This week, we touch on intangible investments. Bandung is a traditional drink in SouthEast Asia made from rose syrup and sweetened soy milk.
The following case study compares the challenges of measuring profit between our humble Bandung stand against a newer, service type business, say, technology.
For our Bandung stand, there are 2 types of expenses.
1) Capital expenditure – the cost required to acquire, upgrade, and maintain physical assets such as property, plants, buildings, or equipment. In our example, this would include table, signboard, containers to mix our drink.
2) Operating expenses – are the cost required for the day-to-day functioning of a business. It would include items like rose syrup, single use cups, and salaries for staff.
In accounting, how do we treat these items?
The 1) capital expenditure items are depreciated over its lifespan, usually a couple of years. This means we spread the cost incurred to buy the tables over a couple of years.
What is depreciation?
The annual payment of this spread out cost is called depreciation. It’s like buying a brand new car; the day you drive it out of the showroom, that will be the highest price you will get. As time goes by and as you drive the car and add mileage, the value of the car goes down. Let’s assume that cars have a 10-year lifespan; you could depreciate one-tenth of the cost of the car per year.
Whereas the 2) operating expenses are expensed in the immediate measurement period. We lay out this effect in the following table
The total revenues generated ($300 each) and cash outflow for expenses ($300 each are) identical in both examples. However, for the Tech company, operating expenses of $300 are expenses, hence the reported profit for the year is $0. For our bandung stall, the reported profit is $66.60 because accounting rules allow us to defer recognizing the capital expenditure over 3 years.
Assume the useful life for the table / Bandung sign is 3 years so we divide the capital expenditure by 3 = 100/3 = $33.3. We call this depreciation.
Notice that the Bandung stand makes a profit of $66.6 vs. the technology company $0 profit. It appears that the technology company is not profitable. The software developer’s wages are an operating expense and not capital expenditures. Is that reasonable? Once the software is built, it can be sold by the company for many years, so its useful life may be longer than the 12 months where we measured it.
In the world of technology, the difference between capital expenditures and operating expenses are often not so simple to distinguish. Technology companies have lower profitability during the development phase of the software. It could even be loss-making for some time when this happens. But when the software is built, and the revenue comes in, there is a sudden spike in profitability. Margins often jump up to 80%. Similarly, in consumer businesses, a lot of marketing expenditure isn’t just transactional. Some builds up the brand and increases top of mind recall. These expenditures are recognised immediately, yet the company can convert customer revenues from the same campaign years after the initial expense.
In 2019, Amazon spent $1bil to get the small medium businesses online in India or $4bil to expand its same day delivery in North America or another $4bil to build Alexa (Amazon’s virtual assistant). These are all long-term investments, but they were all treated as operating expenses, lowering its profitability.
It takes years of marketing expenses to build up a brand like Coca-Cola. The brand value is often not captured by traditional accounting measures. In 2021 Coke spent 4.7bil in advertising, and over the past 25 years, according to sparkline capital, it spent a cumulative 67bil in building its brand. The famous Pepsi challenge illustrates the brand value of Coke. In a blind taste test, subjects preferred Pepsi over Coke. But once you label the bottles, the subjects prefer Coke instead. The book value of Coke is 24bil but the stock trades at a premium of 260bil. Indeed, if it takes 24bil to “replace” Coke, someone would have attempted to do so.
When we look at service industries or technology businesses, we have to be aware of the differences in how intangibles are accounted for. To value these types of companies better, one has to adjust for this information. We need to move beyond traditional accounting data to more directly measure these intangibles. This is a worthwhile challenge as these intangibles are usually misvalued or forgotten by Wall Street.