In the modern world, the manufacturing sector is increasingly being replaced by the service sector in the economy. Therefore, many companies are being valued on the basis of human capital and technological patents. There are various variable which make valuation of service firms different from manufacturing companies. Firstly, in service firms the accountants regularly classify wrongly capital and operating expenses of assets that are said to be intangible whereby they treat R&D expenses as operating expenses though they are capital expenses. Secondly, firms which have assets that are intangible are in the position of easily compensating their employees using the options as well as socks that are restricted. Therefore, this treatment of compensation by accountants affects cash flows and earnings.
There are two realities faced when valuing technology, pharmaceutical and service firms: one, assets of service firms are often intangible and invisible such as patents, knowledge and human capital and the methods used by accountants to deal with these assets investments is varying compared to that of manufacturing firms which result to contamination of basic inputs used for valuation: return on capital, cash flows and earnings. This paper focuses on several variables which make valuation of service companies different from manufacturing companies as well features of companies with assets that are said to be intangible, valuation issues, disadvantages of the valuation and remedies thereof.
Firms with assets that are said to be intangible and their features
The value of public firms is largely composed of assets that are said to be intangible. There are different measures which can be used in measuring the size of assets that are said to be intangible as provided by Leonard Nakamura. He is one of the accountants that provide accounting estimates of Federal Reserve Bank of Philadelphia. These aspects include an estimate that involves accounting the actual values of the R&D investments, services in software operations and updating, the developing of brands together with other intangibles. Inclusive are the salaries and overall wages of all the employees that are involved in research, all the technicians and workers. These workers must have the ability to develop intangibles as well as get engaged in the development of margins for operations by attributing the factors that are intangible. Thus, using these approaches, Leonard Nakamura states the investments associated with assets that are said to be intangible as being over $ 1 trillion. Additionally, I the year 2000, the value of assets that are is estimated to be over $ 6 trillion.
These firms with assets that are said to be intangible have similar characteristics in common which reveal themselves in the following ways:
Inconsistent accounting recorded in assets that are intangible for investments: they do not follow the principle of accounting which states that capital expenses should be separated from operating expenses. However accountants of companies with assets that are said to be intangible mix capital and operating expenses which result to these firms that report expenditures that is small reporting small capital expenditures in relation to both the aspects of their size together with the potential in their growth.
They are involved in borrowing money in small quantities: many of these companies have the tendency of using debt carefully with low debt ratios in comparison with other firms in other divisions having same earnings and cash flows.
Equity options: these firms utilize more options and other forms of equity compensation although using equity options in their management compensation it is not unique. They mostly use equity options as they near growth rather than mature.
Valuation issues of firms with assets that are said to be intangible
There are various issues which arise when valuing these firms through both discounted cash flow and relative valuation. Due to accounting treatment of assets that are said to be intangible, which is defective, the numbers of these assets become unreliable. The current earnings and such as technology earnings are reported representing the earnings after reinvestment in R&D rather than the correct operating earnings and the book value of assets. This affects both discounted cash flow and relative valuation. When growth is used to measure reinvestment and its quality, the treatment of expenditures on assets that are said to be intangible by accountants becomes one of the difficult techniques to use in gauging the number because through this, reinvestment of firms is frequently buried in operating expenses as opposed to be in capital expenses. The failure to have the assets and their values recorded in the required book of returns as well as capital unreliable which are used largely in determining the quality of firms investments. These Firms risk from lenders fearing to lend to them as monitoring their assets is difficult. Additionally, assets that are said to be intangible value like that of human capital can change overnight if the firm gets in trouble or reputation is damaged. The estimation of steady state of assets that are said to be intangible in these firs is complex. It is difficult to value assets that are said to be intangible as they are prone to changes anytime.
The dark side of the valuation
Sector comparison: the effects of accountants miscategorizing capital assets in firms vary widely making comparison of firms hard. Younger firms are greatly affected than mature firms.
Simplistic adjustments: various analysts look for easy solutions to solve the problem of miscategorization of expenses which affects the firms value.
Remedies for the valuation
In valuing firms with assets that are said to be intangible, there are two remedies which include cleaning up the financial statements (income statement and balance sheet) and re-categorizing operating and expenses. This would benefit the firm as it would be able to measure earning better as well as getting a closer sense of their investments for future growth. Secondly, the firms must deal with equity options more effectively: the ones granted in the past and the ones expected to be granted in future.
Cohen, J. A. (2015). Assets that are said to be intangible: Valuation and economic benefit. Hoboken, N.J: Wiley.
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