The Investor's Paradox: Why Unprofitable Companies Are Soaring in Value

The Intangible Asset Revolution: My Perspective on the Future of Corporate Valuation

In the dynamic landscape of corporate finance and investment,?a profound transformation is underway—a shift from tangible assets (like factories and machinery) to intangible assets (like software,?brands,?and intellectual property).?This transition,?while subtle,?has far-reaching implications for how we assess company value,?make investment decisions,?and even understand economic growth itself.?As a seasoned financial analyst with over two decades of experience,?I've witnessed this shift firsthand and have had to adapt my strategies to navigate this new terrain.?In this comprehensive analysis,?I will delve into the intricacies of this intangible asset revolution,?exploring its causes,?consequences,?and the innovative approaches required to thrive in this new era.

The Rise of the Intangible: A Historical Perspective

The rise of intangible assets is not a recent phenomenon.?It began with the advent of the Information Age,?gaining momentum in the late 20th century and accelerating in the 21st century.?In 1979,?tangible investments in the U.S.outweighed intangible investments by a factor of 1.7.?By 2017,?this ratio had flipped,?with intangible investments exceeding tangible ones by a factor of 1.4.?This trend is also evident in the increasing number of unprofitable companies going public,?which has surged from under 20% in the 1970s to nearly 45% in 2024.

This shift is not merely a statistical curiosity; it represents a fundamental change in how businesses operate and create value.?Companies like Walmart,?a retail behemoth,?and Microsoft,?a tech titan,?exemplify this transition.?Walmart's early success was not solely due to its physical stores but also its pioneering use of technology to optimize operations and gain a competitive edge.?The company's investment in logistics,?supply chain management,?and data analytics,?all intangible assets,?allowed it to offer lower prices and a wider selection of products than its competitors.?Similarly,?Microsoft's cloud computing business,?while reliant on tangible servers,?is ultimately driven by its intangible software,?intellectual property,and the expertise of its engineers.

In my early days as a financial analyst,?I vividly recall the social media boom of the late 2000s.?Many of these social media companies had few tangible assets but were valued at astronomical levels.?At the time,?it seemed like a speculative bubble,?but in hindsight,?it was an early indicator of the growing importance of intangible assets.?The bubble eventually burst,?but the lesson remained:?intangible assets could create immense value,?even in the absence of traditional tangible assets.

The Accounting Challenge: A Mismatch of Epic Proportions

The challenge we face is that our traditional accounting methods,?designed for a world dominated by tangible assets,?are ill-equipped to capture the true value of intangible investments.?These methods often expense intangible investments on the income statement,?leading to an understatement of earnings and an overstatement of expenses.?This can distort a company's financial picture,?making it appear less profitable and less valuable than it truly is.

Consider Microsoft.?In fiscal 2024,?its reported unlevered free cash flow was $77.2 billion.?However,?after adjusting for intangible investments using a methodology proposed by economist Charles Hulten,?its adjusted free cash flow remained the same, but its net operating profit after tax (NOPAT) increased by nearly 20%.?This indicates that Microsoft's earnings were significantly understated due to the expensing of intangible investments.

This accounting mismatch has real-world consequences.?In my own experience,?I've encountered numerous instances where companies with substantial intangible assets were undervalued due to traditional accounting practices.?In one case,I was advising a private equity firm on a potential acquisition of a consumer goods company.?The company's financials,based on traditional accounting,?showed modest profitability.?However,?after adjusting for its intangible investments in brand building and marketing,?the company's true earning power became evident.?We proceeded with the acquisition,?and the company's value increased significantly under our ownership.

Rethinking Valuation: A New Framework for the Intangible Age

The rise of intangible assets necessitates a paradigm shift in how we value companies.?Traditional valuation metrics like price-to-earnings and price-to-book ratios may no longer be reliable indicators of a company's true worth.?The "value factor," a popular investment strategy that involves buying statistically cheap stocks,?has underperformed in recent years,partly due to its inability to account for the value of intangible assets.

