Because of GAAP accounting rules, assets can be undervalued or even not recorded at all on a company’s balance sheet. This can be a source of great undervalued stock opportunities, if you know what to look for.
Of course the term “undervalued” can have many connotations and mean a lot of things to many different people.
As they say beauty is in the eye of the beholder, well so is valuation and the perception of value.
I’m not talking about subjective undervaluation for this post, I’m talking about literal undervalued assets that are explicitly under-recorded on a balance sheet, because of current accounting standards.
The two main types of undervalued assets include:
- Brand name
Each of these assets are undervalued in their own way, and can be more or less undervalued based on a variety of factors.
We will cover the following in this post:
- Undervalued Asset #1 – Land
- Undervalued Asset #2 – Brand Name
- How Undervalued Assets Affect Other Key Financial Metrics
- Negative Book Value: Another Side Effect to Undervalued Assets
- Investor Takeaway
Now, let’s dig into some of these biggest factors.
Undervalued Asset #1 – Land
Land as an asset all on its own is not necessarily always undervalued. A famous saying in real estate investing is that the profit is made on the buy, and not the sell, and that’s true with companies buying land to put on their balance sheet as well.
But the longer that land is held on a balance sheet, and the more it appreciates over time, the more undervalued the land asset will be.
This is because in contrast to other assets on a balance sheet which are marked-to-market, land is marked to cost. And it stays there.
In other words, it doesn’t matter if the land held on a balance sheet was purchased at $1 million but is now worth $10 million.
The value recorded on the balance sheet will forever stay at its purchase price of $1 million, until the asset is sold.
So, as you might’ve guessed, some of the greatest sources of undervalued assets will be with companies who accumulated land long ago which has appreciated greatly since then. A perennial example of this is McDonald’s, which was more of a “land company” than a “hamburger company”.
Let’s think about why companies might want to own land instead of lease it.
- Land can be a good long term investment if it appreciates over time
- Buying land can limit future liabilities (rent payments, etc)
- Land gives a company more control and permanence over location (if the location ends up doing extremely well, the landlord can’t hike rent to push the company out)
But there are some cons to buying land as a long term asset for a company:
- If the company can earn a higher ROI on its cash elsewhere, buying land might be a poor use of capital
- Managements at companies might not be as skilled at selecting good locations, at least as well as a real estate specialist might
- Land ties up company equity, and is illiquid compared to other assets
- Financing land can be hard for companies to do, especially smaller ones without access to the bond market
The fact that there are pros and cons to buying land as a company presents the reasons why there are specialized companies who only focus on buying and leasing land (such as REITs).
And whether a company should own land or not is not a black-and-white answer, it depends on many factors including some of the ones above, and depends on each individual company and its business model and goals.
But whether land is (or was) a good investment or not doesn’t preclude it from being a potential source of undervalued assets, particularly if it is largely being looked over by Wall Street.
Undervalued Asset #2 – Brand Name
Brand name is an interesting source of potentially undervalued assets due to the fact that the rules are different depending on how a company acquired the brand.
If a brand name was developed inside of a company, it has zero value on a balance sheet. That’s right, an internally built brand name has a value of $0; it’s not recorded.
But if a brand name was acquired from another company, that asset is recorded as a “goodwill” or an “intangible asset” on the balance sheet.
It just has to do with accounting, but it can have big implications to the presentation of the balance sheet.
Acquisition/ Goodwill accounting
The accounting around acquired brand names has to do with the accounting of mergers and acquisitions. Whatever the price paid for an acquisition, that value is recorded on the balance sheet and periodically re-evaluated for accuracy.
So when a company acquires another company, it acquires all of their assets. This can include cash, investments, property and equipment, etc.
But you almost always have a premium paid for a company over its tangible assets on a balance sheet through an acquisition. This premium, or excess, is recorded as “goodwill”. That means that the more that a company pays for an acquisition, the higher their assets on a balance sheet, even if they actually overpaid for the asset (and won’t see those consequences until later).
What this means is that serial acquirers can actually have overvalued assets on their balance sheet, while those companies which are more prudent and less M&A inclined can have assets which look undervalued compared to peers from a pure numbers perspective.
It’s not some conspiracy, it just makes sense to do from an accounting standpoint.
Basically, when companies acquire or invest in long term assets at any time, they draw from their earnings to do so. In other words, value flows from retained earnings to long term assets on the balance sheet. Just like earnings convert to retained earnings and are recorded on a balance sheet.
To make the accounting square, and ensure that money flowing in-and-out is recorded, and the books are balanced, retained earnings convert to long term assets when reinvested in the business.
Acquired vs In-House Brands
Going back to the relationship between M&A accounting and brand name accounting, the brand name is recorded as a goodwill or intangible asset in an acquisition. The actual numerical value of this brand name can be subjective, but that’s how it is recorded on a balance sheet.
