Why should Intangible Assets be Valued

What is an intangible asset, and why consider it when evaluating a company’s stock? If seeing a stock come on to the market through an Initial Public Offering (IPO) and shoot through the roof has ever given pause, some of the answer lies in its intangible assets. Intangible assets are those factors such as intellectual property, patents, copyrights, branding, client base, research and development (R&D), and many other factors not accounted for in financial reports or profit and loss (P&L) statements.

New Economy Shift

With the shift in business from manufacturing and brick and mortar storefronts to an economy dominated by services and e-commerce, these intangible assets have never been more important in valuing a company’s stock. Companies like Facebook, Google, and PayPal are all examples of companies in which intangible assets dominate.

Even when a product is manufactured (for example, with a pharmaceutical giant), no value is counted in tangible assets until the first pill of a new drug is sold. All the preliminary value (development, drug trials, potential user base) is not recognized under normal accounting rules.

Things get tricky, however, when a company’s value is based heavily on intangibles. For example, in the same case of the new drug coming to market, what happens when the drug turns out to have serious side effects or fails to make the Food and Drug Administration (FDA) cut? Being on the edge of a transformative new technology does not, in fact, guarantee results. There is always the risk of failure.

Developing a Measurement

Analysts, of course, do consider intangibles when valuing a company’s stock. However, these data are not for public record, and likely imperfect measurements. Adding to the confusion for investors is all the spin surrounding a company’s stock. There is plenty of speculation and public relations messages engulfing any attempt to determine a decisive intangibles figure.

Investors may wish for more complete disclosure through financial statements. Many countries, including France and Britain, do account for brand value among a company’s assets. However, when the issue of adding a value for intangibles was discussed in the United States, the drawbacks prevailed, and issue was dropped from consideration.

Estimating the Value of Intangibles

Investors still need a system for valuing intangible assets, however, and one method, illustrated by Ben McClure for Investopedia, is Calculated Intangible Values (CIV), which uses a seven-step process.

To calculate the CIV, complete the following steps. 1) Determine the (pre-tax) earnings by averaging the past three years. 2) Take the average tangible assets from the company’s balance sheet for this same time frame. 3) Determine the Return on Assets (ROA) by dividing assets by earnings. 4) Compare the company’s percentage from step three with the industry average. 5) Multiply the industry’s average ROA from step four by the company’s tangible assets in step two. Then, subtract this from the pre-tax earnings of step one; this will provide the excess ROA figure. 6) Determine the average tax rate from the past three years, and multiply by the excess ROA found in step five. Take the result and subtract it from the excess ROA. This will provide an after-tax number, which is the premium that can be attributed to intangible assets. 7) Divide the premium by a discount rate (such as the company’s capital cost). This will give the net present value (NPV) or net present worth (NPW).

In the end, any investor would do well to consider the intangible assets a company offers when deciding if a stock is fairly priced. Intellectual property and other idea-based assets owned by a company can have a strong impact on that company’s ability to earn over the long term.