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The Invisible Advantage

Intangible assets can be the steering force for longer term survival and higher growth

As economies try to recover from the pandemic, is there a secret recipe that can steer faster revival and growth?

Investments in innovation, brand capital, technology and software, data and intellectual capital are turning out to be the secret ingredients underpinning speedier growth of companies and countries. Although categorized as intangible assets, they are impacting performance in a tangible manner. So, what are intangible assets? Simply put, they are long-term assets of a company that do not have any tangible existence.

In this article, we take a deep dive to understand why intangibles are growing in importance, which intangible assets are likely to be the steering forces of a company’s market value and yet, why firms are reluctant to invest in them.

Let us first take a look at why intangibles are growing in importance?

Investment in intangibles delivers a comparative advantage for business longevity and growth:

It is increasingly evident that firms that have a longer business life and are recording higher growth are those that have secured a comparative advantage – one that gives them an edge over competitors.

Intangible assets such as copyrights, goodwill, non-compete agreements, patents are invisible differentiators that enable longer business life, securing a firm’s product, service, idea, any form of creation or design beyond a time period that it takes a competitor to reverse engineer or recreate the same product. This enables revenue optimization for the product created over a period long enough to create economies of scale, lower costs and higher margins. Similarly, companies that invest on intangibles such as innovation, research and development and closely monitor the impact of such investments through rigorous processes are more likely to record faster growth as opposed to companies that do not spend on such innovation or the creation of new products.

For example, Apple and Samsung have grown faster and stayed in the ever-changing mobile phone industry longer than peers as they have continuously invested in smart phone innovation. A McKinsey survey proves that firms that master the deployment of investment in intangibles will be well positioned to develop a comparative advantage, grow faster and outperform peers.

Investment in intangibles also generates a higher market value: 34% of the total worth of the world’s publicly traded companies is made up of undisclosed value, or intangible assets. A study of the market value of the 5 largest global companies (by Market Cap – S&P 500- Apple, Alphabet, Microsoft, Amazon and Facebook) reveals that as much as 84% of the total enterprise value is being generated from intangible assets. This shows that in companies that have made it to the top, intangibles account for a majority of the value, in turn revealing that, higher the value of intangibles, higher the potential growth of the company.

43 years ago, the top 5 leading companies in the world had only 17% of their value being generated by intangibles. The rise to 84% today is confirming how intangibles are playing a crucial role in value generation and business success today. In order to reflect the ability of value generation, executives have also shifted the investment mix to include a higher ratio of intangibles to tangibles in the overall portfolio of assets. In the past 25 years, the share of intangibles in the portfolio of assets have grown by 29%, while the share of tangible assets has declined by 13%.

Local surveys are seconding these global survey findings. A local survey commissioned by the University of Sri Jayawadenapura covering 90 listed Sri Lankan companies (that belong in the Bank Finance and Insurance, Beverage Food and Tobacco, Chemicals and Pharmaceuticals, Hotels and Travels, Manufacturing and Telecommunication) saw a direct correlation between the value of intangible assets and the market value of such firms. Higher the intangibles, higher the market value.

Despite intangibles generating such value additions, why are firms are not investing in them as much as they should be doing.

Uncertainty of Success: Many firms tend to take a risk-free route of spending on tangibles rather than expend resources on intangibles as the latter has an uncertainty of success toward the creation of a commercially viable product.

High cost of development: The development of intangibles also requires expert skills, processes and technology and are well beyond the affordability of certain small and medium firms. Large expense items coupled with a long time for completion makes it difficult for managers to convince shareholders about the return on such investments.

Unrecognizability on Financial Statements: International Accounting Standards govern expenses incurred on the development of intangibles to be only recorded on financial statements only based on their commercial reality or if they have a fair value from a transaction. Until such time, all cash outflows in this respect are expensed in income statements. Attracting further investments has also been easier if the balance sheet contained tangible assets as cashflow generation based on undisclosed assets is harder to justify to potential investors. To find out how intangibles are recognized on Financial statements, click here.

For all these reasons, most firms tend to deflect from investing in the development of intangible assets. However, their power to drive growth makes it hard to ignore them.

It is increasingly evident that these invisible differentiators are the secret ingredients in the recipe for success of several corporate giants. So, what are some of the vital intangible assets firms should look to invest in?

While there are certain intangible assets that are more valuable than others, specific resources such as brand capital, software and technology, information through content, data and IP as well as skills are seeming to be the cream of the crop.

1. Brand Capital (patents, trademarks, reputation and goodwill) – A trademark is any symbol, name, mark, word, or letter used by a company in order to provide visual differentiation from other companies on the market, and can play a role in increasing a business’s value if it’s widely known and respected by consumers. Copyrights grant a company rights to design, manufacture, and sell its unique products or services. For example, if you create any intellectual works related to your business, those need to be copyrighted to ensure you have complete rights to them. While these are expensive and tedious intangibles to secure; they can prevent any new comers or leading firms copying a firm’s product too fast.

