It is often said that “a single picture is worth a thousand words”. The phrase is meant to highlight that a complex issue can be illuminated with a simple diagram. Yet, in some cases, the opposite is true, a single picture obfuscates instead of illuminating.
The above chart may just be the best example of this. It was sourced from Ocean Tomo the “Intellectual Capital Merchant Banc®”. The firm is the author of the “Intangible Asset Market Value (IAMV) Study”, and this chart hails specifically from the 2017 update also published on SSRN.
At first glance the chart paints an attractive story. Intangible assets have taken over. As the authors put it “data spanning more than a quarter century for the U.S. make it clear the economy is inverting from one where value was measured by “touch” to one where value is driven by thought. This change has been no less significant than the industrial revolution more than a century ago“.
On first thought one instantly agrees. All around us we see the rise of technology and intellectual capital. In the West factories shutter replaced by the knowledge economy. How can one disagree and here is a piece of undisputed evidence showing how intangible assets make up more and more of the value of firms.
This initial agreement makes other arguments more seductive. The Sustainability Accounting Standards Board (SASB) include this chart in their reports in order to highlight, as one LinkedIn commentator put it, “the strongest argument in support of ESG analysis”. The chart is used to spell the end of value investing and with it traditional accounting and financial analysis. It is also used to explain the changing nature of corporates and how they communicate this with the market.
The chart and the arguments it supports chime so well with the current zeitgeist that it is difficult to think critically. Yet think critically we must. The place to start is the original source. There, in a a footnote, IAMV is defined (emphasis ours, as are abbreviations) – “IAMV is determined by subtracting a company’s net tangible asset value (NTAV) from its market cap (MC) to determine its net intangible asset value. Company data is aggregated for the index, and net intangible asset value is then divided by market cap (MC) to determine the portion of the index’s value that is derived from intangible assets. Companies with insufficient data were excluded from the calculation.“
Reading this text brings to mind Edsger Dijkstra, one of the most influential figures of computing science’s founding generation, who said “A picture may be worth a thousand words, a formula is worth a thousand pictures“. Taking this sage advice, the above can be written as a formula which can then be reduced further:
IAMV = (MC – NTAV)/MC.
IAMV = 1 – NTAV/MC.
The astute reader will recognise the last part of this formula as simply the inverse of the famous valuation metric Price to Net Tangible Asset Value (or Tangible Book Value). In other words, the “Intangible Asset Study” is nothing more than another way of pointing out that valuations in the stock market have risen.
In fact if you chart P/TB of the S&P 500 Index (Source: Bloomberg) you get the same result without assuming it is all related to intangible assets.
Going a step further we can actually include intangible assets in this analysis, as recorded by accounting standards, by plotting price to book value (P/B). These standards are far from perfect (an excellent piece on this here) and the data doesn’t go back as far but the idea is clear – that intangible assets account for some but not all of the variation in valuation.
The culprit here could be the word intangible assets. Accounting standards define it very carefully while the authors of this chart use a very broad definition. However, no matter how broad there is still a distinct difference between asking – what has caused valuations to go up? vs. ascribing a big portion of firm value to intangible assets.
With this revelation all of the arguments which are built on the offending chart crumble. Instead of strongly supporting the need for ESG analysis, presenting the chart above is tantamount to saying ESG matters to company valuation – a statement that requires a lot of proof. Similarly, we might have to hold off writing eulogies for “traditional financial analysis and accounting” just because market cap exceeds tangible book value.
This does leave the unanswered question – what has caused P/TB to rise so strongly? One thing is for sure, by presenting it in this way at least the question is asked correctly instead of assuming the conclusion. Some commentators do pick up on this but still fall short by suggesting it is either intangible assets or a stock bubble that explains current valuations. Ultimately the question of what determines company valuation, framed correctly, still remains.
What are some of the lessons to take away:
- Always look for how measures are defined.
- Be careful with words that are poorly defined and open to ambiguity (like “intangible assets”)
- Watch out if something fits neatly into a narrative especially the prevailing one.
- Always know the author and their personal interests (in this case it is in the interest of an entity focussed on intellectual property to show how important it is).
Feel free to get in touch with any thoughts or comments.