Unseen Strengths in Portfolios: The Covert Crusaders of Financial Markets
In today's digital age, the focus of capital expenditure is shifting towards virtual resources, with industries ranging from art and education to fitness and retail embracing this change. This trend underscores the growing importance of intangible assets, such as patents, technology, trade names, and internally financed capabilities, in a company's growth and overall development.
Valuing these intangible assets is a crucial yet complex task, often carried out using three primary approaches: income, cost, and market.
The income approach, which includes the Discounted Cash Flow (DCF) method and the Relief-from-Royalty and With-and-Without methods, projects future cash flows from an asset and estimates its current worth. The Relief-from-Royalty method, for instance, is used to value brand names by calculating the royalty payments avoided by owning the brand.
The cost approach, on the other hand, estimates the cost to replicate or replace the intangible asset, providing a baseline for valuation.
While the market approach is less common due to the scarcity of comparable data, it uses transaction prices of similar assets to estimate value.
The valuation of intangible assets can have a significant impact on a company's growth and financial performance. For instance, intangible assets can increase a company's total assets, enhancing its financial position and attractiveness to investors. Accurate valuation also helps investors and stakeholders understand a company's true value, influencing investment decisions and strategic planning.
Valuing intangible assets allows companies to focus on developing and leveraging these assets to drive future growth and profitability. Proper valuation can also help identify potential risks associated with intangible assets, such as obsolescence or market changes, enabling companies to mitigate these risks proactively.
Companies that master the deployment of intangible investments are better positioned to outperform the market. This is evident in the case of Alphabet, whose intangible assets include 30,000 patents, in-house technology for search algorithms, and various trade names. Alphabet's intangible assets have played a significant role in its growing market capitalization, which went from $730 billion in 2017 to $1.6 trillion in May 2023.
However, the accounting of intangibles can create challenges, as shown in the case of our platform's subscription business, where a subscriber acquisition might be labeled as a loss but could generate significant revenue over time. This concept, known as lifetime value, is particularly applicable in telecom companies, video-streaming companies, newspaper and content publications, Amazon Prime, edutech companies, and more.
Traditional valuation metrics like the price to book value or the price-earnings ratio may not be effective in assessing companies with a high share of intangible assets. Few investors have incorporated this shift towards intangible assets within their investing framework, but as the share of intangible assets continues to grow—with the S&P 500 market value now comprising 84% from intangible assets, compared to barely 17% in 1975—it is becoming increasingly important for investors to adapt their strategies accordingly.
Investing in intangible assets like patents and technology, often facilitated by the income approach or the cost approach, can significantly boost a company's growth and financial performance, as demonstrated by Alphabet's exponential market capitalization growth. However, traditional valuation metrics may not be effective in assessing companies with a high share of intangible assets, making it necessary for investors to incorporate these shifts in their investing framework.
