There are two important sub-metrics for investors to understand on a balance sheet: net tangible assets and goodwill. Both of these figures make up part of a company’s total assets.
The question here is twofold. Does it matter much if a high number of assets on a balance sheet come from net tangible assets vs. goodwill? And is one preferable over another? As is usually the case in debates like these, I form my approach by thinking through the logic rather than relying on what an author said about it.
Let’s first define these terms. At its most basic definition, an asset is something of value that (usually) produces an income stream. These are typically things like inventory and factory plants, but I say usually because things like cash also count as an asset.
Now, assets on a balance sheet can be either tangible or intangible. A tangible assets refers to one that is physical. It’s the assets we typically think of, like the ones mentioned above. But there are also intangible assets– things a company own that contribute to producing a revenue stream but aren’t physical or have a concrete value.
Examples of intangible assets are things like intellectual property, copyrights, and brand recognition.
Intellectual property can be very significant for a cutting edge technology company who dominates an aspect of their field due to a certain methodology or patent/ manufacturing advantage.
Copyrights can be very important to an entertainment/ media company whose revenue is mainly generated from certain shows or movies. The shows or movies don’t have a physical value but produce an income stream.
Brand recognition usually falls under the goodwill category on a balance sheet. This can be significantly important for a food company, whose products are generally indistinguishable in quality from its competitors yet loyalty to a brand leads to an unproportional amount of revenue vs. competitors.
It’s obvious that the reliance of intangible assets to a company’s balance sheet can vary for each company’s unique situation or which industry they are in. So knowing this, does it really matter if a company’s assets are mostly tangible or intangible?
Before answering that question, let’s define net tangible assets real quick.
Tangible assets are everything that are physical and either contribute to the income stream or have an obvious value. In the balance sheet of a company’s 10-k, this is things like cash & cash equivalents, short term investments, net receivables, inventory, long term investments, and property, plant and equipment.
The “net” part of the equation is like the shareholder’s equity of the tangible assets. Basically it’s the number of total tangible assets minus the total liabilities. This number can be negative even when a company’s shareholder’s equity is positive if a high ratio of a company’s assets are made up of intangible assets.
Advantages of High Net Tangible Assets
1. The problem with intangible assets is that because they aren’t physical and have a market value, their true value is debatable. While they may contribute to revenue, it’s not often clear to what extent they contribute to revenue. Because of this, the value of intangible assets must be estimated.
If you’ve experienced just season of earnings reports, you’ll see that analysts estimates are rarely hit perfectly. The excitement behind earnings season is to see if a company outperforms or under performs earnings estimates. Even though there’s a wealth of information about a company’s financials and the market and industry they operate in, these estimates are hard to come up with and be accurate.
The same difficulty applies to estimating intangible assets. You’ll never be able to definitely determine this number, yet it undoubtedly contribute’s to a company’s intrinsic value and therefore has to be included in a balance sheet.
2. The value of a company’s intangible assets isn’t likely to be consistent throughout the years. This becomes obvious as a company starts to fail. Lower sales means that customers value of a brand may be decreasing, or the competitive edge of a piece of intellectual property advantage may be closing.
As such, the value of a company’s intangible assets on a balance sheet may quickly fall. This obviously would impact important investing metrics that depend on shareholder’s equity or total assets, things like the debt to equity ratio and the price to book value ratio. The falling of the number of total intangible assets may fall to a greater extent than a tangible asset might in a short period of time.
The fluidity of the value attached to intangible assets makes estimation even more difficult. Are increased sales due to improvements to a manufacturing plant and the higher asset value the investment in the plant created, or is it more due to an increase of worth in an intangible asset?
If it’s a combination of both, how do you determine at what ratio this increase of value occurred? In fact the contribution of an intangible asset may have had nothing to do with increased sales, and may have been directly a result of a different asset’s increased efficiency and ability to create more income.
In the case of how a company’s workforce contributes to its sales, a certain employee may have not been pulling their weight and may now be laid off. Because this happens on an individual level, how can every situation and their relation to intangible asset value be accurately determined? Surely an employee who didn’t pull any weight and is no longer a liability is strictly an increase in asset efficiency and nothing to do with an intangible asset being better. But it could also be partly from the increased efficiency and partly an increase in intangible asset value.
Employee efficiency may also be largely based on opinion, which again can only be estimated and not definitely determined. Multiply this by hundreds of thousands or millions of workers, and you can see how this effect compounds.
3. Intangible assets may or may not hold be able to be sold to another company in a bankruptcy case where a company is liquidated. Investors like Benjamin Graham looked or still look for investments in companies trading at a discount to liquidation value.
