The first publicly traded firms that grew out of the industrial age derived the bulk of their value from physical assets. These early corporate giants, which included General Motors, Standard Oil and AT&T, owned land, building and factories which lent themselves easily to accounting measures and valuation. The last half-century has created a new generation of firms, such as Coca Cola, Microsoft and Pfizer, that get most of their value from assets that have no physical form. These intangible assets vary across firms from brand name (Coca Cola) to patents (Pfizer) to technological expertise (Intel,
Microsoft) but they do share some common features. The first is that traditional accounting rules either understate their value or completely ignore them; the balance sheets of these companies show little evidence of their value. The second is that a significant portion of the market values of these firms comes from these intangible assets; there is evidence, for instance, that brand name alone may explain more than half of the value in many consumer product companies. Finally, the failure to value these intangible assets distorts both accounting measures of profitability such as return on equity and capital and market measures of value such as PE ratios and EV/EBITDA multiples.
In one study, Leonard Nakamura of the Federal Reserve Bank of Philadelphia provided three different measures of the magnitude of intangible assets in today's economy - an accounting estimate of the value of the investments in R&D, software, brand development and other intangibles; the wages and salaries paid to the researchers, technicians and other creative workers who generate these intangible assets; and the improvement in operating margins that he attributes to improvements to intangible factors.1 With all three approaches, he estimated the investments in intangible assets to be in excess of $ 1 trillion in 2000 and the capitalized value of these intangible assets to be in excess of $ 6 trillion in the same year.
Baruch Lev has argued persuasively that the way in which accountants deal with intangibles is neither conservative nor informative.2 Expensing R&D, for instance, does understate earnings for high growth companies but it overstates earnings for low growth firms. In a paper with Paul Zarowin, he presents evidence that earnings at U.S. firms have become less correlated with stock prices and he attributes this phenomenon to the failure to accounting for intangible assets.3
If accountants have done a poor job of assessing the value of intangible assets, have valuation analysts done much better? Given that we draw so much of the information that we use in valuation from accounting statements, it can be argued that the valuation of intangible assets has suffered from many of the same limitations as the
1 Nakamura, L., 1999,. Intangibles: What put the new in the new economy? Federal Reserve Bank of Philadephia Business Review July/August: 3—16.
2 Lev, B., 2003, Remarks on the Measurement, 2003, Valuation and Reporting of Intangible Assets.
FRBNY Economic Policy Review, September 2003.
3 Lev, B., and P. Zarowin, 1999, The Boundaries of Financial Reporting and How to Extend Them, Journal accounting measures. In fact, the pressure on accountants to better reflect the value of intangible assets like brand name on financial statements has provided an impetus to valuation analysts to take a closer look at how they have valued or failed to value these same assets.
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