However, brands developed internally which are never acquired will never show up on a company’s balance sheet—even though many of them undoubtedly have monetary value and contribute to cash flows.
Curiously, marketing expenses which can build a brand are not considered long term investments (they are just expensed as operating expense to run a business), and so you never have that flow from the income statement to the balance sheet (like you do with retained earnings to assets).
So a company with a strong brand name may itself have all of its assets undervalued, because the brand name is not accounted for whatsoever.
Examples of this can include top companies like Apple, Facebook, Google, Nike, Home Depot, and many others.
How Undervalued Assets Affect Other Key Financial Metrics
One of the obvious implications of unrecorded or under-recorded assets on a balance sheet is that simple metrics comparing assets to price such as the Price to Book (P/B) ratio will become artificially high.
Because the assets should be recorded higher on the balance sheet, the Total Assets and Shareholders’ Equity should also be higher, which would’ve driven down a company’s P/B if it was properly presented.
That much should be obvious.
However, there are other key balance sheet metrics which also source from the balance sheet and become skewed from the presence of undervalued assets, and you have to be careful not to overweight these metrics when they are artificially boosted.
Two classic examples of this are the following:
If undervalued assets driving shareholders’ equity down boosts P/B higher, it also boosts Return on Equity (ROE) higher in the same way.
When earnings, or the numerator of ROE, are constant but the denominator (equity) is lower, ROE goes up.
In the same token, ROIC has Invested Capital as its denominator (which includes long term assets like property and equipment) and (ROIC) will also skew higher from underrepresented assets.
So, the companies with the most undervalued assets in the form of land and/or in-house brand name will appear to be the most efficient due to a higher ROE and ROIC, when in fact their “real” efficiency is probably not as great.
To sustain a powerful brand name, they are likely having to spend heavily on marketing—similar to the way that a capital intensive company might be spending on capex for long term assets.
While it’s a similar type of spend/ investment, the capital intensive business gets punished with low ROE and ROIC because those investments are recorded on the balance sheet, while the capital light business draws artificially high ROE and ROIC even if it is spending similar levels to maintain its brand name and profitability.
The same can be said about land, though maybe to a lesser degree.
A company can naturally achieve a steadily increasing ROE and ROIC even if it never improves its actual profitability efficiency by simply dialing back its land investments and letting them sit over time.
You could possibly argue that these are real efficiency improvements, as previous long term investments are paying off.
Whether that applies to a particular company or not, we still have to acknowledge that these are real effects to the accounting of a company’s balance sheet, and the longer land is held and/or the more it appreciates in value, the more it plays into the ROE and ROIC numbers being presented today.
Exceptions to the ROE and ROIC Distortion
To provide an example of where the accounting of undervalued assets isn’t actually distorting ROE/ROIC, consider a company who has built a very strong brand name that stands the test of time.
Say there becomes a point where the company’s brand is SO strong, that there’s no need to continue a heavy marketing campaign to keep the profitability of the brand.
In that case, the company dialing down SG&A (marketing) expenses while keeping elevated profitability is a perfect example of increased operating efficiency, and arguably should be included in ROE and ROIC.
This is where you can get some of the greatest cash cow investments, when a company (and shareholders) can reap the benefits of previous efforts and simply allocate this capital intelligently in order to not disturb the golden goose (and shareholder return).
Negative Book Value: Another Side Effect to Undervalued Assets
Since we know that undervalued assets can drag down shareholders’ equity, we should also be aware that equity can be dragged down to such an extreme as to create negative shareholders’ equity (or book value) for a company.
Whether this makes negative book value a sign of high risk or not depends on several other factors within the company, which I went through in another in-depth post.
The bottom line is that the presence of undervalued assets creating negative shareholders’ equity means that standard risk metrics such as Debt to Equity become worthless, and investors need to evaluate the riskiness of an investment through other means.
Using coverage ratios from the income statement will help differentiate a risky situation vs one with less risk, as will some intelligent evaluations on why the assets are underrepresented.
There’s a lot to take-in with these implications, but it’s increasingly important to do so in a world that continues to move digitally.
You can substitute technology advantages with brand name and observe similar cases of undervalued assets, especially when the technology is produced through R&D (which is also not capitalized as a long term asset on the balance sheet, at least today).
How you interpret the resulting earnings power that are sourced from these undervalued assets will determine what the ultimate valuation is, and this can vary widely.
So be careful with your assumptions and how much excess weight you are providing to these undervalued assets in your valuation, if at all.
Remember that just because Wall Street agrees that a company’s assets should be valued higher (as evidenced by high valuation multiples) doesn’t make the fact true.
It’s generally better to err on the side of caution with investing, and hopefully you have better tools to do that after understanding the implications of the accounting of these assets.