Ocean Tomo publishes a (more or less) annual study of the percentage of the value of the S&P 500 that is represented by tangible vs. intangible assets. It is regularly cited by commentators as evidence of how intellectual property is the dominant source of value in the modern economy. It is also very popular with marketing agencies because it supports a narrative about the importance of brands.
The 2015 study (the most recent one released) garnered particular attention because it showed a complete inversion of the components of value between 1975 and 2015. Ocean Tomo’s data shows that tangible assets represented 87% of the value of the S&P 500 in 1975, and intangible assets only 13%. For 2015, they show that intangible assets represented 87% of value and tangible assets only 13%.
I am not privy to Ocean Tomo’s methodology but their expertise in the area of intangibles is considerable and their press releases suggest that their approach uses data from the US Department of Commerce. They have done incredible work in promoting awareness of the economic significance of intangible assets.
The goal of this post is to express my concern when people tell me that they derive the proportion of intangible value by inverting the quoted Price to Tangible Book Value (TBV) multiple of a company or index. Few people realize that this ratio is calculated based on an accounting definition of TBV that is very different from the one that would provide a real indication of the relative importance of tangible and intangible assets to that business.
The problem is that Standard & Poors do not define Tangible Book Value as you would expect.
You might hope that, given its name, Tangible Book Value would be defined as the book value of the tangible asset on the balance sheet of the company. If so, prepare to be disappointed. As shown below, Standard & Poors defines Tangible Book Value as the book value of common equity, net of the goodwill and other intangible assets declared on the balance sheet:
Huh? Say what? This definition may make sense from an accounting point of view but defining Tangible Book Value this way is not helpful for anyone who wants to know the actual book value of the tangible assets that a company is actually using in the course of doing business.
So what number do you get if you define Tangible Book Value actually to mean the book value of the tangible assets (that is, the fixed physical assets and net working capital) on the balance sheets of the companies in the S&P 500?
Let’s start with the narrowest definition of tangible assets – physical property, plant and equipment (PP&E). If you sum the total amount of PP&E reported on the balance sheets of the companies in the S&P 500 and compare this with the market value of those companies, you will find that fixed physical assets represent 21% of the market value of the S&P 500:
In performing this calculation, you are forced to recognize that the S&P 500 comprises companies whose balance sheets are dramatically different – there are “regular” companies (everything from Wal-Mart to Cabot Oil & Gas) who provide goods and services, and then there are financial companies and REITs (Real Estate Investment Trusts). As the table below illustrates, these three types of companies vary enormously in terms of the role played by physical assets in their respective business models – PP&E represents 60% of the market value of the average REIT (not surprisingly, given they are in the business of investing in property and buildings), but only 8% for the average bank or insurance company. For the “regular” companies that make up the 82% of the S&P 500 and that are in the business of producing products and services, fixed physical assets represent an average 22% of the market value of their equity:
However, most business managers and investors are interested in defining tangible assets to include net working capital and PP&E because this provides a good approximation of the amount of capital needed to run the business. This capital can come in the form of equity or debt, so business managers and investors want to compare the tangible assets of the business with its total enterprise value (the sum of its equity plus its net debt). This gives them the answer to the question – how much of the total value of this business is represented by the physical and financial assets shown on the balance sheet?
To do this calculation, you have to exclude financial companies because net working capital is not a meaningful concept for companies that fund themselves with short-term deposits/premia to make long-term loans/investments (this is why financial companies account for 80% of the short-term liabilities and 57% of the total assets of the S&P 500 but only 12% by number and 13% by market value).
If we restrict our analysis to the 82% of “regular” non-financial companies in the S&P 500, we find that 26% of their enterprise value is represented by the tangible assets on their balance sheets:
Based on this analysis, we can conclude that 74% of the value of the average non-financial company in the S&P 500 is not explained by the tangible assets on its balance sheet.
Things get even more interesting when we start to look at how this number varies by industry sector. Intuitively, we would expect that certain industries would have high proportions of physical assets (such as mining companies, oil companies, and utilities) while other industries would have relatively little by way of physical assets (software companies and media companies).
This exactly what the data proves.
The chart below summarizes Type 2 Consulting’s analysis of the 2010 to 2015 data for all publicly quoted companies with revenues over $50 million (some 18,000 companies globally). It shows the proportion of intangible value for companies in each industry sector (in other words, the percentage of enterprise value that is NOT accounted for by their tangible assets):
Note that this analysis indicates that the balance between tangible and intangible value in the global economy in 2015 was 41:59 versus the 26:74 ratio for the S&P 500 in 2017. This difference primarily reflects the fact that a large proportion of the companies in the S&P 500 operate in industries on the right side of the chart above and, to a lesser extent, the impact in the rise in equity markets since 2015 (causing the equity value of companies to rise while the book value of their tangible assets has remained the same).
However you look at it, you have to conclude that intangible value is a BIG DEAL if you want to understand what is driving the performance of companies in different industry sectors. But you need to look deeper than the aggregate data for the S&P 500 to understand exactly how big a deal in your specific industry context.