Companies almost always end up owning assets of value that cannot be touched, felt, or seen. These intangible assets consist of copyrights, patents, trademarks, brand names, franchises, licenses, and economic goodwill.
Economic goodwill, which is frequently referred to as franchise value, consists of the intangible advantages a company has over its competitors, such as an excellent reputation, strategic location, or business connections. While every effort should be made for businesses to carry these intangible assets at costs on the balance sheet, they are sometimes given what amounts to near-meaningless values.
- Intangible assets are assets that cannot be seen, felt, or accurately measured.
- Many companies exaggerate their intangible assets on their balance sheets.
- Certain companies such as the Walt Disney Company carry enormous intangible value in their brand.
How an Intangible Can Be Meaningless
To prove the point that the intangible value assigned on the balance sheet can be deceptive, here's an excerpt from Michael F. Price's introduction to Benjamin Graham's The Interpretation of Financial Statements:
"In the spring of 1975, shortly after I began my career at Mutual Shares Fund, Max Heine asked me to look at a small brewery—the F&M Schaefer Brewing Company. I'll never forget looking at the balance sheet and seeing a +/- $40 million net worth and $40 million in 'intangibles.' I said to Max, 'It looks cheap. It's trading for well below its net worth ... A classic value stock!' Max said, 'Look closer.'
I looked in the notes and at the financial statements, but they didn't reveal where the intangibles figure came from. I called Schaefer's treasurer and said, 'I'm looking at your balance sheet. Tell me, what does the $40 million of intangibles relate to?' He replied, 'Don't you know our jingle, 'Schaefer is the one beer to have when you're having more than one.'?'
That was my first analysis of an intangible asset which, of course, was way overstated, increased book value, and showed higher earnings than were warranted in 1975. All this to keep Schaefer's stock price higher than it otherwise would have been. We didn't buy it."
Analyzing a Balance Sheet
When analyzing a balance sheet, you should generally ignore the amount assigned to intangible assets or take it with a grain of salt. These intangible assets may be significant in real life, but the recorded accounting value probably doesn't approximate it to any degree of accuracy (unless the company has developed metrics to measure these assets).
Consider the Coca-Cola Company. It only had around $10.2 billion in net property, plant, and equipment on its balance sheet as of the end of the third quarter of 2019. If the whole firm were to go up in smoke tomorrow, it would easily take over $100 billion to replicate its existing infrastructure, facilities, and distribution network, the difference of which shows up nowhere on the balance sheet.
At the same time, the firm reports more than $26 billion in intangible assets on the books. That $26 billion includes assets such as the Coca-Cola brand name and logo, which are highly valuable.
The Importance of Intangible Assets
For some firms, intangible assets are the engine behind the business. One perfect illustration for this point is the Walt Disney Company. Disney carries $103.5 billion on its balance sheet for intangible assets and goodwill, although it's certainly worth more. Disney's intangibles are powerful and valuable—the value of Disney's "magic" is more than monetary.
For a private investor acquiring shares in a firm that they do not control, such as buying into a blue-chip stock, Benjamin Graham argued that to be of any use, the real value of the intangible assets must show up in the superior performance figures of the income statement, balance sheet, and cash flow statement.
Otherwise, intangibles aren't worth much at all. By treating the intangible asset as another source of value rather than focusing on the cash flows it produced, an analyst is, in fact, "double counting" the benefit.
Warren Buffet's Perspective on Intangibles
Graham's most famous student, billionaire investor Warren Buffett, later went on to take a slightly different approach, insisting that sometimes the value of the brand was sufficient in that you could qualitatively know whether declines in revenue were less likely during periods of economic stress. This would make it wise for the investor to pay a higher, close-to-fair value price for the enterprise rather than seeking a discount.
In other words, you may not precisely know the true value of Disney's or Coke's intangible assets—but if either firm is trading at fair value or lower, and you have a long-term ownership period of 10 or 25 years, it might be better to buy it knowing that the intangible assets add an additional margin of safety.