Econ 181-01: Corporate Finance Writing Assignment 2

Gabriel Alberto Martinez September 26th, 2011

The basis of true valuation is remarkably fixed. Stocks are worth something only insofar as they produce free cash flow. (Lowenstein, 2001)

Value Creation of Intangible Assets After the Dot-com crisis of 2001, a lot of importance has been given to the extent at which intangible assets are capable of creating value to the company. During the last two decades of the twentieth century, annual investment in intangible assets such as research and development, software purchases, and marketing has grown from 4% to 10% of GDP (Wall Street Journal, 2002). But how much of these investments actually will result in greater profits for the company, and hence for the shareholders? From 1987 to 1994, investors thought that the answer was a lot, reflected in a lot of revenues. In fact, the market valued a dollar invested in information technology at 10 times what it valued a dollar of conventional capital during that period (Wall Street Journal, 1999). Despite the arguments of some people that high valuations (with respect to traditional accounting stock valuations) are consistent with a valuation model that considerate intangible assets, the fact is that the 2001 crash of stock prices reflected that investors expectations about the future earnings that intangible assets would yield were wrong. Thus, when the market realized that the expectations were too high, many companies, such as Enron, fell into bankruptcy. To address this thesis, the argument of the intangible assets will be broken into its parts. Intangible assets are defined as the companys nonphysical resources that fuel its future earnings (Wall Street Journal, 1999). Examples of it are people, patents, brands, software,

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Gabriel Alberto Martinez

customer bases, reputation, etc. Apologists of the incorporation of intangibles in a companys evaluation are correct in saying that companies with a large amount of intangible assets cannot be equally valuated to companies with the same capital assets but less intangible assets. Consider the example of McDonalds, exposed by Roger Lowenstein (2001). Hence, they conclude that the expenditure of a company in marketing, research, or computer software, should be considered as equal to investment in capital assets (Wall Street Journal, 1999). In the DDM model the last will imply a larger plowback ratio and ROE, ceteris paribus. The expenditures in intangible assets would be considered as investment from the net income rather than costs. In the books, the net income will be higher, raising the estimated growth of the dividends, g, and supporting increased stock prices. The flaw in the previous argument is that not all intangible assets are real assets that enhance the companys future earnings. Basically, expenditures on such assets enlarge the free cash flow of a company to the extent of the amount of market power they provide. Anything labeled as an intangible asset is, essentially, the result of market strategies to differentiate a product, create a temporal or special monopoly, etc. Therefore, the nature of these assets is very different from that of the traditional capital assets. Trust and reputation can vanish overnight. A factory cannot. (Wall Street Journal, 2002). Moreover, it is well known that market power is a very hard-to-achieve asset, and to maintain it in high levels for long periods is almost impossible. Thus, incorporating intangible assets on the estimation of g is almost certainly misleading because the DDM model assumes a constant dividend growth, g, henceforth. Nonetheless, if one is about to evaluate a new company that has never quoted in public stock markets like Facebook and Groupon disregarding the actual and potential market power they have, i.e. their intangible assets, would be ignoring one of the most important things that
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Writing Assignment 2

Gabriel Alberto Martinez

determine a firms profit: the market structure they will face. So, recalling that the fundamental principle of stock valuation is to add the expected future profits discounted at an appropriate rate of return, it is true that it has to be taken into account the intangible assets, but only provided theres a good story behind how they are going to enlarge future earnings. Definitely, there are no short cuts in the evaluation of a new company because the lack of reliable historical data (data able to approximate future behavior of the firm) is a major issue. The assumptions made over the cost of capital and the cash flow growth will have a major impact on the final valuation of the firm. Personally, I think that in the case of Facebook, the article Is His Company Worth $100 Billion did a good job describing the possible sources of future earnings as well as their potential size, but it said almost nothing about the risk implied in those numbers. It is hard to imagine that a company whose revenue is in the order of 2-3 billion is worth today around fifty to a hundred times those values, and still some say those are very conservative evaluations (Wall Street Journal, 2011). Likewise, I think that in the case of the other startups, even though intangible assets may account for some of the high valuations they are receiving, time will prove that wall street is being too much optimistic about this firms, probably as a result of the inevitably long time they have had to wait for having a piece of this companies. At the end, investors must realize that a companys stock price cant be divorced from how much money that company can expect to earn. (Wall Street Journal, 2002). And even more important, that an over-valuation can result in enormous amounts of money lost.

Writing Assignment 2 References Lowenstein, R. (2001). Eternal Verities. Smart Money, 57-58.

Gabriel Alberto Martinez

Wall Street Journal. (13 de September de 1999). 'New Paradigm' View For Stocks Is Bolstered. THe Wall Street Journal, pg. C1. Wall Street Journal. (04 de April de 2002). Mind Over Matter: Why Many Highfliers Builton Big Ideas are Such Fast Fallers --- Life-Cycles Shrink for Firms With Intangible Assets; Winstar's 2-Year Tumble --- 'Trust Can Vanish Overnight'. The Wall Street Journal, pg. A.1. Wall Street Journal. (14 de May de 2002). Wall Street Is All Dressed up With Nowhere to Go. The Wall Street Journal, pg. A.19. Wall Street Journal. (14 de July de 2011). Is His Company Worth $100 Billion? The Wall Street Journal, pg. B.1.