Many companies use intangible assets such as patents, licenses, computer software, branding, and reputation to earn revenues. These intangible assets have always been part of the economic landscape. Our researchers have studied the impact of intangibles on our ability to identify differences in expected stock returns in U.S., developed ex-U.S., and emerging markets and have found no tangible performance benefits from adjusting for intangibles.
It's important to begin by distinguishing between two types of intangible assets. Under U.S. generally accepted accounting principles, externally acquired intangibles are reported on the balance sheet. They currently represent about a quarter of the reported value of assets for the average U.S. company, and these assets are accounted for when computing book equity. Internally developed intangibles, on the other hand, are generally not capitalized on the balance sheet. Instead, the costs associated with those intangibles are expensed and so are reflected on the income statement. The difference in accounting treatment is primarily due to the higher uncertainty around the potential of internally developed intangibles to provide future benefits and the difficulty of identifying and objectively measuring such benefits.1 After all, internally developed intangibles don't go through a market assessment, while externally acquired intangibles get evaluated in the competitive market for mergers and acquisitions and, at that time, they might already be generating tangible benefits for the company that developed them. For example, Disney bought the Star Wars franchise—an externally acquired intangible—in 2012, many years after the franchise began generating economic benefits for Lucasfilm.
Some argue that to more effectively infer differences in expected returns across firms sourcing most of their intangibles externally versus firms sourcing them internally, we should capitalize on internally developed intangibles. Several academic studies do that by accumulating the historical spending on research and development (R&D) to capture the development of knowledge capital and selling, general, and administrative expenses (SG&A) to capture the development of organizational capital. In one study,2 it was found that while intangible assets are made up more of companies’ assets over time, this stems mainly from growth in externally acquired intangibles; estimated internally developed intangibles haven't meaningfully increased as a proportion of total assets.
Evolution of on- and off-balance sheet assets relative to total assets
U.S. market, 1963–2018
Source: Dimensional Fund Advisors, as of 12/31/18. The weighted average characteristics are evaluated annually at the end of June, assuming zero when the data is missing. Total assets are unadjusted for internally developed intangibles. Property, plant, and equipment (PP&E) is net of accumulated depreciation.
Moreover, the estimation approach for internally developed intangibles has several important caveats in addition to the lack of market valuations. First, the estimation of internally developed intangibles assumes that the development of intangible capital can be captured fully through spending reported on the income statement. Second, the approach is critically dependent on the availability of reliable and comprehensive R&D and SG&A data; however, we observe R&D data for about half of the U.S. market even today. As a result, the estimated knowledge capital is zero for about half of the market. Therefore, we would adjust the value and profitability metrics of half of the market for knowledge capital and leave the rest unadjusted, potentially making firms in the adjusted and unadjusted groups less comparable, not more.
Further, the breakdown of operating expenses into cost of goods sold and SG&A often varies across companies and data sources, which might add noise to the estimation of organizational capital. The estimation approach can also produce noisy results because it applies constant amortization rates through time and doesn't allow for impairments. As a result, a company can be approaching bankruptcy and still appear to have billions of dollars’ worth of internally developed intangibles.
Because of all those different sources of noise, capitalizing estimated internally developed intangibles might not be helpful in identifying differences in expected stock returns. Our empirical research lends support to this expectation: Estimated internally developed intangibles contain little additional information about future firm cash flows beyond what's contained in current firm cash flows. Moreover, we don't find compelling evidence that capitalizing estimated internally developed intangibles yields consistently higher value and profitability premiums. The results are quite similar across U.S., developed ex-U.S., and emerging markets. Therefore, we believe investors are better off not adding noisy estimates of internally developed intangibles to value and profitability metrics.
1 “Statement of Financial Accounting Standards No. 2,” Financial Accounting Standards Board, October 1974. 2 “Intangible Capital and the Investment-Q Relation,” Journal of Financial Economics, February 2017.