Last week I wrote a piece on intangible assets. I made these points:
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- Modern accounting standards fail at recognizing intangible assets. Most intangibles are not recorded on the balance sheet, unless there’s an acquisition. If there’s an acquisition, intangible assets are recognized through a purchase price allocation process (PPA). A PPA process is not adequate at taking into account the economic value of certain intangibles.
- As an investor, a failure to recognize the importance of intangible assets and the role they play in the modern economy will lead to missed opportunities. You might not identify or measure an intangible asset with precision, but you need to recognize how it drives value, even if it’s not on the balance sheet.
- In the modern economy, intangible assets have become the most important factor in value creation. Look at the world’s biggest companies: Apple, Alphabet (Google), Microsoft, Amazon, Netflix, Meta (Facebook). They are built on the back of intangibles.
- Traditional valuation metrics are inadequate for technology-heavy companies. Most of the money spent on intangibles (e.g. R&D) is expensed on the income statement and never shows up on the balance sheet as an asset/investment. This has the effect of reducing earnings and an elevated PE multiple. You have to make adjustments to determine the true economic value of the company.
The day after my post, Barron’s published an article on Apple: Apple’s Expensive Valuation Seems Perplexing. These Factors Explain It.. I like the article because it points out exactly to what I was talking about.
The article nails the flaws I just pointed out. I’m not going to rehash the article, but the gist of it is Apple trades at 29x next 12-month PE, the S&P is at 19x, implying a 50% premium for an almost $3 trillion company, suggesting a high valuation to the broader market.
I’m not going to get into whether a company approaching $3 trillion in market cap is cheap or expensive. What I want to point out is that by simply stating that “Apple trading at 29x PE is expensive” is the wrong approach. Taken at face value, it’s nuts to buy it at that price. But that’s the problem. You can’t take it at face value. Because under that approach you would have left a lot of money on the table. Over the last twenty years you would have never bought Apple, Amazon, Microsoft, Google, or Facebook because it was always trading at a “high” PE.
As I mentioned in my previous post, when it comes to technology companies, you need to adjust the P/E metric. Let’s go back to Apple for example. You need to take into account the massive amount Apple spends on R&D. Last year Apple spent $28b in R&D. Despite being an investment that will generate future cash flow, it’s treated as an expensed and any assets created doesn’t show up on the balance sheet (e.g. their biggest asset, their brand valued at $482 billion, is not on the balance sheet). Because their intangible investments are expensed instead of being capitalized, the profit are lowered and the earning multiple looks inflated. That’s why you get out-whack PE ratios with technology companies.
There’s nothing wrong with the Price to Earnings approach. But when it comes to technology companies, where their intangible assets are the major value driver, you have to dig deeper and make adjustments. However, I do prefer cash flow valuation approach. Adjusting the R&D expenses to capital expenditures will impact the company’s capital structure, but it will not affect the cash flows. And cash flow is what matters.
I didn’t want to make this a long post. I just wanted to highlight the Barron’s article and how it was related to my previous post.
Cheers.
