INTANGIBLE ASSETS

Measurement, Drivers, Usefulness

By

Feng Gu and Baruch Lev*

Please note: The various intangibles

value metrics discussed here were
designed by Baruch Lev who retains
exclusive rights to the measures, and
has a patent pending for them. The
measures should not be used or
reproduced without a written
permission from Baruch Lev.

April 2001

Boston University and New York University, respectively

INTANGIBLE ASSETS
1.

How are The Intangibles Metrics Computed?

It is widely accepted that intangible (knowledge or intellectual) assets are the major

drivers of corporate value and growth in most economic sectors, but the measurement of these
assets has eluded so far managers, accountants, and financial analysts valuing investment
projects.
Why measure intangible assets? Evaluating profitability and performance of business
enterprise, by say, return on investment, assets or equity (ROA, ROE) is seriously flawed since
the value of the firms major asset intangible capitalis missing from the denominator of
these indicators. Measures of price relatives (e.g., price-to-book ratio) are similarly misleading,
absent the value of intangible assets from accounting book values. Valuations for the purpose of
mergers and acquisitions are incomplete without an estimate of intellectual capital. Resource
allocation decisions within corporations require values of intangible capital. These and other
uses create the need for valuing intangible assets, in practically all economic sectors.
Intangible (knowledge) assets, such as new discoveries (drugs, software products, etc.),
brands or unique organizational designs (e.g., Internet-based supply chains) are by and large not
traded in organized markets, and the property rights over these assets are not fully secured by the
company, except for intellectual properties, such as patents and trademarks. The risk of these
assets (e.g., drugs or software programs under development not making it to the market) is
generally higher than that of physical assets.1 Accordingly, many, particularly accountants and
corporate executives, are reluctant to recognize intangible, or intellectual capital as assets in
financial reports, on par with physical and financial assets. While such attitude concerning
1

See, Baruch lev, Intangibles: Management, Measurement and Reporting, forthcoming from Brookings
Institution Press, June 2001, for elaboration on the unique attributes of intangibles.

balance sheets may be understandable, it does not satisfy the need to seek information about and
value of intangible assets.
Some have attempted to gauge the value of intangible assets from the difference between
the companys capital market value and its book value (the balance sheet value of net physical
and financial assets). This approach is unsatisfactory because it is based on two flawed
assumptions: (a) that there is no mispricing in capital markets (tell this to investors who bought
Internet stocks in 1999 and saw them plummet in 2000), and (b) that balance sheet historical
values of assets reflect their current values.
The market-minus-book approach to valuing intangibles is also unsatisfactory because it
is circulatory. One searches for measures of intangibles value in order to provide new
information to managers and investors. What is the use of a measure (market-minus-book) that
is derived from what investors already know (market and book values)? There is obviously a
need for a different approach to estimating the value of intangible assets.
1.

Preliminaries:
Baruch Levs methodology for measuring the value of intangible assets is based on the

economic concept of production function, where the firms economic performance is

stipulated to be generated by the three major classes of inputs: Physical, financial, and
knowledge assets. Thus:
Economic Performance = (Physical Assets) + (Financial Assets) + (Intangible Assets)
, and represent the contributions of a unit of asset to the enterprise performance.
A key ingredient in this approach is the definition of an enterprise economic performance
as an aggregate of past core earnings (earnings excluding unusual and extraordinary items), and
future earnings, or growth potential. A performance measure which is strictly based on past

earnings or cash flows, or a modification of earnings (e.g., the various value added measures),
misses a major part of what intangible assets are all aboutcreating future growth (e.g., by
investment in R&D, Internet activities, or employee training).
Having thus defined enterprise performance, the next step is the measurement of the
performance driversthe three major asset groups. The values of physical and financial (stocks,
bonds, financial instruments) assets are obtained from the firms balance sheet and footnotes
(with proper adjustments, such as converting accounting historical costs to current values). The
derivation of the value of the third performance driver intangible capitalis, in a sense, the
solution to the above production function for the one unknown (intangible capital). This is done
by estimating the normal rates of return on physical and financial assetsthe and
coefficients in the above production functionand subtracting from the estimated economic
performance of the enterprise the contributions of physical and financial assets, namely the
normal asset returns multiplied by the values of physical and financial assets. What remains
from this subtraction is the contribution of intangible assets to the enterprise performance, which
I define as intangibles-driven earnings. Capitalizing the expected stream of these earnings
yields an estimate of intangible capital.
The intangibles value measurement procedure is demonstrated graphically in Figure 1.

