Why book value is dead


Long-lasting structural changes in the economy have turned book value into a weak and incomplete measure of business value. Technological innovations have significantly affected where companies acquire capital, what they invest that capital in, and how the value they create is measured. Underway for more than 40 years, this economic transformation – and its effect on the relevance of book value – has been profound. When Apple was founded in 1976, 83% of the value of the S&P 500 was recorded in the financial statements, in items such as factories, properties and equipment (PP&E). Today, only about 13% of the value of the S&P 500 can be measured in financial statements, meaning that outside of equipment-intensive industries like mining, book value only represents a fraction of the overall value for most businesses. The modern economy is based on ideas and most of the values ​​of companies are not written on the books at all. Indeed, in this century, for the first time in history, more the value of the business lies in the intangible assets.

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Graph 1. The economic revolution

It’s important to remember that book value was once called “tangible book value”, which more accurately describes what it claims to represent: the value of all assets, less intangibles, net of depreciation. It’s a measure of the value of the things you can touch, and that’s it.

Define intangible assets

Little is known about intangible assets, but they are essential to assess the valuations of 21st century companies.st century. Intangibles lack physical substance – they can be used, but not necessarily seen or touched. Examples of intangibles include software, design, partnerships, talent, copyrights, franchises, patents, brands, and trade names. The list in the figure below is illustrative but not exhaustive.

Intangible assets

Figure 2. Examples of intangible assets

Intangible assets work differently from tangible assets

In their book, Capitalism without capital, Haskel and Westlake describe several ways in which intangible assets behave differently from tangible assets. To really understand just how deficient book value has become in the modern economy, it’s worth covering a few basis points.

Intangible assets are created through intangible investments, but intangible assets, such as software, design, or patents, are not good collateral. Thus, banks do not like to lend money to companies to develop this type of asset. This opened up a whole market for companies specializing in lending capital to companies wishing to develop intangible assets. Ownership and control have become the modern alternative to collateral for intangible-intensive firms. Venture capital firms use equity as a form of collateral. They generally assert their rights through control arrangements, such as those that guarantee them seats on the boards of directors of companies in which they invest. The explosive growth of the venture capital category aligns with the massive development of idea-based organizations.

Tangible assets are called competing goods, which means that they can only be used by one consumer at a time. Intangible assets are seen as non-rival concepts. This means that they tend to scale better than physical assets. For example, if you are building a tangible asset, such as a tractor, it can be used on one farm at a time. Whereas if you code an application, like Outlook, it can be used by millions of people simultaneously. The financial statements and the book value do not reflect this evolution.

Intangible assets are considered sunk costs. Suppose a software company writes code for a solution to help bagel stores track inventory. If the software company fails, it is likely that the code will not be of use to other companies or other industries. Which brings us back to the origin of the collateral challenge and the need for investors willing to accept collateral alternatives in exchange for capital. The book value cannot accurately reflect these risks.

Intangible investments have ripple effects. This means that competitors could benefit from your private investment. For example, Uber has created a fantastic network of drivers. It is their most valuable asset and the heart of the business. Yet many Uber drivers also drive for Lyft. The financial statements do not take into account spillover effects and cannot be expressed in book value.

The brand is the face of intangible assets

The collection of highest value intangibles is captured in a subcategory called brand. The brand is the expressed combination of perceptions about people, ideas and the conduct of a business. Companies make intangible brand investments, called brand investments, through categories such as talent, R&D, customer support, sales, advertising, and marketing.

The value stream of brand investments is unique. Brand investments generate perceptual equity, which influences stakeholder behaviors, ultimately creating a business impact on profit, growth, risk, and cost of capital.

Building a successful brand reinforces competitive advantages, sometimes referred to as moat, which translate into consumer preferences and price premiums.

New York-based consulting firm Tenet / CoreBrand, publisher of the CoreBrand 1000®, estimates that 21% of all company value lies in the brand.

Intangible assets are also very synergistic with other intangible assets. Apple didn’t just make a touchscreen mobile phone, they’ve bundled calendars, watches, email accounts, maps, music, videos, and a host of apps developed by third-party companies. Google followed suit with an open source operating system that created synergies for other phone manufacturers. The book value cannot reflect the potential of these synergies.

Intangible assets are valued differently from tangible assets

Generally, experts measure the value of intangible assets by combining the following three approaches. The market approach considers what a similar brand is worth in the market. On the other hand, the income approach asks the question: what kind of cash flow do assets produce? This is the kind of method that makes sense for patents and licenses. Finally, the cost approach considers what a substitute might cost.


Figure 3. Approaches to valuing intangibles

The values ​​of intangible assets only affect the financial statements during strategic events: Mergers, acquisitions or disposals.

Take the example of Tide laundry soap. The Tide brand was created by Proctor and Gamble in the 1940s, but you can’t find any value for Tide in P&G financial statements. It’s not because P&G is a house of brands. This is because P&G has invested in developing Tide internally. Like most intangible investments, they were developed in secrecy to limit the amount of potential fallout for competitors.

On the other hand, when P&G bought Gillette in 2005, they paid $ 57 billion for its brand. That $ 57 billion included $ 35 billion of “goodwill,” the historic bucket for intangible assets, or about 61% of the acquisition cost. This $ 57 billion made allocate the financial statements of P&G (as assets and liabilities). Strategic events impose a calculation that is not part of normal accounting.

Intangible assets created internally are not recognized as assets under United States generally accepted accounting principles (GAAP). That is, conventional accounting methods have not evolved to measure the value of intangible assets as effectively as tangible assets.

The ideas in the book are worth more than the sum of the words

According to intangible asset valuation firms Ocean Tomo and Brody / Berman, about 87% of the value of the S&P 500 is in intangibles. Yet although intangibles make up the bulk of value in the modern economy, they are virtually invisible on financial statements.

Most of the value in the modern economy is intangible. Familiarity with the unique characteristics of acquiring, investing and measuring the value of intangibles will serve investors much better than relying solely on traditional measures of book value.

Tony Wenzel is co-founder and president of Brandometry® LLC. Wenzel is a software entrepreneur and was co-founder of Strata Insights, a branded econometrics consulting firm. Brandometry created the EQM Brand Value Index, a core thematic investment index using qualitative brand signals to identify strong, undervalued brands. The index is accessible via an SMA or 40 Act fund. www.brandometry.net



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