This means the risk is likely eliminated if even in the worst case, a company going bankrupt would still give the investor a positive ROI from the sale of the company’s assets in relation to the price paid by the investor.
When an intangible asset would be mostly worthless in a liquidation (this could be less of an impact in an acquisition vs. a full liquidation), the risk assumed would be greater for investment in a company with lower net tangible assets. Though it may be more relevant based on an investor’s strategy, the impact of low net tangible assets in a liquidation would be equally applicable to investors regardless of strategy.
It also affects all investors regardless of strategy as it affects the attractiveness of a stock at its current price. A company whose assets have increased or decreased may make a stock more or less attractive, thus pushing the stock either higher or lower. So, this effect can’t be ignored even if an investor doesn’t base his strategy on asset value.
Advantages of High Intangible Assets
1. We talked about investors like Benjamin Graham who use a strategy such as net-net investing which depend on high tangible assets for success. In the same token, investors like Warren Buffett have historically looked for stocks with low tangible assets as part of an investing strategy.
Low tangible assets may actually be good for a company because it means their tangible assets are highly efficient. This means a company is less capital intensive, and it may be in a less risky situation because periods of low sales and earnings would not cripple the business. When you need less capital to run a business, you aren’t as dependent on high earnings.
Taking that thought process further, a lower capital intensive business may have an easier time growing and compounding shareholder wealth.
Because capital isn’t needed as much, big improvements to the worth or impact of a company’s intangible assets could cause business or growth to explode much faster than competitors who are more capital intensive. This could mean that smart investments in workforce or marketing could have a greater impact than just more cash. And management’s ability to make these decisions could be considered another intangible asset.
2. The fluidity of the value of a company’s intangible assets may positively affect share price when a company is growing quickly. This could have something of a compound interest effect, where business success begets even higher stock market success as asset values grow at a much higher rate than high capital intensive businesses.
This would depend on how much impact a company’s intangible assets has on increased growth. Again this is hard to quantify but relevant to all investors regardless of strategy.
What’s the Solution for Investors?
We can’t just look at the above and say, well high net tangible assets has 3 advantages and high intangible assets has 2… so it’s clearly the better choice. We can’t say that because the impact and weight of each advantage is debatable.
I solve this conundrum by refusing not to play. I’m not saying sticking my head in the sand, but solving in other ways.
All things equal, I’d prefer to have higher tangible assets than lower. Just because a company has high tangible assets doesn’t mean that it doesn’t have no intangible assets. In fact the value of its intangible assets may be under reported, which could mean I’m getting an even better deal by buying the stock.
But, I don’t want to discount a stock just because it has higher intangible asset values. You can’t deny that a business like that has a great business model that smart investors/ part business owners should want to be a part of regardless of the disadvantages laden with the situation.
And again, it’s hard if not impossible to quantify the extent of these advantages and disadvantages so why ignore a potentially great stock trading at a great price just because we also like high net tangible assets?
How I Mitigate the Whole Thing
My approach looks for low debt to equity and a low price to book ratio. That means I’m invested in situations where total asset values are higher, meaning both net tangible assets and intangible assets are higher than competitors.
I manage the fluidity of intangible asset values over time by also looking at earnings numbers, growth, net cash, and net sales numbers. So, if a company quickly loses the efficiency of their intangible assets, the impact of this will show up in the other ratios I use. You can’t hide declining business performance; it will always show up somewhere.
Maybe you don’t have an approach like mine.
You should still be fine as long as long as you’re watching total assets, total liabilities, and shareholder’s equity. This problem in the balance sheet can be mitigated by watching that same balance sheet.
While declining business performance due to lowered efficiency of intangible assets may show up in the income statement and cash flow statement, it will also likely show in the balance sheet. Think about it. Lower efficiency from intangible assets should eventually show up in how those values are estimated.
You can also watch for a sudden increase in total liabilities. This is often a symptom of lower earnings especially in higher capital intensive companies. It can also be an advantage to watch total liabilities because a company can try to high poor business results by keeping earnings growth steady but fueling it by growth.
By watching the balance sheet, you could potentially cover both disadvantages we’ve discussed here at the same time. Though I do recommend learning about my approach and watching everything that could potentially go wrong.
Because when you watch for trouble in all places, you can’t be blindsided when trouble happens. And isn’t that the whole point of this debate?
You won’t have to worry about net tangible assets vs. intangible assets when all of your bases are covered. As is the case with earnings manipulations, cash flow problems, and even other differences between smart investors and their different methods of calculating intrinsic value.