Figure 1

INTANGIBLE ASSETS
Past Earnings
+

Future
Earnings

Normalized Earnings
Subtract:

Return on Physical
Assets

Subtract:

Return on
Financial Assets

Equal:

Capitalize:

Intangibles-Driven
Earnings

Intangible Assets
5

2.

Specifics:
The measurement procedure outlined in Figure 1 starts with the estimation of annual
normalized earnings, referred to earlier as the performance of the enterprise, which are
based on an average of several (generally 3-5) historical years of reported core earnings
(net earnings adjusted for extraordinary and other one time items), and same number of
expected years earnings. For public companies, I use two alternative approaches to
estimate expected earnings: consensus earnings forecasts by financial analysts, and an
earnings forecast based on the pattern of the firms sales. In firm-specific applications, I
use various public and proprietary sources to estimate growth potential. Normalized
earnings is thus an annual weighted average of 6-10 earnings numbers, giving a heavier
weight to expected earnings.
Based on various economic studies and analyses, I estimate the average contributions of
physical and financial assets, the and in the production function above. For public
rankings of companies (Fortune, CFO magazine), I use after tax rates of 7% for physical
assets and 4.5% for financial assets, reflecting economy-wide averages. For companyspecific applications, I estimate specific rates of return on assets. These rates will
change, of course, with market and company conditions.
I then subtract from normalized earnings (defined above), 7% of the value of physical
assets and 4.5% of the value of financial assets.
What remains of normalized earnings after these subtractions is the contribution of
intangible assets to the enterprise performance, which I define as intangibles-driven
earnings (IDE).

 Lastly, I forecast the series of intangibles-driven earnings over three future periods (a 3stage valuation model): Future years 1-5, using financial analysts long-term growth
forecasts (or a sales-based forecast); years 6-10, linearly converging the forecasts to the
long-term growth of the economy3%; and years 11 to infinity, where IDE are assumed
to grow annually by 3%the expected long-term growth rate of the economy.
The discounted value of expected IDE series, using a discount rate which reflects the
above-average riskiness of these earnings, yields the estimated of intangible assets.

2.

How do They Look?

Tables 1 and 2 present the 1999 intangibles measures computed for the five leading

companies in 22 nonfinancial industries, followed by the industry median measures. These data
constitute the CFO 2001 ranking. 2
The metrics include the firms intangible capital (noted as knowledge cpital in the
tables), as of August 2000; their 1999 intangibles-driven earnings; (noted knowledge earnings)
and the new value measuremarket-to-comprehensive value (third column from right). This
measure modifies the well-known market-to-book ratio (market value of corporations divided by
their book valuenet assets on the balance sheet), by adding to the denominator of the ratio the
estimated value of the firms intangible capital. Thus, the balance sheet value of physical and
financial assets (book value), plus the value of intangibles missing from the balance sheet,
comprises the comprehensive value.
Table 2 indicates, among other things, that many, so called old economy industries,
are reach in intangibles: aerospace and defence, food and beverages (particularly brands), home
products, industrial, oil and gas, retail. Figure 2, based on about 2000 companies for the period
1990-1999, provides a similar message.
We will see below the results of extensive tests demonstrating the unique usefulness of
these measures reflecting intangibles assets.

This work was done in cooperation with Marc Bothwell, vice president and portfolio manager at Credit Suisse
Asset Management.

