It is imperative that investors understand financial instruments before investing in them. But what constitutes understanding of that particular financial instrument, especially stocks?
Apart from company-specific information that is found in documents such as annual reports for listed equities, there has to be an adequate framework for analysing financial data, particularly from the company’s main financial statements.
Key financial data can be obtained from the income statement, balance sheet and cash flow statements but the objective of examining these data must be for a purpose such as gauging profitability or financial safety. The statement of financial position or balance sheet indicates what a company owns (assets), what it owes (liabilities) and sources of capital at any given point in time. The analysis of a company’s assets is an integral part of balance sheet analysis and one key area of focus is the type of asset and whether it is tangible or intangible.
Intangible assets have grown in value and importance over the past few decades and this trend is expected to rise. Data from brand valuation consultancy Brand Finance and the World Intellectual Property Organization show that intangible assets have grown to US$57 trillion ($77.19 trillion) in 2022 from US$6 trillion in 1996.
Also, 48% of the stock market value of the world in 2022 was derived from intangible assets, with the remainder from tangible assets. Therefore, there is a great need for investors to understand intangible assets including how to value them and how they contribute to a company’s profitability and financial safety.
Different types of intangible assets
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Investors should understand the following key points about intangible assets before conducting an asset analysis for a company. An asset is something that can generate cash flow while intangible assets are non-physical assets in simple terms. Intangible assets can be either purchased or internally created and developed. Intangible assets can also have a definite or indefinite lifespan.
There are various types of intangible assets. These include patents, trademarks, franchises and goodwill. Patents are a type of intellectual property that prevents other parties from copying, making, using and selling the particular patented entity. Patents usually have a definite life, which is a key point to note when valuing intangible assets.
Meanwhile, businesses have exclusive ownership over trademarks, which represent and legally distinguish a particular product or service. These trademarks can also be bought and sold.
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Franchises represent licences that franchisees obtain from franchisers to sell a product or service under the franchiser’s brands. The franchisee pays a fee to the franchiser, usually in annual licensing fees or ongoing royalties, for the use of trademarks and proprietary knowledge by the franchisee.
Lastly, goodwill is anything that is paid above the fair market value of an asset when acquiring it. Goodwill is subject to assessments during the financial year and the value of goodwill is marked to prevailing market prices. Impaired goodwill means the potential of the asset to generate cash flow has deteriorated. Essentially, goodwill is the premium paid that represents the collective value of all intangible assets the business owns.
Valuation methods
When valuing intangible assets, investors should consider the characteristics of the asset, given that the quality of the asset is dependent on how well and consistently it can generate cash flow. Different types of intangible assets have distinct characteristics that require different methods of valuation. Examples of such characteristics to consider include the lifespan of the intangible asset, the industry it is mostly used in, its substitutes and alternatives, the price a potential buyer is willing to pay, and the historical pricing of similar assets.
One of the most widely used approaches in valuing intangible assets is the income method, which is based on the intangible asset’s ability to generate cash flow. The income method is more suitable for intangible assets which have a determinate life. These include patents, royalties and trademarks whose income can be projected throughout the useful life of the asset by using discounted cash flow analysis or by finding the internal rate of return of intangible capital used by the company.
Another approach to valuing intangible assets is the market approach, which is based on valuing assets concerning the pricing of similar assets. The market price is used as a reference in valuing intangible assets and is usually based on transactions for similar assets historically. Goodwill is an example where the market approach can be used as a company can have its intangible assets valued based on the goodwill of a similar company. Valuations and pricings using this approach can vary depending on the size, type, quality and useful life of the intangible asset.
The cost approach, which is based on the cost to create, replace or replicate the intangible asset, is more suitable for more “subjective” intangible assets such as brand equity, customer loyalty and personnel quality of the company. The costs and expenditures required to replace the intangible asset with a new one that provides the same utility, opportunity costs, and total historical spending or costs of establishing the intangible asset up until the valuation date, are all points to consider when using the cost approach.
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The purpose of valuing intangible assets is to determine how well a company is utilising its assets to generate profits and cash flow. In terms of financial safety, it also tells whether the intangible assets are fairly valued or whether the discounted value of assets is enough to cover the total liabilities of the company. Other reasons include being part of the balance sheet analysis and overall financial analysis, segregating intangible assets based on their characteristics to better gauge management’s asset allocation strategies, determining the range of market valuations for the acquisition or goodwill, and assessing the company’s moat relative to competitors.
