Why does this matter?
Price-to-Book (P/B) value is one of the key valuation metrics used by investors to assess companies and markets.
When the book value was predominantly made up of tangible assets, such as factories or stocks of manufactured goods, these were arguably relatively easy to measure.
However, when assets are intangible, such as intellectual property or the talents of your programming staff, they can be more difficult to gauge and may be subject to greater swings in valuations.
The rise of the global technology sector over the past twenty years, relative to the manufacturing sectors that had dominated markets for decades previously, has brought this issue into sharp relief.
For example, it was easier to see, understand, and know who owned the assets of US Steel in 1910. But these days, the assets of many companies walk out the door each evening. Intangible assets are just as valuable, but are very different to those assets that investors analysed all those years ago.
Hence the valuation debate today.
Untangling those intangibles
The value of intangible assets held by firms has been rapidly increasing in absolute terms for many years. Even massive Covid-induced global disruptions failed to derail this trend.
For example, while mergers and acquisitions (M&A) activity dipped when global economies locked down, since the initial round of re-openings in mid-to-late 2020, deal making has bounced back.
At the same time, the accumulation of goodwill – the difference between the purchase price and fair market value – on S&P 500 balance sheets has surged.
However, given that the US stock market (S&P 500) is up about 20% since its pre-Covid peak as of the end of August (i.e. the value of nearly all assets has risen) we should examine intangible assets on a relative basis.
A new approach
We can compare tangible versus intangible book values-per-share, under the usual caveat that book value is considered an accounting metric, rather than a financial one (i.e. book value is total assets minus total liabilities).
Intangible assets as a proportion of book value for the S&P 500 has risen to almost 70%, from 40% in the late 1990s (see Chart 1). While companies in other regions have been increasing their share of intangibles on their balance sheet, the trend is especially visible in the US.
This can be explained by sector composition, as the US stock market is skewed towards services, particularly in the form of dominant technology stocks.
Meanwhile, the equity markets of other regions tend to be more concentrated towards sectors that are associated with manufacturing.
Chart 1: Amounting to an intangible amount of value
Source: Bloomberg, abrdn, 12 August 2022. For illustrative purposes only. No assumptions regarding future performance should be made.
What did we find?
Here are three highlights from our analysis:
1. Inter-regional comparisons are difficult. Firms listed in Japan or in emerging markets are likely to be tangible-asset heavy, as opposed to the intangible-asset dominated balance sheets of US companies, and to a lesser extent, European firms.
2. Company management teams are able to use their subjective judgement to a greater extent. Earnings-generation profiles can be very different. This means company executives can use their discretion in the valuation of intangible assets and reporting the timings of revenue or costs associated with those assets. Clearly income statements need closer inspection – a great opportunity for equity analysts to add value.
3. Cash flow generation remains a key indicator of corporate health. Cash is an asset that can be easily valued and one which cannot be manipulated so readily.
Looking ahead
The lessons learned from the pandemic and ongoing geopolitical tensions will likely lead to more companies bringing production and supply chains closer to home.
Companies are re-examining their supply chains in light of US-China trade tensions; the Russia-Ukraine war means European countries are considering large-scale energy investment to reduce dependency on Russian oil and gas; Covid shutdowns have forced firms to reconsider their production and supply models.
This process of ‘on-shoring’ will increase investment in physical capital, and therefore provide a boost to the tangible side of balance sheets at the expense of intangibles.
That said, shareholder pressure to maintain capital discipline is likely to remain strong – particularly with the prospect of a global recession looming larger.
US vs Europe: expensive or cheap?
S&P 500 (US). Even after this year’s market selloff, the Price-to-Book (P/B) ratio still points to US stocks as being expensive – ‘heavily’ overvalued rather than just ‘modestly’ so back in 2019. A sometimes P/B of 5 times almost matches the heady days of the dot.com bubble in the late 1990s.
We arrive at a similar conclusion when looking at the Price-to Tangible-Book value (P/TB). US companies on this metric look ‘significantly’ overvalued (see Chart 2).
That said, the Intangible Price-to-Book ratio, suggests the index is trading at fair value – a result that’s consistent with the P/TB registering as more expensive than the P/B.
It seems the market is more comfortable assigning value to intangible assets on balance sheets, and that part of the price paid for intangible assets is neither expensive nor cheap.
Chart 2: Booking tangible value (S&P 500)
STOXX Europe 600. European stocks look close to fair value, but lean on the inexpensive side. Furthermore, the P/B and P/TB measures generally point to the same conclusion for the period since 2019. The Intangible Price-to-Book ratio also supports this view.
Chart 3: Booking tangible value (Stoxx 600)
Final word...
Expectations, albeit long-awaited, of a pickup in capital expenditure should lead to an expansion in the share of tangible assets on corporate balance sheets, at the expense of intangibles.Therefore, at least in the short term, the pendulum may swing back from intangibles to tangibles. This would, once again, change the mix of assets that investors must assess.
Whether this change makes a company or market easier to value remains debatable. Ultimately, assets – tangible or intangible – are only there to, at some point, generate profits and cashflows.
It’s the discounting of those cashflows that provides a value – whether it be for the latest tech company or a venerable old steel firm.