Investors in equities have been successful using a variety of analytical techniques but one of the more enduring methods is the value approach which involves purchasing a stock at a discount to one’s estimation of a given company’s fair or intrinsic value. Practitioners of this approach generally use comparisons between a stock’s price and the company’s earnings or asset value. While calculating fair value was always an inexact exercise, it has been rendered much more difficult by the changing nature of corporate assets.
Intangible assets now comprise an estimated 90% of the value of the S&P 500 as compared to only 17% in 1975! Examples include patents, brand value, customer data, and software as compared to more traditional tangible assets such as buildings, land, machinery, and inventory. The problem is that intangible assets are very difficult to value; how much is Apple’s logo worth? Additionally, the accounting treatment of intangibles varies. Externally purchased intangible assets are shown on a company’s balance sheet and amortized over time but internally developed assets (R&D) are generally expensed.
All of this wreaks havoc on many analytical techniques and ratios. Given the difficulty in valuing intangibles, assets may be understated on financial statements which creates uncertainty regarding the merit of ratios based on asset or book value. Earnings may also be understated by as much as 10% because the principle assets (intangibles) of many companies are expensed rather than capitalized. Therefore, concern about inflated price to asset or price to earnings ratios may be overdone.
This set of difficulties joins a number of broader economic questions raised by the march of technology. Have accounting rules kept up with the reality of Corporate America? Are current methodologies capturing the true amount of our nation’s economic output? Is inadequate measurement the real explanation for poor productivity growth in recent years?
Never a dull moment in the investment world!