Pharma and healthcare companies are seeing a large portion of their revenues being driven by intangible assets such as brand capital. 4 of the top leading 20 firms on S&P 500 belong to the pharmaceutical and healthcare industry, with patents, trademarks and goodwill through mergers and acquisitions being the secret behind their success. Consumers want to buy their medicines or products simply for the brands reputation, while competitors do not have access to their APIs as they are secured by patents. Johnson & Johnson, for example, recorded a total intangible asset value of USD 361Bn, accounting for all of its enterprise value. Of this close to 10%, USD 32bn of their intangibles were generated from patents and trademarks. AB InBev’s acquisition of SABMiller, a brewing company, for USD 120bn net of debt, mainly was a price paid for intangible assets such as formulas, recipes, customer relationships, goodwill and brands, accounting for 89% of the acquisition price. Only USD 13bn of this was made up of tangible assets such as property, plant, machinery

  • Continuously invest in innovation – This reveals that despite the high consumption of time and resources on efforts to invest on innovation, research and development for the creation of brand capital, its value generation potential is much higher and significantly worthwhile. Firms should hire experts, rent labs and creative spaces, develop new features and carry out product testing frequently to ensure products are in sync with market needs.

2. Software and technology –While hardware technology such as micro-chips and IT architecture are perhaps more tangible and can be directly valued, what is more valuable today are the software systems and solutions. As the world has shifted from a purely physical to a dominantly virtual world, KPIs determining user experience has almost entirely shifted from physical experiences to virtual experiences that a firm can offer and is determined by the speed of software, user friendly interaction and hiccup free experience online. Microsoft, the company with the largest commercial cloud business in the world records USD 904bn in intangible assets, accounting for 90% of the enterprise value. While it goes without saying that software is an intangible that drives digital-centric sectors, even firms across other industries, such as Uber within the logistics space as well as Netflix, within the entertainment space are largely driven by software and technology today, with almost no real physical assets driving revenue.

  • Keep an eye out for growing technologies – For example, technologies such as Augmented Reality (AR) and Virtual Reality (VR) are being adopted by leading firms to enhance customer experience. The global AR and VR market size is forecast to grow at a CAGR of over 35% during 2020-2024, indicating a decisive drive to leverage these emerging technologies in all major industries across the globe. Click here to check out Sandra De Zoysa’s views on some of the key software and technologies that can impact modern business survival and our newsletter on growing technology spaces.

  • Invest in flexible IT architecture – In addition to try and develop such software that can generate solid growth, firms should also invest in flexible IT architecture to avoid being held back by legacy systems—so-called tech debt—and ensure that they can leverage the full power of software through timely updates.

3. Content, Data and IP – Proprietary data is a unique resource creating a differentiating edge for many leading firms across the globe. This is because data-backed innovation helps identify new growth areas and timely opportunities even before the realisation of that need by consumers.

  • Firms should look to invest on data collection – Corporate giants are closely monitoring customer behaviour and collecting data on their preferences using data algorithms and machine learning. This is then used to help with real time predictive analytics, tailoring suggestions based on past searches and preferences to offer a personalized experience, and even going well beyond that to influence key business decisions such as which disruptive products, businesses or business models to invest on.

4. Human capital – The growing knowledge economy is increasing the importance of human capital. Human capital, loosely defined, includes knowledge, skills, and the abilities of employees. All intangible assets including, patents, copyrights, software, intellectual property, research & development rely on human capital in one way or another.

A company’s intangible assets, including human capital and culture, are estimated to comprise more than half of a company’s market value on average.

However, unlike other assets, employees and their intrinsic skills are not within an organisation’s control as they have the power to leave the firm after they have received training or years of experience.

  • Take steps to document tacit knowledge: Tacit knowledge is extremely difficult to explain or write down; it is often knowledge that people do not even realize they have. Hence, it is important to ensure the documentation of employee experience to make tacit knowledge explicit and receive access to a key asset that the company owns, that is otherwise not within an organisation’s control. Training and education programs that encourage sharing of tacit knowledge and unique experiences will also enable access to valuable employee insights. Discounting the importance of capitalizing employee ideas and know-how in a timely fashion could mean the loss of proprietary assets when employees leave the firm, and a loss of productivity and value.

  • Attractive employee retention schemes: In addition to taking proprietary data, employees have the power to take clients along with them too. Clients that engage closely with relationship managers have a high tendency to switch along with them owing to the relationship they share with the employee rather than the company. It is important to offer such employees attractive retention packages such as competitive remuneration, compelling career opportunities, best practices in health and safety, equal opportunity, workplace diversity programs, flexible working hours, while also giving employees a sense that management is committed to their welfare.

While above are 4 key categories of intangible resources really driving business growth and longevity, another key category of intangible resource is organisational capital, which includes business models, organisation structure, managerial capability, business processes and workplace culture, and also has the power to impact a company’s productivity and growth significantly.

Given how much attention the topic has caught, firms should report intangibles in management accounts and reports by adopting rigorous documentation methods and a consistent approach to valuing them. This would offer useful insights to decision makers, who otherwise would have no visibility into the actual potential for revenue generation of a firm.

References : “Global smartphone market share from 4th quarter 2009 to 2nd quarter 2021” – Statista, July 2021; “How Virtual Reality is transforming Customer Experience” – WeAreBrain, April 2021; “Intangible Assets: A Hidden but Crucial Driver of Company Value” – Visual Capitalist, February 2020; “Unrecognised intangible assets and market value of public listed companies in Sri Lanka” – University of Sri Jayawardenapura – research; “Managing Data as an Asset” – The CPA Journal, June 2019; “Can you recognize internally generated intangible assets in your balance sheet?”– PWC, “Getting tangible about intangibles: The future of growth and productivity?” – McKinsey, June 2021; “Intangible Assets: What They Are and How They Can Add Value to Your Business” – Peercomps, July 2019; “Intangible Assets vs Tangible Assets: Which To Invest In?” – Daglar – Cizmeci, August 2021; “Press Release – For Immediate Release AB InBev’s $71 Billion Hangover” – Brandfinance.