To navigate this new landscape,?we need to adopt a more holistic approach to valuation.?We need to move beyond traditional metrics and focus on free cash flow,?which is a more accurate measure of a company's ability to generate cash after accounting for all investments,?both tangible and intangible.?We also need to consider a company's strategic resources,?such as its brand,?intellectual property,?and human capital,?which are often not reflected on the balance sheet but can be significant drivers of value.

This shift in valuation requires a deeper understanding of the financial statements.?For instance,?when analyzing a company's income statement,?it's crucial to scrutinize its selling,?general,?and administrative (SG&A) expenses.?These expenses often include intangible investments like employee training,?customer acquisition costs,?and software development.?By identifying and reclassifying these investments,?we can gain a more accurate picture of a company's profitability and growth potential.

One of the most challenging aspects of valuing intangible assets is their inherent subjectivity.?Unlike tangible assets,which have a clear market value,?the value of intangible assets can be difficult to quantify.?For example,?how do you put a price on a company's brand reputation or the expertise of its employees??This is where experience and judgment come into play.?As a financial analyst,?I've had to develop a keen eye for identifying and assessing the value of intangible assets.This involves not just analyzing financial data but also understanding the company's business model,?competitive landscape,?and long-term prospects.

The Unique Characteristics of Intangible Assets: The Four S's

Understanding the unique characteristics of intangible assets is paramount for investors and businesses alike.?These characteristics,?often referred to as the four S's—scalability,?sunkenness,?spillovers,?and synergies—can provide valuable insights into a company's growth potential and competitive advantage.

• Scalability:?Intangible assets often have high upfront costs but very low incremental costs.?This means that once the initial investment is made,?the cost of producing additional units is often negligible.?This scalability can lead to exponential growth,?as seen in companies like Microsoft and Google.?For example,?developing a new software program can be expensive,?but once it's created,?the cost of distributing it to millions of users is relatively low.?This scalability is a key driver of the network effects that are so prevalent in the digital economy.
• Sunkenness:?Unlike tangible assets,?which can often be resold if a business fails,?intangible investments are often specific to a particular company or context and may have little value to others.?This makes it crucial for investors to carefully assess the quality and relevance of a company's intangible assets.?For instance,?a company's investment in developing a specialized software for its internal operations may have little resale value if the company goes bankrupt.?This sunkenness also means that intangible investments are often riskier than tangible investments,?as their value is more difficult to recover if the investment doesn't pan out.
• Spillovers:?The benefits of an intangible asset,?such as knowledge or technology,?can easily spill over to other companies or industries.?This can lead to increased competition and erode a company's advantage.?However,?it can also benefit society as a whole by fostering innovation and economic growth.?For example,?research funded by one company may lead to discoveries that benefit other companies or even entire industries.?This is why governments often invest in basic research,?as the spillovers can have a significant positive impact on the economy.
• Synergies:?The combination of different intangible assets can create new value.?For example,?a company's brand reputation can enhance the value of its new products or services.?Recognizing and leveraging these synergies is crucial for maximizing the value of intangible investments.?A strong brand,?for instance,?can make it easier for a company to launch new products or enter new markets.?Synergies can also arise from the combination of different types of intangible assets,?such as technology and human capital.

In my own work,?I've seen how companies can harness these characteristics to their advantage.?For instance,?a pharmaceutical company I consulted for invested heavily in R&D to develop a new drug.?This intangible asset,?while protected by patents,?also had significant spillovers,?benefiting the broader medical community.?However,?the company was able to leverage the synergies between its R&D capabilities and its strong distribution network to maximize the drug's commercial success.?The company's brand reputation also played a crucial role in gaining market acceptance for the new drug.

Mathematical Example: Evaluating Intangible Investments Using NOPAT and Free Cash Flow

Purpose:?To illustrate how intangible investments impact a company's Net Operating Profit After Tax (NOPAT) and Free Cash Flow (FCF), highlighting the significance of adjusting financial statements to accurately reflect these investments.