Table 1

The Scope of Intangibles

Name
HON

HONEYWELL INTL INC COM

LMT

LOCKHEED MARTIN CORP COM

BA

BOEING CO COM

NOC

NORTHROP GRUMMAN CORP COM

RTN.B

RAYTHEON CO CL B

Industry
Aerospace &
Defense
Aerospace &
Defense
Aerospace &
Defense
Aerospace &
Defense
Aerospace &
Defense

DAL

DELTA AIR LINES INC DEL COM

AMR
LUV

Knowledge
Capital
8/31/2000

Change in
Knowledge
Market Value /
Knowledge
Knowledge
Capital / Book Market Value / Comprehensive
Earnings 1999 Earnings '99-'98
Value
Book Value
Value

33,839

2,157

235

3.6

3.3

0.71

27,358

1,417

-333

4.2

1.8

23,447

1,590

614

1.9

3.8

15,901

894

65

4.5

8,356

800

-595

Airlines

10,792

709

AMR CORP COM

Airlines

9,230

SOUTHWEST AIRLS CO COM

Airlines

6,668

US AIRWAYS GROUP INC COM

Airlines

3,420

251

AMGN

AMGEN INC COM

Biotech

20,876

1,041

136

6.0

22.4

MEDI

MEDIMMUNE INC COM

Biotech

4,409

124

36

6.1

BGEN

BIOGEN INC COM

Biotech

4,377

219

44

CHIR

CHIRON CORP COM

Biotech

1,508

80

DD

DU PONT E I DE NEMOURS & CO COM

Chemical

49,085

2,543

DOW

DOW CHEM CO COM

Chemical

29,091

PPG

PPG INDS INC COM

Chemical

APD

AIR PRODS & CHEMS INC COM

Chemical

ROH

ROHM & HAAS CO COM

Chemical

4,656

IBM

INTERNATIONAL BUSINESS MACHS COM

Computer Hardware

128,186

DELL

DELL COMPUTER CORP COM

Computer Hardware

83,519

HWP

HEWLETT PACKARD CO COM

Computer Hardware

49,857

EMC

E M C CORP MASS COM

Computer Hardware

SUNW

SUN MICROSYSTEMS INC COM

MSFT

MICROSOFT CORP COM

ORCL

Market Value
8/31/2000

Return 8/31/2000 2/28/2001

30,891

22%

0.34

11,407

32%

1.30

46,270

17%

1.5

0.28

5,440

21%

0.8

0.9

0.50

9,457

21%

-15

2.1

1.2

0.38

6,071

-15%

425

-174

1.4

0.7

0.31

4,920

1%

374

68

2.2

3.7

1.17

11,280

23%

0.72

2,280

21%

3.20

77,958

-5%

24.3

3.44

17,651

-48%

4.4

10.2

1.90

10,229

4%

17

0.8

5.4

2.95

9,863

-13%

23

3.7

3.5

0.75

46,779

-1%

1,844

748

3.2

2.0

0.47

17,761

28%

9,948

632

63

3.1

2.2

0.53

7,045

28%

6,245

379

42

2.4

2.9

0.87

7,746

13%

280

-29

1.3

1.8

0.77

6,356

29%

6,597

212

6.7

12.1

1.58

232,413

-24%

2,490

547

12.9

17.5

1.26

113,251

-50%

2,598

-340

3.4

8.2

1.85

119,385

-52%

45,958

1,569

389

6.9

32.2

4.06

213,677

-58%

Computer Hardware

44,560

1,849

470

6.1

27.7

3.91

202,719

-69%

Computer Software

188,787

8,526

2,406

4.6

8.9

1.60

368,819

-15%

ORACLE CORP COM

Computer Software

54,304

2,314

904

8.4

39.4

4.19

254,509

-58%

CA

COMPUTER ASSOC INTL INC COM

Computer Software

38,908

1,782

279

5.7

2.7

0.41

18,763

-2%

VRTS

VERITAS SOFTWARE CO COM

