Intangible Valuations
It’s no secret that valuations are high relative to the past. One method to value that is often used to value equities is the Shiller PE ratio, or CAPE ratio (Cyclically adjusted price-to-earnings ratio). We’ve discusses this ratio enough in the past that you should roughly know how it’s calculated. Looking at the CAPE ratio now compared to the past century, it looks like equities are extremely overvalued. This chart is the reason why many pundits claim we are in an stock market bubble.
There’s a few fundamental reasons why this could be. The first is record low interest rates. Since the value of stocks are their respective discounted cash flows, the value of stocks will be higher if the discount rate is lower (interest rates make up a component of this). Other reasons include the fact that equities may be less risky due to a larger fiscal and monetary safety net and an overall improvement in institutions. Some also believe the fact that markets are more accessible and liquid than ever warrant a higher valuation. All of these things likely contribute to higher valuations, but there’s another reason for the high price which a recent paper points to.
Michael Mauboussin, a researcher for Morgan Stanley, published a paper discussing the effect that intangibles has on earnings. I’ll then use these conclusions to make some inferences on earnings valuation metrics. First, we have to revisit some textbook finance concepts.
The value of a company can be broken out into two parts. The first is what’s known as the steady-state value. This is how much a business is worth is they only earn their current profits forever. The second is known as the present value of growth opportunities, or PVGO. This is the value of future profit growth less the investment cost to achieve that growth. The paper notes that over the past few decades, markets are placing a high value on growth relative to the past. That is, the steady-state of the business is small in comparison to the PVGO.
The paper goes on to say that this may be a red herring due to accounting rules and the changing nature of corporations. There are two broad categories of expenses (aside from interest and taxes, which are easy to define). Those are regular expenses, which are deducted from earnings in the current year, and capitalized expenses (investments), which are added to the balance sheet and expensed as depreciation in the years ahead. In the past, it was easy to define which was a regular expense and which was an investment. Paying salaries is a regular expense as you have to continue to pay it to reap the benefits. Buying a warehouse is a capital expense as you buy it once and reap the benefits of it for years to come.
Nowadays the lines between regular and capital expenses are blurred. This is due to what’s known as intangible assets, such as research and development, brand building, employee training, customer acquisition costs (CAC), etc. If you spend money on advertising or sales promotion to obtain a client who you will generate revenue from for years to come, is that an expense or an investment? If you develop new Excel tools to help reduce the amount of labor it used to cost to process data, is that an expense or an investment? Under accounting rules, these things are treated as expenses, but you can clearly see why they should be treated as investments.
As you can imagine, intangible assets are becoming far more important in today’s economy than old-economy, hard asset investments. Another recent paper by a few accountants introduced a methodology to determine how important intangibles were to different sectors. The results are below. You can see industries near the top like Software and Healthcare have become a much greater share of today’s economy, while industries near the bottom like Energy and Utilities have shrunk on a relative basis.
Think about how this affects the earnings of a company. If corporations have to invest more in intangible assets than ever before, but these intangible investments have to be expensed in the current year instead of capitalized on the balance sheet, then this means earnings are going to appear lower than they probably should be. The authors of the paper point to the fact that the share of companies with negative net earnings is rising could be due to the fact that companies these days can’t capitalize nearly as much investments as they could 50 years ago. If you can capitalize a significant amount of your expenses, than you can be profitable while still being cash flow negative, which was often the case years ago.
Now back to the steady-state and PVGO of today’s businesses. If you simply take current profitability at face value, it will be artificially lower due to expensed intangible investments. This means that the steady-state of a business is artificially low, and future growth looks like it’s extremely high. The authors looked at Microsoft as an example. When they calculated the return on investment of PVGO without adjustments, the market expects Microsoft to earn a 27% IRR on those investments. When they reclassified intangible investments (such as R&D, CAC, and others), this increased earnings and therefore increased the steady-state of the business while decreasing PVGO. This lead to the market expecting a 19% IRR on their investments. This is still high to be honest, but it’s far lower than before adjustments were made.
Now think about how this applies to CAPE ratios. If businesses these days can’t capitalize nearly as much of their expenses, their earnings are going to be lower than the past on a relative basis. The market knows that these companies are still generating cash flow, regardless of what earnings say, so the market values them based on cash flow, not earnings. Let’s assume the intrinsic valuation of businesses hasn’t changed (the market discounts future cash flows at the same rate they did in the past), then if earnings are lower due to the changing nature of expenses, valuations are going to be higher. It then makes little sense to compare the CAPE ratio of the stock market today to the stock market 50 years ago.
Earnings today are not equivalent to earnings of yester-year. Old-world, hard-asset corporations had the privilege of capitalizing the majority of their investments. The same can not be said about new-world, capital-light businesses. A significant amount of their expenses are investments, but account rules forbid them to treat them as such. As a result, earnings today are worth more relative to the past, and valuation metrics based on earnings recognize that.
