Accountants Severely Undervalue These Brands

Americans love their favorite brands. That mystical, intangible allure of Coca-Cola (KO +0.46%), Starbucks (SBUX 0.87%) coffee,that first sip of Pepsi (PEP 0.17%), and Altria Group's (MO 0.40%) Marlboro cigarettes keeps customers reaching for the same brand time and again.

Although difficult to fathom, some brands add significant value to the products with which they are associated. All of the trucks, bottlers, and cans in Coca-Cola's system would be worth far less if the Coca-Cola brand were not attached to the business. Yet it's hard to say exactly how much the brand is worth.

Accountants don't give brands the light of day
Companies often carry a (usually arbitrary) brand value on the books. For instance, Coca-Cola carries its trademarks at $6.7 billion and all of its intangible assets at $27.6 billion, or 31% of total assets. Starbucks' intangible assets account for just 10% of its total assets. Altria's intangibles account for almost 50%. Finally, PepsiCo's bean counters say 42% of its total assets consist of intangible assets.

If these numbers captured the full value of the brands, then each of these companies would be worth book value -- their accounting net worth. However, most investors are willing to pay much more than book value; the earnings generated by assets not on the balance sheet (i.e., the full value of their brands) makes these companies worth a lot more than any accountant gives them credit.

Source: Morningstar. The far right column shows the P/E ratio if the stock traded at 1 times book.

What's in a brand
Part of the reason accountants are so hopeless in their quest to quantify brand value is that it's hard to put a value on an intangible asset. Brands give meaning beyond the basic utility of a product.

For instance, Coke may have been an important part of a Baby Boomer's childhood; drinking Coke makes them feel young, but drinking a Pepsi or RC Cola does not carry the same nostalgia. Likewise, customers who value the quality of their coffee may be more likely to go to Starbucks, even though McDonald's (MCD 1.05%) sources similar coffee beans. The Starbucks brand shouts "quality!" while McDonald's screams "value!"

There are countless other reasons customers choose Pepsi over Coke (or vice versa), Starbucks over McDonald's, and Marlboro over Camel. Although it is important to understand why these brands are popular, it is even more important to understand the value these brands deliver for shareholders.

Instead of focusing on a dollar figure, it is easier to quantify a brand in terms of what it does for the business. Marlboro enables Altria Group to raise prices and generate additional revenue even as volume shrinks. A large swath of the smoking population reaches for a Marlboro every time they smoke without regard to price. Coca-Cola, PepsiCo, and Starbucks share that quality -- pricing power -- to various extents as well.

Pricing power is perhaps the most valuable asset a business can ever attain. As my colleague Andres Cardenal points out, pricing power is Warren Buffett's favorite business quality. A business that can consistently raise prices -- no matter what the economic environment -- is going to generate a lot of shareholder value.

If you look at return on equity, companies with pricing power are generating enormous profits. Coca-Cola and PepsiCo generate a high-20s percentage return on equity, Starbucks' return on equity is in the low 20s, and Altria Group's is in the low-30s. Imagine you had the choice of either investing in the stock market, or starting a business that gives you a 25% annual return on the capital you invest. You would choose the 25% return on investment every time -- and so would the potential competitors of these companies.

However, strong brands offer these companies protection from competition. Dr Pepper Snapple Co (DPS +0.00%) cannot hope to introduce a brand that can knock Coke off the top spot. Heck, not even Pepsi has a chance of doing that. Coke drinkers keep reaching for Coke -- no other cola can give them what a Coke gives them. As a result, Coca-Cola's high return on equity is protected from competition.

Bottom line
What's the difference between a Coke and an RC Cola? Starbucks and your local coffee shop? Marlboro and any other cigarette? It's the brand, and the brand makes all the difference.

Brands are incredibly valuable, but nobody can say exactly how valuable. Even though it cannot be quantified, investment analysis of companies with strong brands should center on the brand's staying power. After all, it's the brands that generate outsized profits.