Tangible vs. Intangible Assets
Financial statements are historical documents that show what a company was worth at one point in time. Because of standard accounting practices, an asset must be recorded at the value for which it was purchased. Changes in markets, currency, and economic conditions all contribute to discrepancies between book and market values. The longer an asset is held by a company, the greater the chance that discrepancies exist.
One factor that affects the market value of an asset is intangibility. An intangible asset is one that does not have a physical form but provides value to the firm nevertheless. Examples of intangible assets include contracts and patents, i.e. assets that cost money to acquire but do not have easily-accessible markets through which to buy and sell them. Unlike tangible assets like machinery and automobiles, the lack of secondary markets increases the risk that the intangible asset can not be liquidated at a reasonable price.
Assets that are not very liquid, such as plants and proprietary equipment, have secondary markets in which used assets can be sold. These assets typically suffer from low liquidity because there are costs, sometimes high costs, associated with their disposal in secondary markets. Liquidity is based on the ability to sell an item for cash if the need or desire arises.
An Example of the Value of an Intangible Asset
Suppose a company purchases a patent from another company and for many years enjoys the right to build a product without any competition based on the design specified in the patent. Over time, the value of the patent diminishes because of changes in markets, technology, and processes. The cost of the patent as an intangible asset remains on the books at the cost that was paid for the patent. Throughout the life of the patent, this intangible asset became more valuable because it blocked competitors from developing the same product. However, near the end of the patent’s useful life, its market value falls to nearly zero. Throughout this rise and fall of the patent’s market value, its book value remained unchanged.
Unlike automobiles which are depreciated using a regular schedule to estimate the asset’s worth, there is no real way to determine the actual worth of an intangible asset that companies investing in tangible assets enjoy. The variability and uncertainty as to whether a company can make valuable use of an intangible asset is what gives rise to discrepancies and the inability to determine the difference between their book and market values.
Investors who ignore the value of intangible assets are removing from the valuation process important pieces of information that directly contribute to a company’s value. Unfortunately, valuing intangible assets is not an exact science. One of the best methods of valuing such as asset is to analyze what the company would look like if the asset were not owned by the company and the incremental increase in value by owning it is a reasonable estimate. However, this assumes that the company is using the intangible asset to its maximum potential. Other managers may have been able to exploit it for much more value.
This post is part of the series: Accounting Statements as Historical Documents: Important Issues for Investors
Financial statements are nothing more than historical documents that show what a company once looked like at some time in the past. They do not indicate any information about actual cash flows or the value of assets and liabilities that still appear on the company’s books.
- Time Since Acquisition as a Factor Affecting Book and Market Value of a Company
- How Inflation Affects the Market Value and Book Value of Assets
- How Liquidity Affects Market Value and Book Value of an Investment
- How Investors View the Differences between Tangible and Intangible Assets
- Equity and Market Value: How Much is a Company Worth to an Investor?