Valuing intangibles

GUEST COLUMN/ TORCH-LIGHT

You can't make money out of nothing. A company first invests in building assets, and then these assets start producing goods (or services). The company markets these and earns revenues.

Investment is required to build assets, and assets have the ability to generate cash flows. This is the simple concept of investing in a business.

For instance, company A generates sales of Rs 1.1 out of Re 1 of assets and company B is able to generate only Rs 0.6 of revenues from a similar amount of assets. A can't be making the extra money out of nothing.

Clearly, there are some assets that A is using but are not evident in its balance-sheet. These 'invisible assets' are called intangibles.

Intangibles, as any junior college student from the commerce stream would tell you, are things that you cannot perceive with your five senses.

We know what are the assets that feature on the balance-sheet. Plant, equipment, building, land, investments, cash, inventories and so on. These are called tangible assets. But, there are some assets that are not represented in the balance-sheet and they are called intangibles.

But like tangible assets, intangible assets also require investment and they, too, contribute to cash flows. So what would you value most in a company like Wipro or Infosys?

It is not the sprawling offices in various locations but their strong skilled workforce that has helped these companies create the brand equity they have in the domestic software services industry.

It is their ability to attract, develop and retain talented employees that has earned them super-normal growth in revenue, profits and stock value. With their skilled manpower, these companies have built a pool of knowledge, which is driving their value.

Thus, investment in human resources is an important asset that drives these companies' cash flows, though it is not accounted for in their balance-sheets.

So if Infosys and Satyam add 1,000 people each, does it mean that they are adding value? No. Value is added only when a company utilises its workforce productively. For instance, Infosys earns a higher revenue per employee compared to Satyam. This in turn is a reflection of the company's ability to utilise its assets better.

Brand differentiates a product from the rest and fetches a premium. Much has been said and written about the power of brands. Having a facility to manufacture and market soaps is a very small part of the story for Hindustan Lever.

What is difficult is getting hold of the customer's mind in a highly competitive market where loyalty is transient. The cost of making a bar of soap is normally not in excess of 25 per cent of its maximum retail price. The rest and the bulk of the cost differential are accounted for by the selling and distribution expense and the margin.

A brand creates a certain promise that distinguishes itself from the rest and achieves an important objective: it helps the product command a premium.

A good brand can be a great source of cash flow and hence is an asset. And like tangible assets, even brands require investments. Look at the ad-spends of leading FMCG companies even in this era of dwindling bottomlines, and the picture becomes clear.

Similarly, intellectual property rights (IPRs) are exclusive rights that a company owns for the manufacturing or marketing of a particular product that is a result of its own research. This feature enables a company to earn higher profits over a long timeframe.

Companies that have a rich bank of IPRs or potential IPRs have been rated well in the market. For instance, let's assume that company C has evolved a drug out of its own research. So it holds the patent for the new drug, which it has licensed to company D to bring the drug to the next stage.

In turn, C receives milestone payments. So you see that patents are also a source of cash flows. Also, these patents have not come out of thin air.

Hence, though patents do not find pride of place in a company's balance-sheet, they are valuable assets for the company. More and more Indian companies are now investing heavily into R&D activities as they foresee the potential pot of gold at the end of the proverbial rainbow.

What the market also values is a company's ability to start imaginative products and services ahead of its competitors. This trait gives it an edge.

A comparison between the price-to-book ratios of State Bank and HDFC Bank would substantiate this point.

While SBI might be the leader in size, HDFC Bank has always been the innovator in the rapidly-changing banking industry. The ability to innovate is what has fuelled the bank's excellent growth in the past few years while its PSU counterparts have struggled intermittently.

Outside the balance-sheet, there are many assets that are at work for the company, helping it enrich its returns for the shareholders. A very crucial difference between tangibles and intangibles assets is that there is a limit to how much you can utilise or leverage a tangible asset.

You can operate a plant at 100 per cent capacity utilisation. It is difficult to stretch it beyond that. But for an intangible asset, there is no limit. A brand can be leveraged to a very large extent. The only constraint is the size of the market.

So it is clear that we need to value intangibles while valuing companies and stocks. But intangibles have a problem associated with them: they are intangibles and hence it is difficult to affix any standard value.

Notwithstanding the fact that an element of subjectivity will creep in, one can't ignore the fact that unless intangibles, too, are factored in, an evaluation of any company and its fundamentals would become less meaningful.

(The author heads Lotus Knowlwealth, Mumbai, and can be contacted at ceolotus@hotmail.com. Disclosure: He has no outstanding interest in the companies discussed here.)