Few people seem to be satisfied with intangible asset accounting; depending on your perspective, there is either not enough or far too much of it. What is clear is that many valuable intangible assets go unrecognised in financial statements. The result is distorted financial ratios, including price to book.
The lack of intangible asset recognition means that most investors know to use book value with caution. This may not be the case for index providers, ‘smart beta’ funds and quant-based investing where price to book ratios are used to identify ‘value’ stocks and related indices.
The deficiencies of intangible asset accounting are well known. The problem is that most intangibles are self-generated rather than purchased and the majority of these are not recognised in the balance sheet. Valuable intangibles that have ongoing use in the business, and that will contribute to future profits, are essentially ignored in financial reporting and any amount spent on creating or enhancing these assets is immediately expensed.
There are some exceptions such as development costs where, for IFRS reporters, and subject to satisfying certain criteria, capitalisation of the expenditure incurred is required. US GAAP takes a more conservative approach such that even development costs are not capitalised. However, in other respects IFRS and US GAAP are very similar and pretty much everything we say below applies to both.
Intangibles that are separately purchased are reported as an asset at their purchase price and amortised over their estimated useful lives. This includes those intangibles that are acquired together with other assets in a business combination although, because there is no separate price paid, the intangibles have to be valued at the time of the acquisition to determine their cost.
The separate recognition of intangibles in a business combination is controversial. Many of the purchased intangibles recognised following a business combination are assets that for other companies would have been internally generated. This produces a difference in financial statements between companies that have expanded organically and those that grow through acquisition. Their assets in an economic sense might be similar, but the process by which those assets come about can produce enormous differences in financial statements. This also impacts profit and loss and leads to common adjustments in alternative performance (non-IFRS or non-GAAP) measures, a subject we consider in our article Should you ignore Intangible amortisation?
Although many intangibles are not recognised as assets in the balance sheet, their impact on the business is very evident in profit and loss. The problem is that, in effect, a cash rather than an accruals basis is used to account for them. Investment in intangibles produces an expense in the current period but the benefit may predominantly impact profit in future periods. Equally, past investment in unrecognised intangibles that was expensed in prior periods may now be contributing to higher profits, but there is no amortisation charge to reflect the ‘consumption’ of the asset. The current lack of accrual accounting for most intangibles can make profit difficult to interpret and compare. Furthermore, if an unrecognised intangible asset is impaired then nothing happens and a potentially valuable signal for investors is lost.
If you are a ‘bottom-up’ stock picking investor you may be able to make allowances for the deficiencies of intangible asset accounting in your analysis. Most investors realise that price to book and return on equity may be of little use, except in the case of tangible asset or financial asset heavy sectors. Most also realise that when investment is expensed, rather than capitalised, this affects profit measures, particularly of growing companies, and that valuation multiples are naturally raised. What may be of more concern to you is whether a company provides sufficient narrative reporting about intangibles and their impact on the business – but that is another issue.
However, if your approach to investment and portfolio construction is based on ‘factors’, ‘styles’ and data-driven analysis then intangible asset accounting may be much more of a problem, particularly if you favour (or wish to avoid) ‘value’ stocks.
Value investing, value stocks and the value factor
You will often hear investors talking about value investing or value stocks. Unfortunately, the term ‘value’ is used in different contexts.
Value used to mean fundamental value is higher than price
The term value investing may be used to describe the process of picking investments based on their estimated fundamental or real values that are estimated using valuation techniques such as discounted cash flow. The investments that offer the best value are those where the stock price is the lowest relative to the perceived fundamental value of the investment.
Value as a characteristic of the investment
The term value is also used to refer to the characteristics of an investment or an investment ‘style’ or ‘factor’. Stocks with certain characteristics are regarded as value stocks and stocks that do not have these characteristics are commonly referred to as growth stocks. Growth and value are opposites.1This may not be entirely true. Some consider that a ‘high profitability’ factor captures the positive side of growth companies and effectively combines value and growth. See a paper by Robert Novy-Marx ‘ The other side of value: The gross profitability premium’. Those investors investing in the ‘value factor’ are not basing their assessment on a measure of fundamental value but rather are looking for stocks that display value characteristics.
