The Right Way to View a Company’s Intangible Assets

As I discussed in a recent post, intangible assets are becoming increasingly important to the growth, profitability, and value of companies. Yet, because they are difficult to track and value, companies rich in intangible assets that create significant value typically understate their profitability and valuation due to archaic GAAP accounting standards. As I concluded in that post, investors make a huge mistake when they ignore intangible assets when valuing these companies.

However, based on reactions to that post, I felt it necessary to clarify my view of the importance of intangible assets in valuations with two key points. First, while often a key driver of value creation for some companies, intangible assets are not a reliable predictor of future growth, making many of these investments speculative.

Which leads me to my second point – investors should not take my view as an invitation to invest away in companies with significant intangible assets. Instead, they need to understand the role intangible assets should play in their investment process and the long-term impact they can have on companies’ viability and profitability.

Intangible Assets are Real, but Their Value is Illusive

We live in a different world than we did just four decades ago when intangible assets made up only 17% of all enterprise value on the S&P 500. Today, they make up nearly 85% of total enterprise value, and that figure is higher for many companies outside the S&P 500. Amazon’s intangible assets make up 93% of its enterprise value, followed by Microsoft at 90%. Apple, Alphabet, and Facebook are some of the other companies with a high percentage of intangible assets.

But, these are known entities. We’ve watched them grow up and have witnessed the impact that their intangible assets, such as data, software, AI, and R&D, have had on value creation, market share, and earnings growth. Yet, their value still cannot be accurately measured because they aren’t reflected in the companies’ balance sheet. Despite that, these companies have obtained stable, trillion-dollar valuations despite Generally Accepted Accounting Principles (GAAP) deficiencies.

When Intangible Assets Aren’t as Meaningful

Does that mean the market is valuing these assets even though they are not counted on their balance sheets? Or does it mean these companies are still undervalued? What would Alphabet’s valuation be if all the data it collects on every internet user were included in book value?  We really can’t know the answer to that, but we do know these companies are experiencing solid earnings growth because of their intangible assets.

However, we can’t say the same about many companies that rely upon their intangible assets for future growth. For example, with their eye-popping valuations, Airbnb and Uber have relied almost exclusively on the promise of their intangible assets, which has yet to be realized in terms of earnings. With a valuation five times greater than Ford, GM, and Chrysler combined, Tesla’s most significant intangible asset is Elon Musk himself, which should make any rational investor nervous. No one can say with any degree of certainty what their intangible assets can produce. Yet, investors are betting big on the possibilities. That’s called speculation.

Putting Intangible Assets into the Proper Context

The most reasonable and, in my opinion, the best approach to viewing intangibles is as a defensive shield that protects high returns on capital and the existing value of companies. Acting as an economic moat, intangible assets can make the return on equity both dependable and sustainable in the face of fierce competition. We capture this numerically through our Snapshot report with a company’s Operating Margin (OM). A high OM reflects low competition, while a low OM means there is significant competition.

When viewed in this context, it’s easy to see how intangibles-rich companies like Microsoft, Amazon, and Alphabet are firmly entrenched as near-monopolies. Their intangibles can be viewed as real moats that surround the foundation of the castle. Less apparent are companies like Uber, Airbnb, and even Tesla, that have yet to build a solid foundation for a moat to protect.

Like this post? Share your thoughts!

Subscribe for updates

Share this post

Take stock of your investment portfolio today!