Given the rise of trillion-dollar tech companies like Apple and Meta, the value of intangible capital is increasingly essential to the overall valuation of companies. Today, businesses spend far less on tangible costs like office buildings and factories and far more on knowledge, people, and design. In fact, most of a business’s large valuation is thanks to its investments in intangibles like research and development (R&D) as well as selling, general, and administrative expenses (SG&A).
However, US Generally Accepted Accounting Principles require intangibles to be recorded as expenses in financial statements, not as assets, which ignores the value these investments add to the company. According to Shivaram Rajgopal, the Roy Bernard Kester and T.W. Byrnes Professor of Accounting and Auditing and chair of the Accounting Division at CBS, this leaves a gap in company valuations, making it impossible for investors to accurately assess the worth of a business.
“If you try to understand the value creation model for any intangible-intensive company, financial statements have become increasingly irrelevant,” Rajgopal says. “The reporting system hasn't changed for decades, whereas the way value gets created has completely changed.”
As a way to close this gap in valuations, Rajgopal and his co-authors propose a new methodology for measuring intangible capital.
How the research was done: The researchers used archival public data from the past five to seven years to look at companies’ past spending on intangibles, like R&D, as compared to their later earnings. They then ran regressions to correlate companies’ future earnings to their spending today and to statistically determine what portion of a company’s spending will lead to higher future earnings.
They also looked at how long an investment provided value. “There's an economic life to your investment,” Rajgopal says. “If you spend money today, the value or the increased earnings that you derive from that money doesn't last forever. You have to keep spending.” He uses the example of investing in training for employees to become more proficient in the data analysis tool Python. As technology advances, you’ll need to spend more money to keep their knowledge of the program up to date. “We're trying to understand, if you spend the dollar today, how much do you get back in terms of future earnings and how long does that effect last? The further out you go, the less the return, which is perfectly logical.”
What the researchers found: After analyzing the historical data, the researchers found industries such as business services and pharmaceutical products had been undervalued in the past by as much as 220 percent. The analysis further found that the useful lives for R&D and SG&A investments averaged 4.8 and 3.4 years, respectively. Rajogpal says the purpose of this research isn’t its historical results, however, but the introduction of the novel methodology for estimating company valuation in the future.
Why it matters: The aim, Rajgopal says, is to provide a tool for Wall Street investors and others to use to more accurately measure company valuations and, by extension, the likelihood of a company’s success, even if companies aren’t particularly forthcoming about their financial information. “When something looks as though it's highly overvalued, like an Amazon or a Tesla, more often than not, the Street doesn't have a good sense for the value of the intellectual capital, human capital, value of the designs, value of the R&D embedded in the company, because you don't have public information,” he says. “This takes one small step toward addressing that.”
Adapted from “A Better Estimate of Internally Generated Intangible Capital” by Aneel Iqbal from Arizona State University, Shivaram Rajgopal from Columbia Business School, and Anup Srivastava and Rong Zhao from the University of Calgary.
