Profitable investment targets are hard to find. Various micro and macro economical elements introduce a growing number of facts and opportunities, and cloud investor confidence. One of the biggest challenges investors are facing is company valuations, which are as varied as they are inadequate, and which no longer reflect the true value of 21stcentury companies.
The biggest culprits causing flawed valuations are intangible assets and their significant role in business development. New valuation methodologies and data-analysis tools are now being adopted by forward-looking investors who seek to understand what lurks beneath the glossy veneer of corporate reports. They do so in order to identify, value and assess all assets listed on the balance sheet under the dreaded category.
In order to spot the unicorns of the future, a savvy investor should understand of makeup of the 21stcentury businesses, the basics of value creation and analysis and how value is maintained.
Megatrends emphasise intangibles
As the number of opportunities in the market are vast and the chances of finding profitable targets are diluted, investors turn to different sources to find opportunities and justify their decisions. Research, financial statements, private advisors and even media all have their part to play as supporting actors.
The biggest influencers on investment decisions might be the most commonly referred megatrends. Among these are technological advances (e.g. the Internet of Things; artificial intelligence; Fintech), society and demographics (e.g. decline in fertility rates and wealth and income inequality), and environmental challenges (e.g. global warming).
The modern megatrends direct business investment increasingly towards intangible investment and away from traditional fixed asset investment. Therefore, investors are exposed to assessing the value of profit streams that stem not from fixed assets, but from a broad spectrum of intangible assets encompassing software, R&D, brand names, patents, networks and other intangibles that directly link to revenue generation.
As an example, companies working on technological innovations are often knowledge-heavy organisations with a lot of intangible assets. However, these assets are rarely recorded on the balance sheet and, as such, can leave out valuable data about a company’s true value.
Balance sheet data becoming irrelevant
As the underlying assets of companies are rapidly changing, so must change the methods we use to value them. As a matter of fact, recent research has shown that accounting earnings are practically irrelevant for digital companies because the current financial accounting model cannot capture the way companies use investments in intangible assets to scale their businesses.
A study in the Journal of Accounting and Economics, shows that earnings explain only 2.4% of the variation in stock returns for a 21st century company —which means that almost 98% of the variation in companies’ annual stock returns are not explained by their annual earnings.
Also, the commonly used EBITDA (earnings before interest, tax, depreciation, and amortisation) valuation metric is inherently flawed because it is a backward-looking measure. It tells you about a period of profitability that happened in the past. EBITDA will show whether the core operations are profitable, but once you consider how the business is structured and how it plans to remain successful, that’s when you have to broaden your insight.
As mentioned, intangible assets like brand value, networks and key personnel have a lot of value in the digital world. Concretely, in the case of Facebook, value is predominantly created by the users engaged by the platform i.e. the extended network of the company.
Current analysis methodologies, favoured by many market leaders, account for less than 20% of company assets. Undoubtedly, this is like looking at something through a keyhole. An investor will only have a narrow understanding of the company and their attention is likely to be diverted from the underlying risks and what really drives the business forward.
Securing the value of an investment is as important as identifying it. Whether it’s looking at networks within Facebook or decoding companies providing elderly care by utilising human capital, it is important that these companies have clear strategies how to manage their intangible assets.
Investors have a responsibility towards their investment when it comes to nurturing value. The investor should understand how the business model creates value and what strategies the target company deploys to safeguard its value.
If a company has integrated its intangible assets into their balance sheet and has an action plan to protect these valuable assets, it is far more likely to deliver return-on-investment in the long-run.
It is imperative that all parties, from the business owners to the investors, understand, deliver and demand information during each step of the investment process. Spotting future unicorns will require investors to abandon some of the old traditions linked to finding and managing their investments. Adopting new data-driven analysis methods will create transparency within the investment community and keep the whole market ecosystem healthy enabling risk mitigation and revenue optimisation.