Valuation: How to Analyze Companies With Big Brand Names or Big R&D Budgets

Getting to more accurate valuations of companies with intangible assets

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Oct 15, 2018
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In the past, analyzing the value of a railroad was relatively simple: Count the ties, the rails, the rolling stock and so on—the physical or tangible assets. Today, of course, valuing railways gets more complicated because of increased use of technology and other factors.

But, there are other companies that need to be valued primarily on their intangible assets. Think of companies with famous brand names, patents and skilled technicians, among others. In chapter 11 of "The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit," Aswath Damodaran set out to help investors understand the issues involved in valuing such nonphysical assets.

Companies with mainly intangible assets exist in diverse circumstances, but they share two common characteristics.

  • First, accounting for intangible assets is inconsistent with the treatment of physical assets. This refers to the distinction between capital expenses and operating expenses. Normally, an expense which will produce benefits over multiple years would be treated as a capital expense, and an expense that drives a benefit only in the current year would be treated as an operating expense.

    Damodaran challenged accountancy rules that only make sense for companies with tangible assets: “However, they seem to ignore these first principles when it comes to firms with intangible assets. The most significant capital expenditures made by technology and pharmaceutical firms is in R&D, by consumer product companies in brand name advertising and by consulting firms in training and recruiting personnel.”
  • Second, companies with intangible assets reward management with stock options more often than companies in other businesses. He explains this as companies with intangible assets being at an earlier stage in the life cycle (growth phase rather than mature) and with the need to “retain human capital.”

He added:

“The miscategorization of capital expenses, the sparing use of debt and the dependence on equity-based compensation (options and restricted stock), can create problems when we value these firms. Put more bluntly, the accounting measures of book value, earnings, and capital expenditures for firms with intangible assets are all misleading, insofar as they do not measure what they claim to measure and because they are not directly comparable to the same items at a manufacturing firm.”

Thus, the starting point for the valuation of a company with intangible assets is “correcting the erroneous accounting classification of expenses” and restating the fundamentals: Operating income, capital expenditure and return on capital. That restatement makes these companies comparable to companies in other sectors and, consequently, may be valued on the same metrics.

Damodaran noted the same issues confront analysts using relative valuation. For example, the price-earnings ratio of a technology company cannot be immediately compared with the price-earnings ratio of a manufacturing company.

To illustrate his case, using an intrinsic valuation, the author turned to Amgen (AMGN, Financial), a biotechnology company. As a biotech company, its big intangible assets are research, and those expenses should be capitalized. That starts with an assumption about the time needed for research and development to be fully converted into commercial products: Damodaran used 10 years.

He collected data on research and development expenses over the previous 10 years, making the assumption it would be amortized evenly over the years. One-tenth of the research expense is written off each year, and he arrives at a cumulated amortization expense for the current year of $1.604 billion. The unamortized portion of the capital works out to $13.284 billion.

Next, Damodaran calculates the adjusted book value of equity using this formula: “Stated book value of equity + Capital invested in R&D = $17,869 million + $13,284 million = $31,153 million.” Or $31.153 billion.

This amount receives an adjustment for the capitalization of research and development expenses, a process in which the expenses that had been subtracted to get to operating income are added back to show they have been recategorized as capital expenses. Amortization of research assets are then treated as depreciation, to arrive at adjusted operating income and adjusted net income:

  • “Adjusted operating income = Stated operating income + R&D expenses − R&D amortization = 5,594 + 3,030 − 1,694 = $6.930 million.”
  • “Adjusted net income = Net income + R&D expenses − R&D Amortization = 4,196 + 3,030 − 1,694 = $5,532 million.”

Research and development expenses are an obvious example of an operating expense that should be converted to a capital expense. Damodaran wrote that companies such as Proctor & Gamble (PG, Financial) and Coca-Cola (KO, Financial) could argue the same for at least a portion of their advertising expenses since they serve to “augment” the long-term value of a brand name.

Similarly, he argued consulting companies such as KPMG and McKinsey could make a case for the expense of recruiting and training employees because “the consultants who emerge are likely to be the heart of the firm’s value and provide benefits over many years.”

Still, the author had concerns, writing there should be “substantial evidence” that the benefits from operating expenses accrue over multiple reporting periods. He added, “The net effects of the capitalization will be seen most visibly in the reinvestment rates and returns on capital you estimate for these firms.”

Turning specifically to intrinsic valuation, when capitalized expenses are used to create intangible assets, then, in effect, the financial statements are being rewritten and key metrics are being restated:

  • Earnings: Restatement involves adding back current year expenses and subtracting the amortization of past expenses. Generally, the effect on earnings will be positive, i.e., restated earnings will be higher.
  • Reinvestment: Effects will likely be the same as they were for earnings, which usually will increase the restated reinvestment rate.
  • Capital invested: Treating the unamortized portion of prior-year expenses as an asset will add to the estimated equity invested in the company.
  • Return on equity (capital): “Since both earnings and capital invested are affected by capitalization, the net effects on return on equity and capital are unpredictable.” As to the effects, if return on equity increases after recapitalization, it indicates, roughly, that returns earned on research and development are greater than returns on traditional investments.

Overall, the capitalization process should restore consistency of valuations because the growth rates will align with assumptions about reinvestment and return. And, it may have a significant effect on the metrics: Damodaran provides a table showing the effects:

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On the relative valuation side, capitalization of expenses will also have an effect. The extent of effects will vary according to sets of factors:

  1. The age of the company and its stage in the life cycle: The effects will be greater at young growth companies than at mature companies.
  2. Amortizable life: The number of years over which an R&D-derived asset is amortized will have an effect on the restated amount of capital invested.

Summing up, companies that depend heavily on intangible assets can be valued on the same terms as companies that depend on the more familiar tangible assets. The capitalization of expenses, through adjustments to key metrics, is the key to making all companies comparable.

This is the final full chapter in "The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit," and our last review of the book.

The author: Damodaran is the author of three books on valuation and is a professor of finance and the David Margolis teaching fellow at the Stern School of Business at New York University. There he teaches corporate finance and equity valuation courses in the MBA program. His research interests lie in valuation, portfolio management and applied corporate finance.

(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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