Today, intangible assets comprise most of the value of most companies. It follows therefore that understanding the quality and value of these assets is critical to investment decisions – especially in times of market volatility such as we are experiencing now.
While understanding past and current performance is important, most investors accept that past performance is not the most effective lens through which to determine future performance. For experienced investors, this is not a revelation, hence the universal disclaimer “past performance is no guarantee of future results”.
Nevertheless, a primary purpose for analyzing past performance is to assess and determine the probability that it will either persist, be better, or perhaps worse. However, when the world shifts on its axes and the resulting changes are hard hitting and likely long-lasting, investors need to ensure that they look beyond past performance to determine the strength and growth potential of a company’s underlying assets.
An intangible asset investment perspective
Recent research by Columbia Threadneedle shows that 95% of senior investment decision makers agree that a company’s intangible assets contain important information about the future strength of a business model. 88% also agreed that conventional valuation methods (such as discounted cash flow) are inadequate without thorough consideration of intangible assets.
These numbers are extremely high because intangible assets today are the key driver of profitability and growth within an organization. Looking at business performance and potential through an intangible asset lens helps focus attention on those aspects of a business that are critical to future performance but which are not accurately reflected in financial statements or typical business disclosures.
Effective investment decisions should therefore give additional (though in actuality proportional) weight to the quality and strength of a business’s intangible assets. These assets include data, brands, content, code, trade secrets and industrial know-how, internet assets, design rights, contractual rights, regulatory approvals and standards compliance and plant variety rights, among others.
A key challenge for investors is that while these assets are the primary drivers of business value, they rarely show up on the balance sheet and when they do, their recorded value is often incorrect and fails to identify any component parts of intrinsic value.
This is largely the result of outdated accounting standards that no longer reflect where the true value of an organization lies. Accounting rules were developed when businesses and industry were dominated by physical assets but unfortunately, those rules are inadequate for describing intangible assets. Given that intangibles today represent nearly 90% of company equity value, investors should necessarily spend a proportionate amount of time on diligence of intangible assets, which are not reflected in financial statements.
Assessing future performance
If you are looking at making an investment, then an effective understanding of a business’s intangible assets will enables you to address two important questions:
- What are the component parts of value which underpin performance?
- What is the likelihood that past performance will be sustainable into the future?
In the same way that investors might apply a specific methodology or process to the valuation of physical assets, each category of intangibles needs to be assessed appropriately.
For example… the existence of a “granted patent” does not mean that the patent is relevant or even valuable. To understand a patent’s true value, a detailed review of the patent claims and all relevant prior art would need to be undertaken. This should then be contrasted against the form of technology, the addressable or target market for commercial use, and the capabilities of the business to penetrate their target market.
De-risking investment decisions
Given the limited focus on reporting and disclosure of intangible assets, there is significant latent value (and risk) in many businesses, due to the lack of effective management of intangible assets generally. It makes sense that if 87% of more of all business value is in intangible assets then this is also where most of the risk is.
Implementing an intangible asset focus to investing, effectively de-risks investment decisions by:
- Identifying the source of value,
- Measuring and quantifying this value,
- More effectively assessing the potential that such value can or will persist, and
- Identifying material risks to these high impact assets.
This perspective is what investors such as Warren Buffett and others have done with great success (by identifying what Buffet calls ‘business moats’).
By recognizing intangible assets as a key driver of profitability and growth, investors are more likely to do effective due diligence on these assets. This in turn means it is more likely that investors will be able to accurately identify a target company’s or assets competitive advantages/moats and better be able to determine sustainability of performance into the future.
During times of market volatility, understanding what is driving and protecting the underlying growth of a company performance is imperative. Intangible assets are really the only lever that can move enterprise value beyond cash flow multiples, which means that ensuring that these assets are factored into any investment decision will help paint a clearer picture of a company’s true worth both in the short and longer term