However, the value characteristic can itself be thought of in two ways, either a measure of the extent of ‘assets-in-place’ or a measure of cheapness.
Value factor based on ‘assets-in-place’
The value of a company can be thought of as the sum of the value derived from business activities already in place and the current value of expected future investment and growth opportunities. Furthermore, the value of existing business activities can itself be thought of as the current balance sheet value of (net) assets plus the added value derived from the way those assets are utilised i.e. their profitability. If returns earned on the existing asset base are above the cost of capital, then current business value should exceed current balance sheet net asset value or book value. The difference is often referred to as the present value of economic profit, although only economic profit that is derived from existing business activities.
Price = Existing business value + Growth opportunity value
Price = Book value + PV existing business economic profit + Growth opportunity value
There is disagreement as to how the above relates to the value factor. Some regard the value factor as referring to just the book value component of the above and that the other two components relate to separate ‘profitability’ and ‘investment’ factors. Based on this, a value stock is one where the book to price ratio is high relative to other stocks. However, others regard a value stock as one where the existing business value (book value plus PV of economic profit) divided by price is high. However, this approach means that the value factor captures not only the assets-in-place but also the profitability of these assets.
Part of the challenge is how to measure book value or existing business value. Book value might appear to be objective but deficiencies in accounting, including intangible asset accounting, may present problems (we return to intangibles below). The existing business value cannot be directly observed, so some sort of proxy is required, which is where a wider analysis of valuation multiples comes in.
If a stock has, for example, a low PE ratio then it is likely that more of the current price is represented by the existing business value. However, this is not necessarily the case because periodic differences in current profitability and growth also complicate matters. Basing value stock classification on measures that include profit means that more than just assets-in-place may be being captured and it becomes a joint test of value and profitability (or cash flow, dividends etc. depending on what additional measures are used). Some value investors and index providers regard this as a dilution of the value style.
Value factor as a measure of ‘cheapness’
To further confuse matters value can also be regarded as the characteristic of cheapness based upon one or more valuation metrics. This obviously overlaps with the idea of assets-in-place but the emphasis is on selecting stocks with low multiples rather than necessarily high assets-in-place. Furthermore, some index providers, while trying to focus on assets-in-place, have added other profit related factors, such as a low price earnings ratio, in response to the recent relative under-performance of the value factor, but this may be more of an opportunistic response rather than one grounded on some underlying concept.
More about the origin, theory and performance of the value factor …
The origins of the value factor are generally attributed to the work on asset pricing and portfolio management by Fama and French2The classic paper often cited is ‘Common risk factors in the returns on stocks and bonds’. In their original 3-factor model the expected return on equity assets is given by an extended form of the traditional CAPM asset pricing model. In addition to the market risk factor, the expected asset return also includes a small versus large capitalisation factor (a return premium applies to smaller capitalisation stocks) and a high versus low book to market factor (a further return premium applies to high book to market stocks). All other things being equal, a high book to price stock would be expected to have a higher return than a low book to price stock. Value stocks are those that have a relatively high book to price, with the opposite for growth stocks
Empirical evidence for the value stock premium is dependent on what market and time period you select, but certainly many believe, and there have been many studies which demonstrate, that in the long run value stocks outperform growth stocks. Having said that, this definitely has not been the case over the last decade or so. Since the 2008 financial crisis value has significantly underperformed growth. Nevertheless, some investors believe that there is still a structural value premium and that the Fama-French model (and the various alternative versions that have been produced) is not disproved just yet.
The chart below shows the relative performance of value and growth in the US market and is taken from a recent paper by Research Affiliates, a quant-based investment firm.
Relative performance of Value versus Growth
What explains the value premium?
Different explanations are offered as to why value stocks have tended to perform better than growth stocks. Some are based on investor behaviour. Others offer a more rational explanation based on the assertion that value stocks display higher risk and that this risk factor is compensated through a higher expected return.
The particular risk pertaining to the value factor is downside risk in times of recession. The idea is that companies with more assets-in-place have higher downside potential when times are tough. This is because the recession directly impacts their existing business, and most will have limited flexibility to avoid a significant fall in profitability and value; so-called ‘irreversibility of assets in place’.
