As we prepare to close out the first decade of the twenty-first century, intangible assets – such as intellectual property, patents, brand value, and access to customer data – are increasingly replacing physical ones as dominant drivers of value creation in a knowledge-based economy.
To illustrate how these changes have impacted the valuation of a firm’s book value relative to its market value, Baruch Lev, an accounting professor at New York University’s Stern School of Business, analyzed the gap between the two valuations over the period between 1978 and 1998. He discovered that while in 1978, market and book values were near equal, with book value representing just 95% of market value, twenty years later, book value accounted for a mere 28% of market value.
Yet, despite the increasing disparity between book and market valuations, historical growth rates, derived from previous financial statements, are often looked at as a predictor of future growth rates. Financial statements are used to derive many of the assumptions that investors rely upon as well as the performance indicators that executives are held accountable for meeting.
This occurs – at least in part – because there is painfully little guidance provided to help investors or executives compare hard numbers to soft ones. Seeking benchmarks is an instinctual component of decision making and numbers are the easiest and most broadly agreed upon inputs used in setting benchmarks.
In the future, competitive advantage in both corporate strategy and investor decision making will likely come from a more broad based and holistic understanding of growth drivers in business segments – broken out by some combination of sector, business model and relative maturity of a firm. Additionally, there is likely a need to itemize non-tangible variables – as we currently do with tangible variables – in order to better assess the relative weight of various variables on a company’s future performance.
Such an exercise will also help with normalizing quantitative and qualitative growth drivers and enable a more accurate analysis of how internal, external, and competitive activity influence a given firm’s performance.
Until such time, as many investors struggle to incorporate intangibles into historical models, the most savvy of them will find that a focus on the intangibles is a key driver of long-term equity – particularly when they are afforded early insight in a market that is rife with ignorance.