Businesses in sectors where intangibles dominate tend to have higher observed values and returns—but this may have more to do with the accounting than underlying economics. When these higher reported returns on invested capital (and forward-looking expected incremental ROIC) are used in a DCF or in a valuation multiple model input, valuation experts “need to apply a higher figure … and one that is structurally above the cost of capital,” so argues The Footnote Analyst in their latest (21 September) article “Missing Intangible Assets Distorts Return on Capital.” The new article also offers an excellent (and free) interactive model to help financial experts demonstrate how capitalising intangible investment would affect target company profit and returns.
Small, growing companies without recognized intangible assets (typical of those valued by business valuers) generally see an understatement of profit and, of course, a reduction of invested capital on the balance sheet, both of which distort ratio analysis versus larger comparable companies. This forward-looking return indicator also skews DCF analyses.
The authors support current intangibles accounting while recognising that “estimates of internal intangible asset ‘investment’ and the useful life and recoverability of the resulting assets are all difficult” and open to manipulation by management. “We believe that investors need more information about the differing nature of operating expenses, and the extent to which these are ‘future-oriented’ and result in value creation and therefore intangible assets. Even if intangible asset investment is not capitalised in the primary financial statements there should, at the minimum, be better information provided in the footnotes.”
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