Return on equity and intangibles in stock valuations
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
You can use shareholder’s equity or net worth to calculate the number known as return on equity [ROE]. This ratio measures as a percentage how the earnings for the four preceding quarters figure in terms of the return on shareholder’s equity. The calculation is straightforward and, if the company has earned $1 million over the last four quarters on equity of $10 million, the ROE is 10%. Some seasoned investors use this measure to filter for stocks that have a high ratio and low capital investment needs. They find these stocks so attractive that a company that meets these criteria can consistently trade at high multiples while growing at say 10% every year.
Intangibles are playing an increasingly important role in stock valuation as the focus of many investors shifts to such areas as intellectual property. Apart from high-tech companies with valuable patents, arguably the most single important intangible asset is brand. Take a company like Coca-Cola that has been a global leader for many years when it comes to the strength of their brand. This allows the company to be continuously successful in any part of the world and, for many people, soda or fizzy soft drinks are synonymous with Coke. There are techniques that exist to value brands but many of them require adjustments to be made to the figures in the GAAP accounts. As a result, these valuations tend to be subjective.
Many investors consider brands to be an important part of the investment strategy because of the tremendous edge that it gives any company over its competition and provides long-term sustainable competitive advantage. Moreover, the power of branding is such that if it is intelligently applied to other products, those products can find ready acceptance. Take for instance the incredible success of Apple over the last few years. Every new product launch from the iPod to the iPod to the iPhone has been incredibly successful because of the qualities and standards that are promised by the Apple brand. This is why Apple is one of the most valuable companies in the world.
Brands of course mean nothing by themselves unless you have a competent management that can extract the maximum value from the brand. Even Coke made a major mistake in the 1980s by trying to replace their gold mine with a new product and allowed Pepsi to catch up. However, the reintroduction of the original product and the sheer strength of the brand and showed that there was no long-term impact on the fortunes of the company. The presence of valuable intangibles will allow the company to trade at a higher price than it would normally have been accorded. Although intangibles are difficult to measure, there is no doubt that they have a significant impact on the stock price. You should however bear in mind that intangible assets can be significantly devalued by what investors consider to be bad news. As Bill Gates is fond of saying, despite the phenomenal success of Microsoft, the company is never more than two years away from complete extinction. This means that if the company misses one major step in technology development, the value of the company and the brand would be completely wiped out.
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