similar tangible assets. The following steps are taken (retrieved from www.investopedia.com):

Step 1: Calculate average pretax earnings for three years.

Step 2: Go to the balance sheet and get the average year-end tangible assets for three years.

Step 3: Divide earnings by assets to get the return on assets (ROA).

Step 4: For the same three years, find the industry's average ROA.

Step 5: Calculate the "excess return" by multiplying the firm's tangible assets by the industry ROA and subtracting them from the firm's pretax earnings.

Step 6: Calculate the three-year average income tax rate and multiply it by the excess return. Subtract the result from the excess return to come up with an after-tax number, the premium attributable to intangible assets.

Step 7: Calculate the net present value of the premium by dividing the premium by the company's cost of capital.

Conclusion

It should go without saying that the creation and management of intangible assets is imperative to a company’s long-term success. Moreover, they can often be more important than tangible assets. If you are interested in additional information, there are a number of publications available to further assist you in the valuation of these types of assets. It would be in your best interest to consult with one of these.