Digital Companies and the Valuation of Intangible Assets

Digital Companies and the Valuation of Intangible Assets

The move to a digital economy has coincided with a higher proportion of enterprise value - 84% of the S&P 500 - being derived from intangible assets, such as patents and software. Yet, accounting rules have not caught up with this shift and current disclosure practices can paint an incomplete picture for investors.

Current accounting guidance rules do not capture the value drivers of digital companies very accurately. At least not as well as they do for traditional, physical goods types of companies. Valuing assets for a physical goods company is arguably quite simple - take the fixed asset and depreciate it on a straight line for x number of years.

But what do you do when your investment in assets is primarily intangible in nature, such as software, patents and brand names? Through my work in finance and strategy, I have seen these issues increase in relevance, due to the move towards a digital economy and the increased prominence that technology companies have in our lives and, indeed, the stock market. For example, take Alphabet - the parent of Google - who recorded a $1.3 billion operating loss in 2019 on moonshot projects that it classes as “other bets” on its earnings line. How can a discernible investor in Alphabet asses such expenditures, compared to a similar business that purchased a new warehouse facility?

Drawing from my experience in the PwC Transaction Services team, I will explain why this is an issue and my ideas on how to rectify it. I will explain how some of the recent ways that digital companies are being valued and benchmarked have introduced challenges that are inherent in financial statements and accounting. Following that, I will offer recommendations for the financial guidance and reporting arena such that the value of digital companies is accurately captured.

The Digital Industry: Financial Reporting and Evaluation Framework

Over the past 10 to 20 years, we have seen a proliferation of technology and digital companies in the US economy and witnessed a shift from companies providing physical goods towards companies that provide information, digital goods, and services.

The companies I’m thinking of include Disney, Netflix, Facebook, Google, LinkedIn and many more. Outside of this digital realm, corporates, in general, are now investing more and more into intangible assets like technology, software, customers and brands, rather than just physical assets and property, plant and equipment. In fact, a significant portion of companies’ corporate balance sheets is now composed of intangible assets, versus physical assets. Whereas 30 years ago this was not the case. There is now a gap of approximately 5% between the two in corporate America.

Investment Rate by Type of Asset as Percentage of Private-Sector GDP

Investment rate by type of asset as a percentage of private-sector GDP.

This shift to digital has introduced new business models and monetization strategies. This has created new revenue streams, information sharing possibilities, efficiency and productivity gains, and subsequently enhanced profitability and market penetration. Customers have in turn benefited through an increased emphasis on improved customer service and accountability towards satisfaction with goods and services.

Digital transformation though has added to the challenges and complexities of financial decision making, financial reporting, and accounting guidance perspectives that investors and market participants base their capital market decisions on. This raises the following question: does the current framework accurately capture the value of these companies and the intangible assets that they rely so heavily upon?

How is the Valuation of Intangible Assets Conducted?

Traditional valuation methods of companies rely on methods such as DCF analysis and comparables analysis to produce an informed proxy for a business or a specific asset valuation. These methods, while incredibly useful, apply primarily to companies that have been generating stable revenues and cash flows, experiencing consistent growth in earnings and very often have a sizeable portion of their assets invested in fixed assets. Additionally, these companies rely heavily on the sale of physical goods. But what about digital companies whose goods are intangible in nature? How are they being valued and how do you capture something you can’t touch?

Well, one of the ways I can tell you based on my experience in Transaction Services is through utilizing earnings and cash flow methodologies catered specifically to assessing the valuation of intangible assets. These can consist of a range of assets, such as technology, trade names, customer relationships, film libraries, and in-process research and development.

Where do these methodologies come from? When a company acquires another company they are required for financial reporting and US GAAP purposes to perform a purchase price allocation (ASC 805 guidance) where the allocation of the purchase price to all the individual assets being acquired is required. As part of the purchase price allocation exercise, methods such as relief from royalty and the excess earnings approach are utilized to value the intangible assets. This exercise turns out to be very handy when considering the valuation of digital companies.

I would argue that the valuation of intangible assets based on these techniques presents an accurate picture of where the real worth lies and what the value drivers are for these digital companies. Furthermore, I believe that regular disclosures on the value of internally generated, as well as acquired assets, should be required under the current financial reporting rules.

Current Financial Statements Don’t Capture Value of Digital Companies

The current financial statement reporting framework while necessary and mandated by the financial authorities does not necessarily capture returns generated by intangible assets. Digital companies build significant parts of their value, brand equity and worth through intangible assets. The question to ask then is: how are the financial statements capturing the worth of these intangible assets? Well, they aren’t exactly doing it properly.

In 2015, according to the merchant bank Ocean Tomo, intangible assets were approximately 84% of the value of S&P 500 firms. As I mentioned previously, these assets are significant drivers of growth in companies and one of the catalysts for the bull market we have seen in recent years from public exchanges.