Computer Software

16,988

176

143

5.3

15.1

2.40

48,465

-46%

SEBL

SIEBEL SYS INC COM

Computer Software

6,180

176

53

6.9

45.6

5.76

40,715

-61%

AES

AES CORP COM

Electric Utilities

28,486

691

197

7.1

7.3

0.90

29,119

-15%

DUK

DUKE ENERGY CORP COM

Electric Utilities

15,380

934

211

1.6

2.9

1.10

27,531

10%

SO

SOUTHERN CO COM

Electric Utilities

10,351

847

177

1.1

2.1

0.99

19,418

6%

FPL

FPL GROUP INC COM

Electric Utilities

5,385

391

67

0.9

1.7

0.85

9,488

24%

DOMINION RES INC VA NEW COM

Electric Utilities

3,358

418

77

0.5

1.8

1.22

12,604

26%

EMR

EMERSON ELEC CO COM

Electrical

24,717

1,426

130

3.9

4.5

0.91

28,273

2%

ROK

ROCKWELL INTL CORP NEW COM

Electrical

9,431

536

16

3.5

2.8

0.62

7,534

15%

CBE

COOPER INDS INC COM

Electrical

5,950

363

27

3.3

1.8

0.43

3,292

25%

APCC

AMERICAN PWR CONVERSION CORP COM Electrical

4,311

199

32

4.3

4.6

0.87

4,629

-49%

KO

COCA COLA CO COM

Food/Beverages

67,165

3,484

394

7.3

14.2

1.71

130,326

1%

PEP

PEPSICO INC COM

Food/Beverages

50,480

2,334

67

7.5

9.1

1.08

61,593

9%

HNZ

HEINZ H J CO COM

Food/Beverages

18,565

1,064

85

11.4

8.1

0.65

13,223

14%

UN

UNILEVER N V N Y SHS NEW

Food/Beverages

18,390

1,306

36

3.0

4.4

1.10

27,007

19%

CPB

CAMPBELL SOUP CO COM

Food/Beverages

13,022

835

47

95.1

81.3

0.85

11,140

20%

KMB

KIMBERLY CLARK CORP COM

Forest Products

25,308

1,579

201

4.5

5.6

1.02

31,514

23%

IP

INTL PAPER CO COM

Forest Products

11,369

1,103

841

0.9

1.2

0.63

15,361

20%

GP

GEORGIA PAC CORP COM GA PAC GRP

Forest Products

8,884

854

369

2.2

1.1

0.35

4,568

13%

WY

WEYERHAEUSER CO COM

Forest Products

5,762

572

285

0.8

1.5

0.81

10,322

18%

WLL

WILLAMETTE INDS INC COM

Forest Products

1,044

221

69

0.5

1.5

1.01

3,331

54%

PG

PROCTER & GAMBLE CO COM

Home Products

63,450

3,882

143

5.2

6.6

1.07

80,719

15%

GILLETTE CO COM

Home Products

26,145

1,343

124

11.0

13.3

1.11

31,590

9%

60 NM

NM

10

CL

COLGATE PALMOLIVE CO COM

Home Products

19,296

1,097

109

11.8

17.8

1.40

29,257

17%

CLX

CLOROX CO DEL COM

Home Products

8,151

502

96

4.5

AVP

AVON PRODS INC COM

Home Products

7,675

455

24 NM

4.7

0.86

8,517

0%

1.27

9,304

TYC

TYCO INTL LTD NEW COM

Industrial

56,184

2,970

640

3.7

9%

6.3

1.34

96,177

-4%

UTX

UNITED TECHNOLOGIES CORP COM

Industrial

25,856

1,564

438

CAT

CATERPILLAR INC DEL COM

Industrial

23,132

1,166

54

3.4

3.9

0.87

29,231

26%

4.2

2.3

0.44

12,705

15%

ITW

ILLINOIS TOOL WKS INC COM

Industrial

15,800

957

IR

