littlebook The Little Book of Valuation

Companies with intangible assets: Value Drivers

Nature of intangible asset

While R&D expenses are the most prominent example of capital expenses being treated as operating expenses, there are other operating expenses that arguably should be treated as capital expenses. Consumer product companies such as Gillette and Coca Cola could make a case that a portion of advertising expenses should be treated as capital expenses, since they are designed to augment brand name value. For a consulting firm like KPMG or McKinsey, the cost of recruiting and training its employees could be considered a capital expense, since the consultants who emerge are likely to be the heart of the firmÕs assets and provide benefits over many years. For many new technology firms, including online retailers such as, the biggest operating expense item is selling, general and administrative expenses (SG&A). These firms could argue that a portion of these expenses should be treated as capital expenses since they are designed to increase brand name awareness and bring in new presumably long term customers.

Efficiency of intangible asset investments

When we capitalize the expenses associated with creating intangible assets, we are in effect redoing the financial statements of the firm and restating numbers that are fundamental inputs into valuation – earnings, reinvestment and measures of returns.

1.     Earnings: As we have noted with all three examples of capitalization (R&D, brand name advertising and training/recruiting expenses), the operating and net income of a firm will change as a consequence. Since the adjustment involves adding back the current yearÕs expense and subtracting out the amortization of past expenses, the effect on earnings will be non-existent if the expenses have been unchanged over time, and positive, if expenses have risen over time. With Amgen, for instance, where R&D expenses increased from $663 million at the start of the amortization period to $3.03 billion in the current year, the earnings increased by more than $1.3 billion as a result of the R&D adjustment.

2.     Reinvestment: The effect on reinvestment is identical to the effect on earnings, with reinvestment increasing or decreasing by exactly the same amount as earnings.

3.     Free Cash flow to the equity(firm): Since free cash flow is computed by netting reinvestment from earnings, and the two items change by the same magnitude, there will be no effect on free cash flows.

4.     Reinvestment Rate: While the free cash flow is unaffected by capitalization of these expenses, the reinvestment rate will change. In general, if earnings and reinvestment both increase as a consequence of the capitalization of R&D or advertising expenses, the reinvestment rate will increase.

5.     Capital Invested: Since the unamortized portion of prior yearÕs expenses is treated as an asset, it adds to the estimated equity or capital invested in the firm. The effect will increase with the amortizable life and should thererfore be higher for pharmaceutical firms (where amortizable lives tend to be longer) than for software firms (where research pays off far more quickly as commercial products).

6.     Return on equity (capital): Since both earnings and capital invested are both affected by capitalization, the net effects on return on equity and capital are unpredictable. If the return on equity (capital) increases after the recapitalization, it can be considered a rough indicator that the returns earned by the firm on its R&D or advertising investments is greater than its returns on traditional investments.

7.     Expected growth rates: Since the expected growth rate is a function of the reinvestment rate and the return on capital, and both change as a result of capitalization, the expected growth rate will also change. While the higher reinvestment rate will work in favor of higher growth, it may be more than offset by a drop in the return on equity or capital.

In summary, the variables that are most noticeably affected by capitalization are the return on equity/capital and the reinvestment rate. Since the cost of equity/capital is unaffected by capitalization, any change in the return on capital will translate into a change in excess returns at the firm, a key variable determining the value of growth.  In addition to providing us with more realistic estimates of what these firms are investing in their growth assets and the quality of these assets, the capitalization process also restores consistency to valuations by ensuring that growth rates are in line with reinvestment and return on capital assumptions. Thus, technology or pharmaceutical firms that want to continue to grow have to keep investing in R&D, while ensuring that these investments, at least collectively, generate high returns for the firm.