WARNING: Substancep specifically asked that I add more thoughts about valuation. You may regret his request. :)
substancep,
The problem I am having is that accounting has no way to assess intangible assets.
I'll need to digress a little bit before directly responding to that so you understand the context of my thinking. In my mind, the two best sources for coming to an opinion about the value of intangible assets are David Gardner's writings about his Rule Breaker portfolio that specifically address the subject and Moore's manual we hold in such high esteem. As recently as yesterday David wrote in his piece something to the effect that, in the case of high-tech products, great marketing can be more important than having the best product. Moore discusses in great detail the competitive advantage gained when a high-tech company owns the dominant marketshare of a proprietary, open technology, when it controls a strong value chain, etc., etc.
Though we can't quantify the value of those and other important intangible assets, it's critical that we appreciate their value relative to the value of the competitors' same assets. For me, nothing helps put that into perspective more than the stuff in the Gospel According to Geoffrey Moore.
Understanding that perspective, you can maybe appreciate why I'm not the least bit concerned that valuation doesn't address the value of an intangible asset. However, I do believe that there are some numbers that can be extracted from the financial statements that do help us somewhat as we attempt to quantify the relative value of competitor's intangibles, especially if you believe as I do that quality of management is at the very core of a company's intangible assets and thus is the most important intangible asset. (I believe that because management's effectiveness increases or lowers the value of intangible assets.) Numbers that provide trends in return on invested capital (ROIC), the Fool Flow Ratio, gross margins, and the like go part of the way, though admittedly not all of the way, toward giving us a quantitative picture of the intangible assets.
how do we avoid throwing the valuation baby out with the bathwater when obviously accounting fails to account for intangible assets?
You wouldn't throw the baby out because you know that would be the wrong thing to do. Similarly, simply make sure you don't throw valuation tools in the trash. They indeed are valuable even though they don't address all the aspects of a company.
Certainly there is no single valuation tool that "accurately" determines the stock's fair value. Worse, there are also no combination of valuation tools that do it. However, appreciating that doesn't give us enough reason NOT to use them. When used consistently, they do help us.
When buying an apple, how do you assign a value to the taste of one you prefer over another? How do you assign a value to the impression you have about the long-term track record of a car manufacturer before buying one of its models? Or the value of anything you might buy that has an intangible quality that benefits you?
My way of responding to those issues is to assign a range of premium I'm willing to pay for the things that add value to my life. I do it the same way when evaluating stocks. I'm willing to pay more for a strong gorilla candidate or established gorilla in a tornado than than I'm willing to pay for any other kind of company on the planet.
There are probably many ways to assign that premium in one's mind. One method that makes me feel comfortable is to add a premium to a traditional valuation metric to determine the range of a stock's fair value. Whereas a traditional Fool Ratio (one version of the PEG ratio) says that a fair price hovers around a ratio of 1.0, I try to buy gorilla candidates as low as 1.5 (knowing that only in very rare situations will I be able to buy them lower.) Depending on the strength of the intangibles, I'm willing to buy at a ration as high as 2.0. That extra range of 0.5 to 1.0 (above the traditional fair value of 1.0) is the premium I'm willing to pay for those intangible qualities.
Using a PSR, I look at the profit margins, the expected growth in earnings and sales, and come to a conclusion about a "fair" PSR. After doing that, I'm willing to buy at a higher PSR when evaluating gorillas and strong gorilla candidates. (The realm of determining a "fair" PSR is nebulous at best. However, once we appreciate the range of PSRs the market assigns to competitors in the context of their varying fundamentals which of course include the intangible assets, PSRs do offer a guide that in the very least gives us a hint about a stock's fair value.)
Another way I look at valuation is to determine the minimum growth in a stock's price I'm willing to accept in my portfolio over a ten-year period. I make a range of estimates the company's earnings might grow which also requires having an opinion about the impact the intangible assets have on the rest of the business. Doing that allows me to project a range of EPS ten years down the road. I then assign a range of PEs to the range of EPS. After applying the PE multiple to the range of EPS I now have a range of stock prices. By determining (with a spreadsheet or a financial calculator) the rate of growth in the stock price from today's price ten years out, I finally know whether or not the criterion about my minimum requirement is likely to be met.
I really don't have the slightest idea if this missive even begins to explain why I'm comfortable using valuation tools even though they don't specifically address intangible assets. All I can say is that the combined valuation tools I described above make me feel more comfortable about a decision to buy a stock than if I were to ignore them altogether.
What about mis-steps? Company fundamentals change and some for the worse, especially in a ten-year period. I might later learn that I assigned too much of a premium for the intangible assets. But if I apply the methods consistently and don't put too much of my portfolio in one stock acquisition I'm not likely to make a horrible mistake repeatedly. And when I mentioned in an earlier post that the second most important thing the Fool taught me is the stuff of valuation, the most important thing they taught me is that though we investors can and will occasionally make relatively horrible mistakes, none of those mistakes will decimate our net worth if we apply long-term decision-making processes.
Hope this helps. I hope others pipe in for added perspective.
--Mike Buckley |
