Sharpening the Intangibles Edge
By Baruch Lev
Harvard Business Review – June 2004
Intangible assets – a skilled workforce, patents and know-how, software, strong customer relationships, brands, unique organizations designs and processes, and the like – generate most of corporate growth and shareholder value. They account for well over half the market capitalization of public companies. They absorb a trillion dollars of corporate investment funds every year. In fact, these “soft” assets are what give today’s’ companies their hard competitive edge.
Yet extensive research indicates that investors systematically misprice the shares of intangibles-intensive enterprises. Sometimes the market overvalues intangibles – widely, for some dot-coms- and wastes capital. For companies in established sectors, the reverse is more often the case: Investors undervalue intangibles. This burdens firms with an excessively high cost of capital, which in turn leads them to underinvest in intangibles, thereby squandering opportunities for the earnings and growth investors seek.
Managers, meanwhile, often fly blind when deciding how much they should invest in intangibles or which ones offer the best rewards. In the case of investment in research and development, for instance, companies not only spend too little but also shift resources fro risky next-generation innovations that could be potentially lucrative to safer modifications of current products and technologies. What ought to be the cutting edge of corporate progress is as a result blunted, to the detriment of both companies and the economy.
How do you break this vicious cycle? How do you hone rather than dull the intangibles edge? Research that I and others have done into intangible assets, particularly those related to R&D, indicate that companies need to generate better information about their investments in intangibles and the benefits that flow from them – and then disclose at least some of that information to the capital markets. Doing so will both improve managerial decisions and give investors a sharper picture of the company and its performance, which will lead to more accurate valuations and lower the cost of capital.
The Problem of Undervaluation
Most managers are quick to acknowledge that intangible assets are crucial to their company’s success. The trillion dollars that - according to the research by Federal Reserve economist Leonard Nakamura – U.S. companies spend annually on intangibles is on par with the total corporate investment in physical assets. Such investments are pervasive throughout the manufacturing and service sectors of all developed economies. Financial service firms, for example, invest substantial resources in product service innovation, even if not through the centralized R&D units found in manufacturing companies. Moreover, the share prices of intangibles-intensive companies command a large premium over book value, reflecting an apparent recognition by investors of intangibles’ value.
But look carefully beneath the shiny veneer of intangibles and you will find a knotty and unattractive reality, one in which information deficiencies both at companies and in the capital markets feed negatively on one another. Take the findings of the research I conducted with colleagues Doran Nissim of Columbia University and Jacob Thomas of Yale on the market valuation of companies that invest in R&D.
Interested in learning more? Please contact us to discuss.