When I first started investing back in 2003 or so, I was obsessed with buying companies trading under book value. Like most obsessions, this one wasn’t healthy.
Book value, for those of you unaware, is one of the simplest financial ratios out there. If a company’s share price was under the net worth of that enterprise, it traded under book value. Buying $1 worth of assets for 75 cents seems like a pretty easy way to make money, especially if those assets historically traded for $2. All I needed to do was repeat this process a few dozen times and I’d be RICH, BABY.
Alas, it turns out investing is much harder than that. Who coulda thunk it?
These days, book value only enters the equation as a secondary ratio when I’m doing analysis. It turns out there are lots of reasons why it’s not the greatest. Asset values can go down, and companies are not excited to admit this. The logical conclusion to this is obvious; assets that really should be impaired remain fully valued on the balance sheet, giving investors the illusion they’re still worth the full amount.
(Note that book value is still useful when looking at some sectors, like REITs and financial stocks. It’s not a completely valueless ratio)
Intangible assets make up the majority of value when looking at a company’s balance sheet today. Pepsi is a great example. Much of that company’s value lies in its brands. People like Pepsi, Lays chips, Quaker oatmeal, Tropicana orange juice, and so on. Because they like those brands, they’re going to keep on buying them. Both those attributes have value, just like a piece of real estate. But unlike physical property, you can’t easily value them. Intangible assets will always be trickier to value.
How about your own balance sheet?
We’re taught that net worth has a very simple definition.
Assets – Liabilities = Net Worth
Both categories only include tangible items. Stocks. Real Estate. Debt. Note the absence of intangible items. Hell, the next net worth statement I see with intangible items on it will be the first.
But I’m becoming more and more convinced this is the wrong way to go about it. Let’s use getting a college education as an example. As much as I’m anti-college, I’m also the first to admit the statistics are right. People who go to college and graduate tend to enjoy much higher earning power. Let’s say the average university graduate earns $1 million more in their life versus the average high school grad. Sure, there are some duds who took gender studies in there, but they’re cancelled out by all the finance and engineering folk.
Now let’s imagine the net worth statement of a recent college grad. Assets likely are pretty close to zero. Liabilities are through the roof, thanks to all the debt taken on to fund the degree. We’re left with a negative net worth and a recent grad hopefully super motivated to get that ratio back to positive.
This isn’t entirely accurate, however. That debt wasn’t acquired for shits and giggles. It exists because becoming proficient in a topic is profitable. That knowledge is clearly worth something, yet it’s never put onto a net worth statement. Why is that?
There’s one very simple reason why not. Like the value of Pepsi’s brands, it’s tough to figure out. There are also a million variables that could impact the value of that intangible asset over time too. Is a degree really so valuable if you plan to drop out of the workforce in five years to start pushing out babies? Or because you want to work 15 years and then retire early? Degrees are still worth something to these folks, but perhaps not as much versus someone who plans to use their degree for 40 years.
One could argue the benefits of the college degree end up on your net worth statement anyway, thanks to the increased income it provides. Okay, fine. I’ll allow that. But what about other intangible assets? Unless you’re a weirdo hermit living in your mother’s basement (THAT’S ME, BABY!), you know people. Those relationships have value. They could lead to a lucrative new job or a business opportunity. It’s the same thing with your family. I know a kid whose family is worth anywhere from $20 to $50 million. His last name absolutely opens doors for him. Why shouldn’t he be allowed to put that value on his own balance sheet?
The bottom line
I admit this becomes a slippery slope very quickly. It also opens up all sorts of uncomfortable questions about privilege and whatnot. And to be completely honest, I think allowing people to put intangible assets on their net worth statements is a bad idea. The average person overvalues the hell out of everything they own. They’ll do the same with their university degree and contacts.
But at the same time, these intangible assets are hardly worthless. They’re definitely worth something, even if it’s hard to value. They shouldn’t be immediately valued at nothing. Keep this in mind while paying off your college loans and it’ll make that journey a little better. It might even cure someone of the “student loans must be paid off at all costs” mentality.