With the growing prevalence and importance of intangible assets within the company’s balance sheet and to the overall company performance, investors should identify, assess and value intangible assets which are key drivers to the business. The challenge, however, is to find appropriate valuation methods — which is why understanding the business is of utmost importance before any attempt to value a business and its assets.
Table 1 shows all the Singapore-listed companies with total intangible assets greater than their market capitalisation. These companies allow investors to examine the reason and breakdown of the significant amount of intangible assets. Do these companies have a higher proportion of intangibles such as patents and trademarks that provide earnings and cash flow visibility or is it due to goodwill that is more subjectively valued and could potentially cause the company to be undervalued? We have also provided other valuation metrics to judge the overall viability of these companies as investments in the table.
Chart 1 shows the largest companies in the world and the proportion of intangible assets to total assets. The companies that have growing intangibles as a proportion of total assets have seen better investment returns relative to the other companies, denoting the growing importance of intangibles, and as a productive asset compared to physical, tangible assets. This point further stresses the importance of performing a balance sheet analysis when valuing companies.
Table 2 shows Singtel’s FY2022/2023 breakdown of total assets. The full balance sheet can be found in its annual report. We will demonstrate how to use discounted asset analysis to gauge the financial safety of the company. Firstly, the discounted asset analysis is used to gauge the minimum price that its assets can be sold in the event the company is wound up.
For investors, this is the minimum amount they will obtain or the maximum theoretical risk to the investor for investing in the company. Each item in the asset line of the balance sheet should be discounted and the amount it is discounted by is dependent on how liquid the asset is or the ease of converting that asset to cash. The more liquid an asset, the lower the discount.
The discounts used are estimates and should be guided by the notes to the financial statements. There is no correct or incorrect discount figure and it should be based on the risk tolerance of the investor. Generally, more conservative investors use a higher discount rate. The following is a guide on how to discount assets in the balance sheet.
Assessing financial safety
Firstly, for cash and cash equivalents, there is usually no need for a discount as cash is the most liquid asset. An examination of the notes in the financial statements shows that the company has a small sum of restricted cash and cash and cash equivalents denominated in other currencies, which can warrant a small discount rate.
Next, we look at trade and trade receivables, which are less liquid than cash. Although the company accounts for expected credit losses, it is still important to look at the age analysis of trade receivables. Generally, the longer the receivable days, the higher the discount, as they are less liquid. Investors can also look at the exposure of trade receivables, as exposure to riskier sectors and parties should result in a higher discount rate.
After trade and trade receivables, inventories have to be discounted. Inventories are generally less liquid than receivables and, depending on the business, have a higher discount rate relatively. Derivative financial instruments can also be risky unless they are specifically used for hedging, although nothing is guaranteed. Due to this, derivatives should have a higher discount rate. The company’s current assets comprised of Singapore Treasury bills (T-bills) and fixed deposits of more than three months so it should be relatively less risky as the latter is a small portion of the total amount of other assets. This means a lower discount rate can be used.
Moving on to non-current assets, property, plant and equipment (PPE) are usually the largest item in its list of assets. When discounting these assets, it is important to consider the nature of PPE in terms of how easy it is to convert it into cash. Other factors to consider are depreciation and the useful life of the asset. Right-of-use assets refers to the right to use an asset over the life of a lease. From the notes to the financial statements, the right-of-use assets are subject to various factors that can alter their valuation, such as write-offs and translation differences. This should warrant a higher discount rate for right-of-use assets.
As the company’s intangible assets are mainly made up of goodwill, this item should have a high discount rate, as intangibles such as telecommunications and spectrum licences which have a much more visible contribution to the earnings only make up a small portion of intangibles.
Joint ventures (JV) and associates are generally exposed to risk factors during the normal course of the business, and the risks are dependent on the quality of the partners in the JV and the associate. Hence, a higher discount rate can be justified for more conservative investors. The company’s fair value through other comprehensive income (FVOCI) mostly comprises unquoted equity securities. This makes it illiquid and highly risky, which requires the use of a steep discount rate. Deferred tax assets, as mentioned in the company’s notes, are recognised to the extent that it is probable that future taxable profit will be available against which the temporary differences can be utilised. Hence, it is subject to judgment on the future financial performance of the company, and a higher discount rate should be used. Other assets under non-current assets for the company are made up of net capitalised contract costs, prepayments and other receivables, hence a moderate discount rate can be used.
In this example, the worst-case scenario occurs when the discounted assets are almost 20% below the reported value of assets. This figure is conservative but it is something investors should expect in the unlikely event the company is wound up. This is just one aspect of assessing the financial safety of the company and other metrics such as financial ratios should be utilised by the diligent investor to assess the financial safety of any potential investments.
