About twenty years ago Buffett experienced a Damascene conversion.
The Economist Magazine called it ‘Diminished Value’. The article contained the line: “Old-style value investing looks increasingly at odds with how the economy operates.” I thought this strange. It seemed at variance with everything I know about value investing. So I decided to write this post.
Let’s begin at the beginning. When we think of value we often think of book value. Financial statements include a balance sheet that summarizes the assets and liabilities of a company. Stock prices are often measured against book values, as in, price to book value (p/b). So it’s natural to look at the balance sheet when trying to value a company. Today, this is largely a useless exercise. How so?
Book value and balance sheets
Normally when companies make capital investments, the outlay is capitalized and appears on the balance sheet at cost. The investment is not a company ‘operating expense’ and so does not reduce reported income. Typically, this approach applies to investment in tangible assets, things you can touch. But, when companies invest in intangibles of lasting value, normally they expense the outlay. This reduces reported net income. It shouldn’t. What’s more, the investment doesn’t appear on the balance sheet. It should. I used the expression ‘intangibles of lasting value’.
As The Economist magazine article notes: “….intangibles’ treatment in company accounts is a bit of a mess. By their nature, they have unclear boundaries. They make accountants queasy. The more leeway a company has to turn day-to-day costs into capital assets, the more scope there is to fiddle with reported earnings. And not every dollar of R&D or advertising spending can be ascribed to a patent or a brand. This is why, with a few exceptions, such spending is treated in company accounts as a running cost, like rent or electricity.”
The problem is this: As noted, company investment in these intangibles doesn’t appear on the balance sheet. So, they don’t become part of book value. How do we solve the problem? Can we track them down elsewhere? Can we adjust the balance sheet to reflect company investment in intangibles of lasting value? For example, we could get into an analysis of the income statement. We could analyse selling, general, and administrative (SG&A) costs, which includes research and development (R&D) expenses, to estimate the intangibles of lasting value and adjust the balance sheet accordingly. This is a bit like a dog chasing its tail. Lots of dust but no results.
Balance sheets are becoming obsolete, as is, book value. This is not just a tech stock problem. Visa Inc. (V) has a five year average p/b ratio of 9.0. That is, for every dollar of book value, the stock has nine dollars of market price. Colgate Palmolive Co. (CL) has a five year average p/b ratio of 129.7. That’s not a misprint. For every dollar of book value, the stock has $129.7 of market price.
We need to be clear about what this last graph tells us. It shows intangibles as a percentage of the market capitalization of S&P 500 companies. It tells us nothing about what is shown on company balance sheets about the book value of equity. It is consistent with a Haskel and Westlake graph showing the tremendous rise in intangibles investment since 1950. For more on Haskel and Westlake see below.
So, back to my question, can we adjust the balance sheet to reflect intangibles? The answer is that we don’t have to. We don’t need the balance sheet to value a company.
Intangibles and value investing: Warren Buffett got there first
About forty years ago Buffett experienced a Damascene conversion.
Warren Buffett says: “…You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission.” 1983 Berkshire Hathaway, Chairman’s letter to shareholders, quoted in (Buffett/Cunningham, 1998) p171. (Emphasis added)
Warren Buffett makes a clear distinction between Economic Goodwill and what he calls, ‘spurious accounting goodwill.’ (Buffett/Cunningham, 1998) p176. He defines Economic Goodwill as follows: “Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.” (Buffett/Cunningham, 1998) p173. (Emphasis added) See below for more on Economic Goodwill.
Buffett goes on: “Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring [economic] Goodwill and that utilize a minimum of Tangible Assets”. (Buffett/Cunningham, 1998) p171. (Emphasis added)
Put another way, he says:
“Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.
In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined Intangibles of lasting value with relatively minor requirements for Tangible Assets.” (Buffett/Cunningham, 1998) p176. (Emphasis added) Note, not all intangibles are of lasting value. But, that is a study in itself.
With that in mind it is no surprise that Berkshire Hathaway’s largest investment today is Apple (AAPL)
Stock valuation in an age of intangibles of lasting value
If book value of assets won’t get us there, can we use reported earnings. Price earnings ratios (p/e) is a popular short cut to ‘valuing’ companies. But, because company investment in intangibles of lasting value reduces reported earnings, companies report distorted earnings that are lower than they should be. In my view the p/e ratio is rapidly becoming useless. For more on this see below.
The answer is the use of Warren Buffett’s Owner Earnings. It is close to Free Cash Flow but not quite. It’s good to start with Free Cash Flow. I use a three year weighted moving average. I count three years but double weight of the most recent year. That smooths out lumpiness. I have access to several services that offer analysts’ estimates of fair value using DCF methods. See below for a post on using Discounted Cash Flow (DCF) analysis to value stocks.
So that’s it. Discounted cash flow is the right way to value companies and stocks in an age of company investment in intangibles of lasting value.
Value investing is alive and well. Assessing intrinsic value or fair value, as it is sometimes called, is the heart and soul of value investing. Value investing is perfectly capable of valuing stocks in an age of intangibles. Value investing is not to be confused with investing in ETFs that use value factors to identify value stocks. The Economist magazine article referred to makes this mistake. The mistake is very common today. The difference between them is explained in a post below.
Here is a list of posts I have written relevant to the subject of intangible assets:
>>>For more on using Discounted Cash Flow (DCF) analysis to value stocks
>>>On how Warren Buffett has a shorthand DCF technique
>>>On the Obsolescence of book value.
>>>On the difference between value stocks and value investing
>>>For more on Haskel and Westlake and how p/e ratios becoming useless
>>>On how at the best of times p/e ratios have never been a good guide to value
>>> All about moats and intangible assets
>>>On measuring financial strength when book value is useless in age of intangibles
>>>And finally how CAPE needs to be seen in an entirely new light in the age of intangibles
To read more deeply on the subject of how to go about portfolio construction see the Motherlode Part 7: Building and managing a portfolio
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