Real-World Application:?Understanding the adjustments needed for intangible investments helps investors make better-informed decisions about a company's true financial health and potential for value creation.

Expected Outcome:?By following the example, readers will grasp how to adjust financial statements for intangible investments and understand the impact on NOPAT and FCF.

Step-by-Step Calculations

Step 1: Calculate Unadjusted NOPAT and FCF

1. Operating Income (EBIT):?$53 billion
2. Cash Taxes:?$8 billion
3. Net Operating Profit After Tax (NOPAT): 53-8 = $45 billion
4. Capital Expenditures (CapEx):?$19 billion
5. Depreciation:?$11 billion
6. Net CapEx: 19-11 = $8 billion
7. Change in Working Capital:?-$1 billion (negative indicates a decrease in working capital)
8. Free Cash Flow (FCF): 45-8+1 = $38 billion

Step 2: Adjust for Intangible Investments

1. Intangible Investments (SG&A Components):

• R&D: $19.3 billion (100% intangible)
• Sales & Marketing (S&M): $19.6 billion (70% intangible)
• General & Administrative (G&A): $5.1 billion (20% intangible)

1. Total Intangible Investment: 19.3+(19.6*70%)+(5.1*20%) = $34.04 billion
2. Amortization of Intangibles (Example: 6 years for R&D, 2 years for S&M and G&A): (19.3/6)+(13.72+1.02/2) = $10.59 billion
3. Adjusted NOPAT: 45+34.04-10.59 = $68.45 billion
4. Adjusted FCF: $68.45-8+1 = $61.45 billion

In this example, I examined the impact of intangible investments on a company's financial health, specifically through adjustments to NOPAT and FCF. Starting with unadjusted figures, I calculated the necessary adjustments to reflect the true value of intangible investments like R&D, sales and marketing, and general and administrative expenses. Our calculations showed that accounting for these intangibles increases NOPAT from $45 billion to $68.45 billion and FCF from $38 billion to $61.45 billion. These adjustments provide a clearer picture of the company's profitability and potential for value creation, underscoring the importance of including intangible assets in financial analyses. This comprehensive approach helps investors make more informed decisions by highlighting the true financial health and future prospects of a company.

A Real-World Example: Uncovering the Hidden Value of a Pharmaceutical Client

In my years as a valuation professional,?I once worked with a pharmaceutical company,?"PharmaGrowth," (name masked due to confidentiality) that was struggling to attract investors due to its seemingly low profitability.?The company had been investing heavily in research and development (R&D) for a new drug,?which had yet to be approved by regulatory authorities.?As a result,?its financial statements,?prepared using traditional accounting methods,?showed significant expenses and minimal profits.

Purpose and Real-World Application:

The purpose of this example is to demonstrate how the misclassification of intangible investments,?such as R&D expenses,?can distort a company's financial picture and undervalue its true worth.?By applying the principles discussed in the article,?we can reassess PharmaGrowth's financials and uncover its hidden value.

Expected Outcome:

We expect to find that PharmaGrowth's value is significantly higher when we account for its intangible investments in R&D compared to using traditional valuation methods that focus primarily on tangible assets and reported earnings.?This will not only provide a more accurate assessment of the company's financial health but also make it more attractive to potential investors.

Step-by-Step Calculations:

Traditional Valuation:

• PharmaGrowth's current net income is $500,000.
• The industry average price-to-earnings (P/E) ratio for pharmaceutical companies is 20.
• Using the traditional P/E valuation method,?PharmaGrowth's value would be $500,000 * 20 = $10 million.

Identifying Intangible Investments:

• PharmaGrowth invests $2 million annually in R&D for the new drug.

Reclassifying R&D as an Investment:

• I reclassify the R&D expense as an investment and capitalize it on the balance sheet.