For growth stocks, more of the stock price is represented by future growth opportunities and, because those growth opportunities are more flexible (because the related investment has not yet been made) then a recession is less likely to have such a big impact. The downside protection offered by growth stocks means that, at least in this respect, they are less risky, and hence should offer in the long-term, a lower expected return. Remember that the value risk premium is in addition to the normal market risk premium based on stock volatility; nevertheless, it is an explanation as to why value stocks have historically tended to outperform. The return premium expected for value stocks is due to additional risk that is not captured in market betas. However, none of this explains the outperformance of growth since 2008.
Book to price is key to identifying value stocks
Although different index providers adopt different approaches when identifying value stocks, the book to price ratio tends to feature in most, if not all, such classifications.
For example, STOXX and MSCI use an approach that equally weights book to price, earnings to price and cash flow to price. Rival index provider Scientific Beta3Scientific beta is an offshoot of the EDHEC Risk Institute and was recently acquired by the Singapore Stock Exchange., on the other hand, prefers to classify value stocks using only book to price because they believe that this is the best way to differentiate based on assets-in-place and that this aligns with the consensual definition used in academic studies in asset pricing literature. They claim that any alternative approach produces an index that combines different factors, including profitability, which reduces the value factor effect.
But is the book to price ratio used in deriving the value factor the most relevant one? The ratio used in practice seems to almost always be based on reported shareholders’ equity, but this creates a number of problems.
- Measurement: Financial reporting uses a mixed measurement model with some assets reported at cost and others at current value. In addition, measurement choices available to companies mean that comparability within asset classes may be affected.
- Goodwill: While goodwill is regarded as an asset for financial reporting purposes, the question for investors seeking to identify ‘value’ stocks is whether it is an asset-in-place and, if so, whether balance sheet values are relevant.
- Intangible assets: As we explain above, the recognition of intangibles is generally limited and often inconsistent, primarily due to the very different treatment of those assets that are purchased and internally generated.
In our view, goodwill should not be included in shareholders’ equity for the purpose of price to book ratios used for identifying value stocks. While some goodwill may represent unrecognised intangibles and measurement differences for recognised assets and liabilities, which arguably should be included, we think that most goodwill generally relates to synergy benefits, future growth opportunities and, potentially, overpayment. We do not think that such future anticipated value gains are assets-in-place. In addition, goodwill obviously varies enormously by company depending on their acquisition history, or lack thereof.
Intangible assets are more difficult to deal with. Intangibles are most certainly an asset-in-place. Many intangibles, such as a patented drug or media rights, are internally generated, but these often fail the accounting criteria for capitalisation of the amount spent on their development, in which case book to price is misleading. Even if these assets are capitalised, they would almost certainly be reported at cost, in which case the balance sheet amount could significantly understate the value of the intangibles and hence book to price could be artificially low.
Not making any adjustment in respect of intangibles risks making the book to price ratio useless for identifying value stocks. For example, mature companies with significant unrecognised intangibles risk being incorrectly classified as growth stocks due to an artificially low book to price ratio – a “value false negative”.
This is something that the index provider Scientific Beta has acknowledged in a recent paper ‘Intangible Capital and the Value Factor: Has Your Value Definition Just Expired?’. They suggest that an intangible adjusted value factor better identifies value stocks and that back-testing of their revised approach demonstrates higher out-performance of value relative to growth and without overlap to other factors such as profitability.
So how are index providers and quant investors adjusting for intangibles?
Both Scientific Beta and Research Affiliates estimate unrecognised intangible assets-in-place by following a ‘perpetual-inventory’ approach previously used in another academic paper4See Intangible capital and the investment-q relation; Peters and Taylor. The estimated amount of expenditure written-off in each period, but that relates to intangible asset acquisition or internal development, is accumulated and in each period the balance is reduced by a defined percentage amount.
Scientific Beta differentiates between two broad categories of intangibles which it calls knowledge capital and organisational capital. Knowledge capital is derived from the capitalisation of the research and development expense and organisational capital is derived from the capitalisation of other operating expenses that are deemed to contribute to other intangible assets.
