There has been renewed academic and investor interest in the topic of how to value intangible assets and, more importantly, unrecorded intangible assets such as expensed R&D and SG&A. The question is whether the intrinsic value of these unrecorded intangibles should make some companies appear more reasonably valued than when considering traditional balance sheet and free cash flow metrics.* We suspect that this debate has heated up as some investors seek to justify continued purchase and ownership of equities that have greatly appreciated in value, despite the companies having low or negative earnings, and low or negative book value levels.
We firmly believe that the fair value price target of any asset is the discounted value of its future cash flows. This method was true on the first day of our first finance class, and remains true today. We also assess balance sheet measures such as tangible book value, return on equity and return on assets to discern base asset values and downside protection price levels. Investors should be extremely cautious in attempting to attribute value to non-balance sheet unrecorded intangibles, and must only attribute value to the rare intangibles in this class that can produce positive free cash flow, over and above any recording of existing assets on a company’s balance sheet.
There are instances of valuable intangibles that are not fully captured on a balance sheet, for example a brand name. In our view, a trusted brand often gives consumers added confidence to purchase a good or service, like a McDonald’s hamburger or a Hilton hotel room, with the expectation that the delivered good or service will meet well defined and de-risked purchaser expectations.
We caution investors against extending this line of logic to past expenditures of R&D or SG&A with the implication that these past expenses must contain some future value. In our opinion, no where is this line of thinking potentially more dangerous than in relation to fast revenue growth technology companies that are producing negative free cash flow and will likely need future capital infusions. While there are many positive technologies produced by these companies, we note that the space is highly competitive and technology advances are very often shortly eclipsed by newer technology offerings.
We all remember the one-time dominance of Netscape and AOL, but we believe investors have a hard time envisioning that leading technology offerings today will not quickly become obviated in the future. In contrast, we believe the rapidly advancing pace of technological innovation will only increase in the near future, and this will more than likely bring the destruction of value to existing category leaders that fail to develop and invest in future dominating technologies. As such, scratching around to develop an alternate measure of value for past expenditures is not only inappropriate, but may be financially dangerous.
We prefer to keep it simple and straight forward. We do not believe that new approaches are necessary to value companies in today’s world. The discounted value of future free cash flows, in our view, when correctly applied, produces the intrinsic value, or price target, of an asset. We believe that a potential asset that can not produce free cash flow should not be considered an asset in a valuation model. This is true for a company, true for real estate, and really any asset, even for the value of art. The exercise of forecasting and risk-adjusting these future cash flows is where we believe analysts should focus their efforts, and not on re-defining categories of value, such as ‘clicks’, ‘eyeballs’ and now potentially ‘unrecorded intangible assets’.
As always, caveat emptor!
*Dugar, Anthony and Pozharny, Jacob “Equity Investing in the Age of Intangibles”, Financial Analysts Journal, Volume 77, Number 2, Second Quarter 2021, Page 21-42.