Calculating Amortization:

• Assuming a 10-year amortization period for the R&D investment (typical for pharmaceutical R&D),?the annual amortization expense would be $2 million / 10 = $200,000.

Adjusting Net Operating Profit After Tax (NOPAT):

• We add back the net R&D investment (R&D investment - amortization expense) to the net income to arrive at NOPAT.
• Adjusted NOPAT = $500,000 + ($2 million - $200,000) = $2.3 million

Factoring in Changes in Working Capital, Capital Expenditures, and Acquisitions:

• Working capital increased by $100,000.
• The company invested $500,000 in new lab equipment (capital expenditure) and incurred $50,000 in depreciation.
• PharmaGrowth acquired a smaller competitor for $3 million.

Calculating Investment in Growth (I):

• I = Changes in working capital + Net capital expenditures + Acquisitions
• I = $100,000 + ($500,000 - $50,000) + $3 million = $3.55 million

Calculating Free Cash Flow (FCF):

• FCF = Adjusted NOPAT - I
• FCF = $2.3 million - $3.55 million = -$1.25 million

In this scenario,?PharmaGrowth has a negative free cash flow of -$1.25 million.?This means that the company's investments in growth (R&D,?working capital,?capital expenditures,?and acquisitions) exceed the cash generated from its operations.

To determine the revised valuation,?we would use the adjusted NOPAT (Net Operating Profit After Tax) and the industry average price-to-earnings (P/E) ratio.

• Adjusted NOPAT:?$2.3 million (as calculated in step 5)
• Industry Average P/E Ratio:?20
• Revised Valuation = $46 million

In the context of the PharmaGrowth example,?the company has no debt.?This simplifies the calculation and allows us to use adjusted NOPAT as a proxy for earnings.

This revised valuation of $46 million is significantly higher than the initial valuation of $10 million,?which was based on the unadjusted net income.?This demonstrates the importance of considering intangible investments like R&D when valuing pharmaceutical companies.

The Intangible Revolution: A New Era of Value Creation

The intangible asset revolution is reshaping the corporate landscape,?demanding a fundamental shift in how we value companies and allocate capital.?Here are the key takeaways and actionable recommendations for investors,?businesses,and policymakers:

For Investors:

• Re-evaluate Valuation Models:?Traditional metrics are no longer sufficient.?Focus on free cash flow and incorporate intangible assets into your valuation models.
• Assess Strategic Resources:?Look beyond the balance sheet and evaluate a company's brand,?intellectual property,and human capital.
• Demand Transparency:?Advocate for greater disclosure of intangible asset investments to make informed decisions.

For Businesses:

• Invest Strategically:?Prioritize investments in intangible assets like R&D,?branding,?and employee training.
• Measure and Communicate Value:?Develop robust frameworks to quantify and communicate the value of intangible assets to investors.
• Foster Innovation:?Create a culture that encourages innovation and the development of intangible assets.

For Policymakers:

• Update Accounting Standards:?Advocate for accounting standards that better reflect the value of intangible assets.
• Incentivize Investment:?Create policies that encourage investment in intangible assets,?such as tax incentives for R&D.
• Invest in Education and Research:?Support the development of the knowledge economy through investments in education and research.

The rise of intangible assets is not just a trend; it's a paradigm shift.?It's a shift that requires us to rethink our assumptions,adapt our strategies,?and embrace new ways of thinking.?The companies and investors who understand and embrace this shift will be the ones who thrive in the new economy.

As we move forward,?it's crucial to remember that the intangible revolution is not without its challenges.?The valuation of intangible assets remains a complex and evolving field.?There are no easy answers,?and the path forward will require ongoing research,?innovation,?and collaboration between investors,?businesses,?and policymakers.

However,?the potential rewards are immense.?By embracing the intangible economy,?we can unlock new sources of value,drive economic growth,?and create a more prosperous future for all.?The intangible asset revolution is not just a challenge to overcome; it's an opportunity to seize.