Clearly, measurement of intangibles is challenging and subjective, not least because of the limited accounting disclosures. Scientific Beta assumes that for all companies a constant 30% of SG&A relates to intangible value creation. Such an approach is bound to be approximate and would not capture company and sector differences. For example, we would assume that the capitalisation rate for Utilities should be significantly lower than for, say, a Consumer Goods company.
There are also challenges regarding the method of amortisation, risk of double counting intangibles already recognised, and the use of cost rather than an estimate of value as a measurement basis. In addition, the perpetual inventory method of capitalisation means that capitalised amounts remain in perpetuity, irrespective of whether they have been impaired or are no longer used in the business.
Scientific Beta makes one additional adjustment which is to remove recognised goodwill.
The chart below shows the average change in book value due to capitalising intangibles and eliminating goodwill. Reported book value is indexed at 1.0. When estimated intangibles are included the most recent book value increases by around 50% but, with goodwill eliminated, the effect is much less and has been declining as goodwill balances have risen. However, point is that these adjustments vary by company, which is what impacts the classification as value or growth.
Scientific Beta intangible adjusted adjusted book value
Regardless of the limitations of adjusting the book value of assets-in-place for intangibles, both Scientific Beta and Research Affiliates say that their adjusted classification better captures the value factor and leads to a higher value premium (at least in their back tests). We don’t evaluate their claims.
But what index providers and quant-based investors could really do with is better accounting information about intangible assets and the related expenditure.
Can financial reporting for intangibles be improved?
The reason why there is limited recognition of internally generated intangibles is primarily due to the difficulty in obtaining reliable measures to include in financial statements. The development of many intangibles is closely embedded within the business, such that it is difficult to separate the expenditure that relates to running the business now and the expenditure which represents investment in intangibles that will provide a return later.
There is an ongoing debate about recognition, measurement and disclosure of intangibles. However, due to the reliability constraint, it seems that any increase in intangible recognition in the balance sheet is unlikely anytime soon. Therefore, much of the focus seems to be on enhancing narrative reporting about the existence, nature and use of intangibles. While such enhanced disclosures would be welcome, they may not help those who want an estimate of the cost or value of all intangible assets, such as investors seeking to identify ‘value’ stocks.
A recent paper by the UK Financial Reporting Council contains a proposal that, if implemented, might help. They do not suggest that recognition of intangibles in the primary financial statements should change, but rather that supplementary data be provided in the footnotes about the investment in intangibles. Their proposal is that expenditure that represents “investment in future orientated intangibles” be separately identified and that the cumulative amount of future-oriented expenditure that has been expensed in the income statement, but that is expected to provide future benefits, should be provided in a note. In effect, this is the amount that would have been reported as an asset had the expenditure been capitalised and amortised.
An illustration is provided based upon expenditure on staff training.
FRC proposal: ‘Capitalised’ investment in future oriented intangibles
We like this approach. Like many, we do not think that comprehensive capitalisation of intangibles in the balance sheet is feasible or desirable; the measurement challenges are just too great. Although disclosure, such as that above, would also be subjective and potentially lack comparability, we think it would still very useful for investors. It would solve the problems of the index providers in determining adjusted book to price ratios and provide all investors with the potential to view other metrics on an intangible asset adjusted basis.
Better disclosure about intangibles is desirable, but this should not be limited to narrative reporting.
Tell us what you think …
Do you agree that additional disclosure of future oriented expenditure in the current period and a cumulative balance of the amount that is estimated to relate to future periods would be useful?
In other words, would you support disclosure of the above illustrative note, replicated for different types of ‘future-orientated’ expenditure?
Insights for investors
- Use book value with caution. Many factors affect its comparability and usefulness, but especially the partial and inconsistent recognition of intangibles.
- Be aware that, in effect, much of the investment made to support and develop intangibles is accounted for on a cash and not an accruals basis. This means that for intangible asset-heavy businesses a significant portion of the income statement is, in reality, a cash flow statement.
- The term ‘value’ is used in multiple ways in investment; specify what you mean and question its use by others.
- If you use value indices or invest in active or passive value-factor funds, find out what index is used as a benchmark and whether that index is based on unadjusted book to price ratios. Not all ‘value’ indices define value in the same way.
- Failing to adjust for the lack of intangible asset accounting may result in the misclassification of value stocks.
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