Tonight, I'm going to talk about what on the surface may be viewed as heresy by many accountants, Rule Maker investors, and others that focus on a company's financial statements. You see, in many ways the information reported in an income statement and a balance sheet makes it nearly impossible for investors to determine a company's true value, as these tools exclude the value of intangible assets.

Before I get to the meat of tonight's discussion, let's talk a little bit about what intangible assets are. Quite simply, intangible assets cannot be seen or touched. Intangible property can include any of the following:

  • patents, inventions, formulae, processes, designs, patterns, know-how;
  • copyrights, literary, musical, or artistic compositions;
  • trademarks, trade names, or brand names;
  • franchises, licenses, or contracts;
  • methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; or
  • any similar item.

By the way, if you're wondering where that list comes from, it can be found in the U.S. Internal Revenue Code. It's not surprising that the IRS understands the value of intangible assets; it realizes that such assets can be the key to a company's ability to generate income. And, of course, it wants to make sure it taxes that income, particularly if the assets are transferred either outside the U.S. or to another taxpayer.

Phew! Now that we've got that out of the way, we can get back to tonight's discussion. After all, this is supposed to be about investing, not taxes.

As Rule Maker investor, we have developed criteria that are meant to show us the quality of a company's financial statements and give us some measurable ways of determining which companies are the best places to invest. Underneath these criteria is something that's even more important. It's what Warren Buffett likes to refer to as the "moat" around a business. This moat is what serves as the biggest obstacle for companies trying to take market share from the leaders in any industry.

For consumer goods companies like Coca-Cola (NYSE: KO), Gap Inc. (NYSE: GPS), and even American Express (NYSE: AXP), the power of the brand name is a key element in the value of the business. For Intel (Nasdaq: INTC), process technology (know-how) is one of the critical elements. When it comes to pharmaceutical companies like Pfizer (NYSE: PFE) and Schering-Plough (NYSE: SGP), patents add significant value.

One of the things that is often overlooked when analyzing the success of Cisco (Nasdaq: CSCO) is the way in which its business processes differentiate it from the competition. When you hear people talk about how the first mover in the Internet world has a key advantage, you're also talking about an intangible asset. We all know that these intangible assets are there, but we can't put our arms around them. Unfortunately, Generally Accepted Accounting Principles (GAAP) require us to use a double-entry accounting system that is based on the historical costs of the inputs rather than fair market value.

OK. Some of you are probably shaking your heads at that last statement and thinking to yourselves that it was about as clear as mud. So, let's take a step back and I'll try and explain what I meant. Accounting is based upon a set of entries to the books. One is normally a debit (an increase in an asset, a reduction in a liability, or an expense) and the other is normally a credit (an increase in a liability, a decrease in an asset, or an item of income).

For example, when Cisco sells a router, it makes the following entries to record the sale:

  • Debit: Accounts receivable (or cash), which is an increase in an asset.
  • Credit: Sales revenue, which is an item of income.

That works pretty easily, and makes sense to me. Now, though, let's assume that Cisco has spent some money on research and development (R&D). To record this expense, it makes the following entries:

  • Debit: R&D, which is an expense.
  • Credit: Accounts payable (or cash), which is an increase in a liability (or a decrease in an asset).

This last entry shows where the problem comes in. When Cisco is spending money on R&D, what it's really doing is investing in its future by either developing new products or improving existing ones. But, GAAP forces Cisco to record an expense on its income statement and create a liability or reduce an asset. Nowhere is credit given for the fact that if the R&D effort is successful, Cisco will have new or improved products to sell and generate additional revenues.

Similarly, money spent on advertising is used to build a company's brand name recognition in the marketplace, make its customers aware of new products, or just to remind people about the company and its products. From an accounting perspective, the entries are similar to those that were made to record R&D expense. Once again, there is no asset created on the balance sheet to reflect the value of, say, the Coke brand name.

From an accounting perspective, all that you're left with is the book value of the company. The way that we determine a company's book value is by taking the difference between the historical value of the inputs used to create its tangible assets and the historical value of its liabilities. The result is what's found in the owner's equity section of the balance sheet or the book value of the company. (In shorthand this equation is: Assets - Liabilities = Shareholders' Equity.) However, when a company is sold or valued on the open market, it's highly unlikely that it will be sold for its book value. It will be sold for fair market value.

GAAP actually makes this problem a bit worse when an acquisition takes place, particularly if it's accounted for using the purchase method of accounting. You see, when that method is used, goodwill is actually created on the balance sheet. It represents the difference between the fair market value of the tangible assets and the purchase price of the company. But, rather than let the company keep this asset on its balance sheet, GAAP requires that it be amortized (written off) over its estimated useful life (under current rules, this is not more than 40 years, which seems kind of ludicrous when one considers that a company like Coke has been building brand name value for over 80 years). This is one reason why I like to use the pro forma earnings (i.e., those excluding amortization and other acquisition-related charges) when analyzing a company.

Now, you might be asking yourself whether I think we should abandon our Rule Maker criteria that focus on the balance sheet. The short answer is NO! The good thing about our balance sheet-related criteria -- the ratio of cash to debt and the Flow ratio -- is that they focus on the parts of the balance sheet that have the most integrity: current assets, current liabilities, and long-term debt. The other stuff is a lot fuzzier.

What I mean by my last statement is this: The current items you find on the balance sheet have been incurred more recently, which means that there's less distortion than what can be found when comparing the historical value with the market value. The same can be said about long-term debt, as it's pretty easy to identify how much outstanding debt a company has (or doesn't have, as is the case with many Rule Makers).

This argument was strengthened recently when the accounting-powers-that-be allowed companies to report marketable investments at fair value rather than historical cost (as long as the securities are classified as "available for sale" or "trading securities"). It should be noted that unrealized gains or losses on such securities are recorded in stockholders' equity and do not flow through the income statement until the investment is sold. But, the problem is that, except to the extent that they're being amortized, intangible assets can't be found on a balance sheet. Granted, it's tough to value them, but they can't be ignored.

Unfortunately, that's all that we have time for tonight. This topic is one that I plan to revisit again. In the meantime, check out the articles linked below. The second and third articles include some information on work done by professor Baruch Lev (the subject of the first article), who is working on a patented system to value Knowledge Capital.

  • New Math for a New Economy (one of Rule Breaker David Gardner's favorite articles on accounting)
  • The Second Annual Knowledge Capital Scoreboard
  • Seeing Is Believing
  • A P&L for R&D
  • Who Knows?

    Have a great night and best of luck to the Duke Blue Devils in their quest for this year's NCAA championship.

    Phil (TMFGrape on the boards)