INGERSOLL-RAND CO COM

Industrial

14,453

819

113

3.1

3.3

0.81

16,922

9%

77

4.5

2.3

0.42

7,340

-4%

DIS

DISNEY WALT CO COM DISNEY

Media

53,012

VIA.B

VIACOM INC CL B

Media

16,759

2,126

59

2.2

3.5

1.07

82,396

-20%

646

188

0.3

2.1

1.55

102,113

CCU

CLEAR CHANNEL COMMUNICATIONS COM Media

-26%

9,536

447

119

0.9

2.7

1.40

27,518

-21%

FORD MTR CO DEL COM PAR $0.01

GM

GENERAL MTRS CORP COM

Motor Vehicles

90,338

6,685

1,680

3.7

2.1

0.44

50,941

18%

Motor Vehicles

55,026

4,257

282

1.9

1.3

0.46

38,758

-25%

DPH
JCI

DELPHI AUTOMOTIVE SYS CORP COM

Motor Vehicles

13,413

962

97

3.8

2.6

0.54

9,205

-14%

JOHNSON CTLS INC COM

Motor Vehicles

8,573

480

74

3.5

1.9

0.42

4,589

26%

PCAR

PACCAR INC COM

Motor Vehicles

4,159

306

-4

1.9

1.5

0.51

3,246

13%

GCI

GANNETT INC COM

Newspapers

17,733

1,087

137

3.8

3.2

0.67

14,928

18%

TRB

TRIBUNE CO NEW COM

Newspapers

10,388

502

140

1.7

1.7

0.66

10,999

14%

NYT

NEW YORK TIMES CO CL A

Newspapers

5,619

336

44

4.2

4.9

0.95

6,594

13%

KRI

KNIGHT RIDDER INC COM

Newspapers

4,921

329

12

3.0

2.5

0.63

4,127

10%

DJ

DOW JONES & CO INC COM

Newspapers

3,562

210

10

6.6

10.1

1.33

5,467

-1%

XOM

EXXON MOBIL CORP COM

Oil

114,347

8,544

878

1.7

4.2

1.57

284,382

0%

RD

ROYAL DUTCH PETE CO NY REG GLD1.25 Oil

27,258

3,818

585

0.8

3.7

2.10

131,204

-5%

CHV

CHEVRON CORPORATION COM

Oil

24,559

2,210

1,026

1.3

2.9

1.27

55,150

3%

PHILLIPS PETE CO COM

Oil

8,697

877

198

1.7

3.1

1.14

15,756

-13%

UCL

UNOCAL CORP COM

Oil

8,453

376

42

3.4

3.3

0.74

8,106

7%

PFE

PFIZER INC COM

Pharaceuticals

128,610

5,796

3,017

8.6

18.2

1.90

273,069

5%

MRK

MERCK & CO INC COM

Pharaceuticals

109,217

6,583

902

8.6

12.6

1.32

160,694

15%

JNJ

JOHNSON & JOHNSON COM

Pharaceuticals

76,446

4,336

699

4.3

7.1

1.35

127,891

7%

BMY

BRISTOL MYERS SQUIBB CO COM

Pharaceuticals

74,002

4,254

424

8.3

11.7

1.26

104,255

21%

PHA

PHARMACIA CORP COM

Pharaceuticals

55,373

2,193

543

4.7

6.5

1.13

75,998

-11%

LLY

LILLY ELI & CO COM

Pharaceuticals

48,163

2,641

328

8.7

15.0

1.54

82,453

10%

WMT

WAL MART STORES INC COM

Retail

81,239

4,867

1,167

2.9

7.5

1.94

211,872

6%

SEARS ROEBUCK & CO COM

Retail

23,457

1,421

115

3.6

1.7

0.36

10,697

33%

TGT

TARGET CORP COM

Retail

15,406

885

128

2.6

3.5

0.98

20,999

68%

COST

COSTCO WHSL CORP NEW COM

Retail

6,006

349

40

1.5

3.8

1.52

15,404

21%

KSS

KOHLS CORP COM

Retail

5,504

250

50

2.9

9.8

2.50

18,486

18%

INTC

INTEL CORP COM

Semiconductors

