Investment in intangible assets is growing at an ever-increasing rate, outpacing investment into capital machinery, equipment and all other tangible things. Companies in the US collectively hold more than $8 trillion in intangible assets, almost half of the S&P 500 at the time of study. While intangible assets consist of rights, relationships and intellectual property, one particular form stands out: intellectual property, which encompasses the result of R&D spending; the bread and butter of any modern organisation. This creates a perplexed investor. The current fundamental problem reflects the inability of the price mechanism to attach a price to a good of abundance. Inevitably, the valuation of intangibles will be distorted by unsuitable accounting policies and valuation methods of the 21st century.
Valuation in the 21st Century
A combination of unsuitable accounting policies and complacency within models create a cause for concern in the world of equity valuation. Despite almost every company exhibiting a high proportion of intangibles, accounting regulations and valuation methods are not congruent with the technological developments of the 21st century. Regulatory bodies such as the IFRS only recognise intangibles when a transaction takes place, such as an acquisition. While this may be useful in some cases, it does not account for the existing, internally created intangibles which create shareholder value. The significance becomes stark when $30.1tn is considered to be ‘Undisclosed value’ out of the mammoth $89tn enterprise value figure.
Secondly, the classification of expenses may inaccurately portray certain metrics, which directly affects valuation models such as discounted cash flow. The primary expense which drives the informational innovation is R&D. The income statement labels this certain expense as operational, while by nature it represents an expense that creates long-term economic benefits. By manually reconfiguring the income statement and rendering R&D spending as a capital expense, a more accurate representation of earnings is created.
An analyst may use several approaches to mitigate the increasing levels of information amidst unsuitable accounting policies. Common methods include the income approach and the market approach. The former aims to identify the incremental cash flows which are created as a result of consuming information in the production process. The latter involves looking at transactions involving the transfer of similar intangibles between firms while performing an adjustment using multiples to account for differences between the two intangible assets compared.
However, the following methods still make it difficult to quantify and attribute the contribution of intangibles to cash flow, while market-data on traded intangibles is unlikely to be publicly available and is heavily reliant on adjustments, making valuation of modern companies increasingly difficult. Over the long-term, there needs to be a pricing system capable of quantifying information, leading to a spillover effect into equity valuation.
The Fundamental Problem
The fundamental problem resides in the inability of the price mechanism to price something that is not finite. Market forces and the whole economic system can’t imagine a world where information embodied goods will have a diminishing marginal cost, eventually approaching zero. It costs nothing for a company to reproduce multiple lines of code and copy data. Consequently, natural market mechanisms can’t create a price.
While some studies show that information consumes processing power when deleting “one bit” of information, a more robust system is required to record value.
The solution is likely to lie in classical pricing theories, allied with heavy calculations which are made possible by today’s computational power. Theories such as labor theory of value could be utilised and modified to acknowledge profit and measure the amount of effort that creates the respective good or service. Effort can be measured by physical hours worked, cognitive activity which stimulates creativity and innovation and other emotions related to work. Currently, this idea may seem utopian without taking into account recent developments. With the advancements in Neurotechnology, it is possible to quantify neuro-based activity using technical and computation tools. This can enable pricing theories such as the labor theory of value to be fully functional.
The short-term solution is likely to lie in current accounting policies. Some countries are starting to move closer to acknowledging the value of intangibles within the reporting framework. For example, China is slowly shifting away from capital intensive industries to technology and services. As a result, new policies are introduced in anticipation to capture the externalities associated with intangibles. While this provides clarity, it does not provide a robust pricing system that the current business environment requires. Could the next long economic cycle provide what is required?