One of the finest researcher in the finance world Michael Mauboussin came out with fantastic paper on how to value the new age technology business which contains majorly intangible assets which are not being reported on the balance sheet.
Read our summary of the paper below:
Michael Mauboussin, the author of the research paper makes a stellar observation that no company ever in the history whose sales was more than 100 billion dollars ever grew at mid teens rate for a sustainable period of time. (The critical observation here is that companies which have higher base rate don’t grow that fast)
There was an estimate made by an analyst who projected that Amazon would continue to grow its sales at a 16% compound annual growth rate through 2025. But what we saw was a staggering growth of around 27%. Even 16% seemed too optimistic for the analyst.
The author shares that there are basically two ways of doing analysis. The first one involves causal thinking. Causal thinking refers to studying the business, financial statements and management discussions and based on a historical growth rate you try to project the growth of the company into the future.
It is like saying that the company has grown at a good rate historically and even in the times of crises the company has continued to do well so based on that you try to establish a causal link between what has happened and what can happen.
The other way to do the analysis is to use base rates. Now causal thinking comes naturally to us because it involves an element of narration but using base rates are an unnatural way because they involve statistics.
In base rate thinking we instead of just relying on our own company for analysis we take the peer companies too into the picture. Base rate thinking involves carefully studying comparisons so that we get a fair idea of what our company can perform.
When we say that even in the bullish times our competitor managed to grow at around 15% what makes me think that my company has the capability to grow more than the competition. Both Causal thinking and Base rate thinking are essential in doing the analysis.
When we look at the example of Amazon we may think that base rates are not useful because Amazon was able to comfortably beat the averages. Now Base rate thinking might not be able to identify outliers but it is still beneficial to at-least gauge the average. Mauboussin feels that we underestimate the role of base rates rather than overestimating them.
He focuses on the importance of correctly identifying the reference classes. I think this is half the job; we have to correctly identify reference classes so that the comparison is valid. He also mentions that reference classes may change over time.
He mentions another crucial point that if a company beats the average than there might a change in the nature of business. Amazon does not only deal with sales of goods but it is also a platform, so basically valuing Amazon based on the reference classes of traditional brick and mortar companies will not be ideal, here the reference classes itself has to go through some change.
Mauboussin explains key distinctions between tangible assets and intangible assets. When we expand tangible assets only a single company can use it, at the same time if we invest in the growth of intangible assets, they can be used by more than one company at the same time, which means that achieving economies of scale is much easier with intangible assets than tangible assets (The marginal cost of sharing an input is comparatively low in intangibles). But at the same time if I reinvent the intangible asset the old asset goes extinct because it will be no longer be in use. Plus the intangibles have very low salvage value.
Now we are seeing companies investing into the intangibles which are leading to higher growth trajectories because of the economies of scale advantage I just highlighted. So the trajectories of base rates themselves will change in the near future.
This provides investors with both good and bad news. The good news is there will be some businesses that grow in excess of what history would suggest, creating opportunity. The bad news is some businesses will lose their positions of prominence and decline more rapidly than their predecessors did. Base rates remain extremely informative, but we must have the mental flexibility to acknowledge how the population of companies has changed over time.
The professors of finance used M&A model to check the intensity of intangibles. They took the large sample of companies from 1978-2017 to figure out where intangible asset intensity was highest. They found that the order of ranking from highest to lowest by industry was healthcare, technology, consumer, and manufacturing.
They observed that the sales growth rates, measured either as the median or average, consistently go from highest for companies that are most intangible-asset intensive to lowest for those that are least intensive.
While the short term numbers are noisy, the relationship holds over 1-3-5 and 10 year periods. The median compound annual growth rates over 5 year periods were 10.4% for healthcare, 7.9% for technology, 6% for consumer, and 5% for manufacturing.
The standard deviation of the growth rates follows the same pattern. Where intangible asset intensity is high, the standard deviation is also high.
To capture the potential impact of size, they broke the universe into seven bins based on starting year sales. A couple of patterns emerge. The first is that the average and median sales growth rates and standard deviations tend to decline as companies get bigger.
The second is that the basic relationship between high intangible asset intensity and high growth rates tend to hold across all size bins.
The global pandemic in 2020 was a substantial change for global health and economic growth. One silver lining was the ability of digital companies, built largely on intangible assets, to thrive in the chaos.
They examined the sales growth rates of the companies in the Russell 1000, the largest one thousand companies in the U.S., to see which companies fared well. Healthcare and technology, the industries with the highest intangible asset intensity, represented over 60 percent of the top 202, 50 and 100 growers despite being only 29 percent of the universe.
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