Saturday, September 26, 2009

Intangible Assets

I very much dislike intangible assets, the growth or continued presence of them on a balance sheet always throws up a red flag for me. Maybe it is due to my value investor perspective but giving financial credence to a resource that I can't see, can't touch and can't prove generated a cent of revenue in a business is something I just don't like.

Definition

An asset that is not physical in nature. Corporate intellectual property (items such as patents, trademarks, copyrights, business methodologies), goodwill and brand recognition are all common intangible assets in today's marketplace.

Intangible Assets Do Exist

Surely the brand Coca-Cola carries some value in its name alone. If a consumer is provided the option of buying Coke or a noname product for the same price there will be a pronounced inclination towards the Coke product. How you value this on a balance sheet is a question that businesses and investors both struggle with.

As KPMG states, with reference to intangible assets:
It is difficult to think of another class of corporate asset which is subject to such careless stewardship. This is particularly apparent when it comes to the governance of intellectual property, as many intellectual property based relationships depend upon self-reported activity.

The successful policing of these self-reporting entities is a matter of real importance in the post-Enron environment. Declarations made under self-reporting relationships almost invariably reveal misreporting when properly examined.
As it is a business' responsibility to assess the value of these intangible assets errors are common place. In Michael F. Price's introduction to Benjamin Graham’s book The Interpretation of Financial Statements he describes his first encounter with intangibles when doing analysis of Schaefer's Brewery:
I called Schaefer's treasurer and said, 'I'm looking at your balance sheet. Tell me, what does the $40 million of intangibles related to?' He replied, 'Don't you know our jingle, 'Schaefer is the one beer to have when you're having more than one.'?'
Price struggles, as any value investor would, to understanding how a marketing message could possibly be worth $40M.

Specifically Defining Intangibles

The International Accounting Standards Board provides but a few criteria for defining an intangible asset. It must be:
  • identifiable
  • have the power to obtain benefit
  • be able to provide future economic benefits
In layman's terms it has to be specific enough that we can point to it, be able to be sold off now if we needed to, and has the capacity to continue generating financial benefits in the future.

Sound vague? Well it is. So vague is the description that some in the industry have made efforts at self regulation. Among those being the Intangible Asset Finance Society who have made it their intent to provide guidance and direction to businesses on how to properly identify and allocate intangible assets.

How to Work with Intangibles

As an investor you should get into the habit of evaluating a business with its intangible assets completely removed. Do this until such time as you can understand the intangibles well enough to agree with the business’ assessment of their value. Every effort should be excreted to truly understand what these intangibles are. Sometimes that is as simple as it was in Price’s case, sometimes this involves deep analysis. Invariably if you are leaving them in financial calculations without investigation you are doing little more than taking a company at its word.

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