Growth indices have drastically outperformed their value counterparts over the past 10 years, yet a look under the hood of benchmark construction shows that the results can’t be viewed from the traditional perspective of style classification. Indeed, radical changes in business models and the failure of modern accounting practices to fully value intangible assets have muddled the distinction between value and growth companies.
A variety of metrics are used to classify companies as either value or growth. One common practice is to place companies with low price-to-book value ratios in the value category and high price-to-book values in the growth category. Yet, the method for calculating book value, including the treatment of intangible assets, has become increasingly misleading. The matter has received high profile attention. Just recently, Knowledge@Wharton, which is a business publication of the Wharton School, focused on the issue.
In a recent article, Barry Libert, CEO of OpenMatters, Megan Beck, Chief Insights Officer of OpenMatters, and Wharton Marketing Professor Jerry (Yoram) Wind argue for a change in the Standard & Poor’s Global Industry Classification Standards (GICs) and Generally Accepted Accounting Principles (GAAP). They maintain that changes are required to better reflect the dramatic increase in companies relying on intangible assets, such as registered users of website, rather than more traditional tangible assets, such as factories.
Under current practices, intangible assets aren’t factored into book value. Indeed financial consultancy Ocean Tomo estimates that 83% of the market value of the S&P 500 in 1975 comprised companies that were based on physical assets. As of early 2015, the percentage had declined to only 16%.
By not fully valuing intangible assets, digital companies such as Facebook, which has 1.7 billion monthly active users, appear to have low book values. That means they are more likely to be classified as growth companies. Few investors would argue, however, that Facebook’s users aren’t highly valuable, especially when considering the advertising revenue that they generate.
Simply changing accounting standards, however, may not be the answer. A prior FastCompany article maintains that valuing intangible assets can be tricky. In some instances, intangible assets may be worth less than tangible, in part because physical assets are secure.
For example, American Airlines’ software for making flight reservations may be worth as much as the company’s aircraft. Yet unlike aircraft, the software is more vulnerable to theft.
Earnings from tangible assets, such as office buildings, furthermore, may be more dependable than from certain intangible assets, such as knowledge assets, which can include research and patents. Certain investors may also object to how companies value their intangible assets.
In 1994 and 1995, American Airlines capitalized customer-acquisition costs and was accused of cheating by financial analysts who claimed the company was trying to manipulate earnings.
Changes in accounting standards, if they happen at all, are likely to be a slow process. For now, investors may want to keep the challenges of valuing intangible assets in mind when assessing the appeal of growth and value equities.
Investors should also keep in mind that no classification system is perfect, regardless of the industry. A simply visit to a food supermarket illustrates this where eggs are often kept with dairy products, or in the automotive industry where what was once considered a station wagon is now called an SUV.
In the digital world, of course, classification challenges go beyond value and growth, with Amazon.com being one example. Today, investors continue to debate if the company should be considered an internet technology company or retailer.