Making Intangibles Tangible: The Benefits of Measuring Intangible Assets
If you have trouble understanding intangible assets, don’t worry – you’re not alone.
Any discussion around intangibles can get complex due to accounting rules that are hard to explain, let alone understand. There are certain basic concepts, such as intangible assets, that as a manager you should know well. Why? Because intangibles are meaningful and material to your business at many different levels, and yet you cannot rely on accounting to help manage them because intangibles are not on your company’s balance sheet unless they have been acquired.
And, in another strange twist, even if the intangible assets have been acquired in a commercial transaction and, therefore, are on the books, they can only be assessed for impairment, but not appreciation of value.
So, what makes up the intangible assets of the company? Simply put, tangible assets are things you can touch such as buildings, equipment, inventory, trucks, etc. Intangible assets are things you can’t touch but have indeterminate value. The categories of intangibles are marketing-, customer-, artistic-, technology-, and contract-related. Some specific examples of intangible assets are patents, software, brands, intellectual property, contracts, customer relationships, and training programs.
Intangible assets are a topic that many leaders still avoid, despite the growing evidence that they are a valuable component of enterprise value. Renowned business professor Aswath Damodaran outlined both the history of intangible assets and the need to change the methods of accounting in his book, Dealing with Intangibles: Valuing Brand Names, Flexibility, and Patents. He explains that the firms that arose in the industrial age were associated with physical assets. The titans of industry such as GM and Standard Oil owned land, buildings, and factories that were easily valued using existing accounting measures.
As Damodaran points out, in the mid-1900s new giants emerged that followed a different valuation formula. Coca-Cola, for example, had valuable patents and brands, and Microsoft had technological expertise, but they shared key concerns about these intangibles. First, traditional accounting rules ignored internally grown intangible assets, and balance sheets showed no evidence of them. Second, a significant portion of the total market value of these companies came from their intangible assets.
Yet, he argues that more than half the value of consumer product companies could be explained by their brand names alone. Damodaran concludes that the failure to value intangible assets distorts all key financial measures including profitability, return on equity, and capital market measures such as price-earnings (PE) ratios and EBITDA multiples.
While intangible assets do not generate cash flows independently, they enable a company to charge a premium price for its products, which generates more cash flow overall for the company and, in turn, creates a premium for the company stock price. This leads to the theory of intangible capital, which is a framework for measuring, managing, and valuing internally grown intangible assets as potentially accretive or impaired components of the enterprise. The framework is based on quantitative benchmark tracking descriptive attributes of a corporation that represent its intangible assets. Typical attributes that I have found to be very effective in developing consistent results over time are overall reputation, perception of management, investment potential, and culture of innovation (Note: A company is not limited to these attributes, but keeping the list of the attributes to a minimum doesn’t limit the usefulness of the results).
The audience being measured is critical. In most corporations, there is a tendency to want to interview customers and people who know the company well. That is fine for qualitative research, but I find that impartial observers representing both business leaders and influential consumers provide a stable and sizable resource, which results in a stable and consistent audience over time.
From this reliable and consistent data, a regression analysis is applied that uses the descriptive attributes and numerous financial inputs as independent variables and the cash flow multiple (stock price per share divided by cash flow per share) as the dependent variable. The resulting model provides a reliable management tool for predicting the impact of changes in spending on the intangible assets on the cash flow multiple.
The theory of intangible capital embraces current GAAP (generally accepted accounting principles) financial standards that treat investments in intangible assets as expenses. Intangible capital is a management tool designed to help marketers, business leaders, accountants, and investors understand the material gap of large unreported intangible asset value in corporations. Today, intangible assets are unaccounted assets of significant value but with no prospect for accountability. Intangible capital will be a management tool to maximize full value potential of the corporation and provide accountability without changing GAAP.
Dr. James R. Gregory is a senior fellow at The Conference Board and is leading the Making Intangibles Tangible initiative. Jim is chairman emeritus of Tenet Partners, a global brand strategy and innovation firm based in New York City. Jim is a leading expert on measuring the power of corporate brands and their impact on financial performance. Jim has written five books on corporate brand measurement and strategy. He is currently working on a new book titled The Theory of Intangible Capital.