Putting a price tag on intangible assets in business valuation

Constellation Brands is set to buy The Prisoner Wine Company portfolio in April 2016. (theprisonerwinecompany.com)

THE ECONOMIST, THE ECONOMIST

When you work as an equity analyst at an investment bank, your task is clear. It is to comb all the statements made by corporate executives, scour the industry trends and arrive at an accurate forecast of the company’s profits. Achieve this, and your clients will be happy and your bonus check will have many digits.

Is all this effort worthwhile though? Not as much as it used to be, according to Feng Gu and Baruch Lev, writing in a recent issue of Financial Analysts Journal.

The authors imagined that investors could perfectly forecast the next quarter’s earnings for all companies. They then assumed that investors bought all the stocks that they expected to meet or beat the consensus of analysts’ forecasts, and that investors could short — that is, bet on a declining price for — the stocks of those that were predicted not to reach their estimates. They made their investment two months before the end of a quarterly reporting period and got out of their positions one month after the quarter ended, by which time the earnings had been reported.

In the late 1980s and 1990s, this would have been a highly successful strategy, achieving excess returns — higher than those achieved by stocks of similar size — of 4 percent or more every quarter. These abnormal returns have dropped, however: In recent years they have been only 2 percent a quarter. A similar effect appeared when the researchers examined the returns that would have been achieved by perfectly predicting those companies that achieved annual earnings growth.

Although an excess return of 2 percent a quarter still would be highly attractive, it would require a perfect forecasting record. That suggests that the number-crunching performed by fallible analysts and investors produces much lower returns.

The intriguing question is why those returns have been falling. The authors argue that the decline is because of the rising importance, in recent decades, of intangible investments in areas such as software and trademark development. Such investment may be a big driver of value growth.

Accountants have struggled to adapt. If a company buys an intangible asset, such as a patent, from another business, it is classed as an asset on the balance sheet. If they develop an intangible within the business, however, that is classed as an expense and thus deducted from profits.

As the authors note: “A company pursuing an innovation strategy based on acquisitions will appear more profitable and asset-rich than a similar enterprise developing its innovations internally.”

As a result, the authors argue, reported earnings are no longer such a good measure of a company’s profits, and thus may not be a useful guide to future share performance.

To test this proposition, they divided companies into five quintiles based on their intangible investment. Sure enough, the more companies spent on intangibles, the lower the excess return available to those who correctly forecast the earnings.

The paper’s message echoes the themes of “Capitalism without Capital: The Rise of the Intangible Economy” (Princeton University Press, 2017), a new book by Jonathan Haskel and Stian Westlake, which explores the impact of the growing importance of intangible assets in modern economies. The book suggests a link between the poor productivity record of many leading economies since the crisis of 2008 and the sluggish rate of investment in intangible assets since then.

The problem is that intangibles have spillovers. A company may undertake expensive research and development, but the gains may be realized by other businesses. Only a few companies, such as Google, can achieve the scale needed to take reliable advantage of their intangible investments. Unlike machines and equipment, furthermore, intangibles may have limited resale value. The risks of failure thus may put businesses off intangible investment.

This is both good news and bad news for investors. On the one hand, it may explain why profits have remained high relative to GDP. In theory high returns should have attracted much more investment, with the resulting competition driving down profits. However, the difficulty in exploiting intangibles may have prevented that.

On the other hand, the reluctance of many businesses to invest in intangibles may restrict their scope for growth in the future. Investors looking for growth stocks will face a restricted choice, and such companies will be so apparent to everyone that they will command a high valuation — not so much the “nifty fifty” stocks that were fashionable in the early 1970s, as the nifty five or six.