Ignore Intangibles at Your Own Risk

Earnings quality -- or the lack thereof -- has been a hot topic in recent years, due in no small measure to the much-publicized woes at Enron, Tyco, WorldCom and their ilk.

To help investors gauge a firm's "true" corporate performance, Standard & Poor's unveiled what they call "core earnings." David Blitzer and David Wyss, Standard & Poor's chief investment strategist and chief economist, respectively, explained to Barron's last July that core earnings include the expense of employee stock options, restructuring charges from ongoing operations, writedowns of operating assets, pension costs and in-process research and development.

Excluded are items like goodwill impairment, gains and losses from asset sales, pension gains, merger and acquisition costs and proceeds from litigation and insurance settlements.

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"Although no single definition is perfect," Blitzer and Wyss contended, "we believe that core earnings provide the clearest possible definition, allowing meaningful comparisons across time and across companies."

While there's a lot to like about core earnings, Standard & Poor's doesn't go far enough. That's because we're still left with the four limitations of the accrual income statement. As discussed previously, these limitations are the omission of investment in fixed capital, the omission of investment in working capital, the expensing of intangibles and the fact that stockholders' equity is free.

In this column I want to take a closer look at the third limitation, the expensing of intangibles. My purpose here is first to persuade you to both expense and capitalize intangibles, and second to show you how to do the math. To illustrate, we'll look at pharmaceutical company Pfizer (PFE - commentary - Cramer's Take).

Why Accountants Expense Intangibles

Under the rules of accrual accounting, companies may depreciate fixed capital like warehouses, trucks and equipment over their expected useful lives, but must immediately expense intangible growth-producing initiatives like research and development, marketing and advertising, employee education and store preopening costs. There are a few exceptions, but that's for a later column.

So, when it comes to intangibles, why do accountants deviate from their basic policy of matching current sales with current expenses and future sales with future expenses? Or, why are bricks assets and brains expenses?

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].