Market Value of Intangible Assets, S&P 500

Market value of intangible assets, S&P 500

But under current accounting rules, US companies aren’t allowed to record these items on their books as assets which is a huge shortcoming (unless such assets have been acquired in an M&A deal). Rather, these items are internally expensed on the income statement per US GAAP whereas industries such as industrials, toys, and retail–which are more physical in nature–are allowed to capitalize their physical assets (e.g., PP&E and tooling), which are their value drivers.

What this entails is that the more a digital or technology company invests in growth and development in the form of intangible investments, the more it is also simultaneously making itself less profitable in the form of higher operating expenses. In addition, we also need to consider that physical assets depreciate and lose value over time with use, whereas intangible assets increase with use. For example, take an eCommerce portal or a social media website. The more users there are, the better for the company, as this will attract more customers and advertisers to the site. Thus, the larger the networking effect for all parties involved.

Recommendations for Enhancing Current Financial Statements

Some current digital companies do disclose details on users, rates, and downloads, in addition to other performance metrics. There is wide diversity in practice, but no common framework is set in stone for investors to rely on.

The way I see it is that the financial, along with the non-financial disclosures, paint the real picture for investors to determine what the value drivers are and where the value of digital companies lie. These disclosures have to be together in one place in the financial statements or under the Management’s Discussion & Analysis section to convey the entire story.

Adopting the following framework and best practices may help in signaling to the market the real worth of digital companies and their intangibles, rather than just having them report financial results because they are required to by the regulatory authorities.

1. Mandatory Disclosures

There needs to be additional and mandatory disclosures on the business model and revenue drivers of the company. This may seem obvious to the reader, but in reality, it’s not always the case to investors and outside parties. For example, the answers to questions such as these should be paramount:

  1. How are revenues made?
  2. What is the supply chain process?
  3. Who are the parties that are involved in the business model?
  4. What are the other specifics that are necessary for an investor to understand?

These all need to be clearly and coherently answered. A sample of how a company (social media or user content platform in this case) can report, answers these questions and disclose this information to investors is below in a demonstrative example:

Our website is a content aggregation and social networking platform that engages users, who watch outside videos and movies, upload their own personally developed content and share with peers. The platform also attracts companies that seek to advertise on our website and reach our target audience, and we sell them advertising space. The supply chain process and players involved in the business model are as follows: users sign up for the website and develop a profile. They have to pay a monthly subscription fee for the premium version of the service otherwise the basic features are for free (freemium model). Simultaneously, advertisers that seek to market their products with us on our website pitch to us and based on a variety of factors such as economics, space, rates, message, etc., we decide what advertisers to show on the platform. So essentially, we have us as the service provider, the users that subscribe and utilize our services, the advertisers that desire for us to publish their ads, and any other partners that are involved (technology, profit sharing partners, etc.). We feel that the primary economic value of our business lies in the relationships we build with the end users and advertisers, the technology and content platform, which we have developed internally, and lastly the brand equity of our trade name within the marketplace.

Factors that our top line revenues are dependent on include: ability of our platform to consistently and constantly innovate and attract the right users, audience engagement, spending by marketers, competition from other players in the market, general economic and industry developments within the digital landscape, ability to secure protection for our intellectual property, know-how, inventions, etc.

In addition to the above summary and commentary and the financials, there are other industry-specific key performance indicators (KPIs) and metrics that may also serve to paint a meaningful picture about the state of the company and its overall conditions. Below is a sample snapshot based on Q1 2019 this year.

Non-financial metrics and KPIs.

2. Elaboration on Uses of Cash Flow

I believe that a company should be required to show uses of its cash and how that cash is allocated amongst its current opportunities, priorities, and initiatives. For example, based on a project I worked on at a previous job at a digital company, the following was put together as part of a financial reporting package:

Uses of cash flows.

Notice the clear and granular elaboration of cash flow usage, which allows the reader to see that clearly the AI engine and user platform are the main focus of expenditures and thus, should be under more scrutiny for their effect on growth. In addition, I’d recommend showing a split of expenses between in-house development and what is being capitalized based on assets that have been acquired (per ASC 805). This should also help with benchmarking.

In-house versus capitalized.

3. Future Projects and Initiatives

By disclosing details such as projected capital expenditures, roadmaps for product development (shown below) and the timeline to complete, patents secured, new partnerships entered into and newly acquired customers, etc., investors and readers have a general idea of where the company is heading and what its focus areas are going forward.

Roadmap Example for Intangible Asset Planning

Roadmap example for intangible asset planning.

Accounting Rules Will Continue to Adapt

We can’t expect the current financial guidance, reporting, and accounting system to change overnight and asking them to address the issues above will take some time and will have to be heavily scrutinized from a cost-benefit perspective.

In short, we live in a digital age and digital companies invest heavily in R&D, technology and customers, all of which are intangible in nature. As more and more companies travel down this path, I feel that the current financial and accounting guidance will need to adapt and help investors, market participants and other decision makers realize where the value of these companies’ lies, instead of merely relying on outdated practice and rules, just because it has always been that way.

Rather, the current framework should not penalize companies for embracing and investing in digital value drivers and rather, should help bring about enlightenment for readers of financial statements when they analyze digital companies by adding further clarity and details to paint a meaningful and purposeful picture.

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