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formerly Realindex Investments
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The debate over the importance of intangible assets continues, in academia and in the market1. Parts of the investment community dispute the inclusion of intangible assets in a company’s asset base, claiming that the definition of intangibles is too restrictive or perhaps not restrictive enough. Other parts claims that valuation of intangible assets for accounting purposes is too subjective. A final group acknowledges that intangible assets are important, that defining and including them in company asset valuations is important, but that conservatism is better than the alternative. We at RQI are in this third camp.
Further to this, no-one really disputes the difficulties associated with accounting for and valuing goodwill, but almost everyone agrees that it exists and is important. Our main aim here is to better understand goodwill in the context of intangible assets, so we want to:
- Outline the idea of goodwill in the context of intangible assets
- Look at its size, evolution and importance
- Discuss excess build-up of goodwill and why it is probably a negative signal
An important note: in RQI Value strategies, we use accounting metrics to calculate the four factors in our Core portfolio: cash flows, dividends, adjusted sales (gross profit) and adjusted book value. Book value is simply the difference between total assets and total liabilities, which includes only the intangible assets that the firm chooses or is required to report. So this final element of Core – adjusted book value - is reported book value with two sets of further intangible assets added back; Research and Development (R&D) (as cumulative R&D expenditure over the preceding 5 years) and brand value. (We choose to measure brand value conservatively as cumulative sales and marketing expenses, also over the preceding 5 years. Different methods and proxies exist but in general they are more subjective in nature.) Of course, reported goodwill is already in total book value so no further adjustment is made for it.
We also note that excessive build-up of reported goodwill can be a sign of an overly aggressive acquisition strategy, which on average leads to write downs and future underperformance. So it is as an alpha source, rather than a core measure, that we use goodwill.
1 See Lev, B. (2018) “Intangibles” NYU Working paper (2018) or Corrado C. and C. Hulten (2010) “How do you measure technological revolution?”, American Economic Review, 100 (2) or https://www.mckinsey.com/capabilities/growth-marketing-and-sales/our-insights/getting-tangible-about-intangibles-the-future-of-growth-and-productivity
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