"A disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets" - Warren Buffett, Berkshire Hathaway Annual Report, 1983
The above statement by Warren Buffett may be found more relevant today than ever before. In an era driven by innovation and technology, where profits are centred on your ability to create rather than produce, competition on the basis of tangible resources is losing significance. In fact, tangible assets can hardly offer a durable competitive advantage, which is absolutely essential in today's competitive business environment. Professor Baruch Lev of New York University suggested this had happened because most companies now have access to the same physical resources, and consequently these resources have become commoditised. As with most commodities, they also lose their ability to act as economic moats to protect a company's earning power. Therefore, a firm's ability to create value now relies heavily on the intangible assets it controls.
We do not need to look too far to see why intangible assets are now responsible for generating the most value for firms. From pharmaceutical companies with patented drugs (the situation here in Bangladesh is different though) to tech companies that rely on the technical expertise of their engineers and designers and consumer product companies whose reputation hinges on the superior brand names, we see the importance of these "invisible" assets in lifting business profits worldwide. Therefore, there is now a growing consensus about the need to know more about these invisible assets. And this is reflected in the pricey acquisition deals we are seeing globally -- deals that are now driven by the perceived value of intangible assets firms hold.
CASE STUDIES: In mid-2014, Facebook made headlines by announcing its plans to buy WhatsApp, a loss-making company, for a staggering $19B.
This seems to be antithetical to what we learned in basic finance courses that the value of companies is largely based on their ability to generate income. However, in their years of existence before acquisition, a lot of such companies will not post a penny in profit. And even if we are certain that the long awaited profits will materialise, will they be high enough to justify the sky-high valuations? We don't know for sure. But what we do know is the importance businesses put on the value of intangible assets. While WhatsApp was an asset-light company, it had a user base of almost 700 million users and was one of the fastest growing social media applications with a global footprint.
So, it will not be unreasonable to claim that its valuation was driven by its perceived value of intangible assets - expected future synergies from growth. In its WhatsApp acquisition, Facebook allocated, from its total offer, almost zero per cent to tangible assets, and 11 per cent on the acquired users. Similarly, Yahoo allocated only 8 per cent for tangible assets in its acquisition of Tumblr in 2013. A few years back, news about such "outrageous" prices paid for these unprofitable businesses would have sparked debates. Now, it seems to be the norm.
These days, while the rest of the world puts such importance on identifying and reporting intangible assets, where does Bangladesh stand? A quick look at some of the biggest listed companies presents a dismal picture. In the DS30 index constituent companies, the blue-chip index in Dhaka Stock Exchange, total intangible assets constituted only 1.53 per cent of total assets. This too was highly skewed in favour of one company. If we exclude that company, the number stands at only 0.05 per cent. Compare this with Dow Jones Industrial Average, where the same number is close to 11.2 per cent. And what is more worrying is that this trend has been decreasing for the last 3 years. In 2013, total reported intangible asset was 2.23 per cent of total assets, sliding down to 1.82 per cent in 2014 and then eventually to 1.53 per cent in 2015. In the DJIA, all except one company reports their intangible assets. In DS30, only 9 companies report any sort of intangible assets.
So, do all these companies really lack intangible assets? Certainly they must have built some sort of reputation in the market. In fact, most do; but corporate balance sheets do not do a good job of reflecting the inner workings of the business. For most local companies, the intangible assets are purchased as intangible assets -like softwares, broadband spectrum, copyrights and trademarks etc. In contrast, market reputation and customer capital, which create the bulk of intangible assets are internally created. And for these assets, there does not yet exist a consensus among accountants on how to value and report them.
Although intangible assets are typically not showing up in balance sheets, their impact is felt in the income statements. How? Take a very simple example. Generic medicines are now manufactured by most pharmaceutical companies. Yet, most of us will eventually purchase the same medicine from a handful of reputable companies. The trust these companies have built over the years have helped them attract consumers such as us, and our trust is reflected in our buying the medicines from them instead of other lesser-known manufacturers. These scenarios are also typical in consumer goods, technology and even asset-heavy manufacturing companies. The strong brands built over decades influence customer's buying behaviour and so these businesses can often charge a premium. This "extra" income effect of the intangible assets is reflected in the income statement instead of the balance sheet. This is the trust that is built over years and in the coming years, we may expect to see companies invest more in intangible assets, particularly in human-capital based industries. After all, who else but consumers are to put a price tag on market reputation and brand equity?
Syed Muhtasim Fuad is a Programme Associate at the Centre for Policy Dialogue (CPD) and Showvonick Datta is an Accountant in Australia.