208,641

9,502

2,749

5.7

13.7

2.05

502,711

-62%

AMAT

APPLIED MATLS INC COM

Semiconductors

44,667

1,858

1,090

7.3

11.4

1.38

70,011

-51%

TXN

TEXAS INSTRS INC COM

Semiconductors

39,390

1,860

1,012

3.1

8.7

2.11

109,810

-56%

BRCM

BROADCOM CORP CL A

Semiconductors

5,704

137

38

6.8

65.8

8.48

55,509

-80%

HD

HOME DEPOT INC COM

Specialty Retail

48,849

2,230

621

3.5

8.0

1.77

111,287

-11%

LOW

LOWES COS INC COM

Specialty Retail

10,962

567

171

2.1

3.3

1.06

17,154

25%

CVS

CVS CORP COM

Specialty Retail

10,320

512

84

2.6

3.7

1.02

14,504

65%

WAG

WALGREEN CO COM

Specialty Retail

9,243

510

73

2.3

8.2

2.50

33,231

35%

RSH

RADIOSHACK CORP COM

Specialty Retail

4,552

271

60

6.3

15.2

2.08

10,962

-27%

VZ

VERIZON COMMUNICATIONS COM

Telecom

114,464

6,462

1,277

3.3

3.5

0.80

118,573

15%

SBC

SBC COMMUNICATIONS INC COM

Telecom

113,618

6,903

2,730

4.0

5.0

1.00

141,514

15%

AT&T CORP COM

Telecom

81,221

4,851

-222

0.7

1.1

0.62

118,288

-26%

BLS

BELLSOUTH CORP COM

Telecom

53,812

3,568

660

3.3

4.3

1.00

70,185

13%

WCOM

WORLDCOM INC GA NEW COM

Telecom

23,277

1,772

30

0.4

1.9

1.35

104,734

-54%

CSCO

CISCO SYS INC COM

Telecom Equipment

162,218

4,910

2,434

6.1

18.5

2.60

489,845

-65%

LU

LUCENT TECHNOLOGIES INC COM

Telecom Equipment

62,824

3,220

315

2.4

5.3

1.57

139,633

-70%

MOT

MOTOROLA INC COM

Telecom Equipment

26,947

1,684

1,016

1.3

3.7

1.62

78,639

-58%

GLW

CORNING INC COM

Telecom Equipment

24,786

867

210

3.3

12.6

2.97

96,184

-75%

NM

11

QCOM

QUALCOMM INC COM

Telecom Equipment

19,317

672

192

3.3

7.7

1.78

44,610

-8%

NM Not Meaningful

12

Table 2
Industry Medians (of Companies in Table1)

Industry
Aerospace & Defense
Airlines
Biotech
Chemical
Computer Hardware
Computer Software
Electric Utilities
Electrical
Food/Beverages
Forest Products
Home Products
Industrial
Media
Motor Vehicles
Newspapers
Oil
Pharaceuticals
Retail
Semiconductors
Specialty Retail
Telecom
Telecom Equipment

Intangible
Capital
23,447
7,949
4,393
9,948
49,857
38,908
10,351
7,690
18,565
8,884
19,296
23,132
16,759
13,413
5,619
24,559
75,224
15,406
42,029
10,320
81,221
26,947

Intangible sDriven
Earnings
1,417
399
171
632
2,490
1,782
691
450
1,306
854
1,097
1,166
646
962
336
2,210
4,295
885
1,859
512
4,851
1,684

Change in
Intangibles
Earnings
65
22
40
42
389
279
177
29
67
285
109
113
119
97
44
585
621
115
1,051
84
660
315

Intangible
Capital/
Book Value
3.58
2.12
5.18
3.08
6.69
5.68
1.11
3.70
7.48
0.87
8.10
3.65
0.94
3.50
3.77
1.71
8.44
2.89
6.23
2.62
3.26
3.25

Market
Market Value/
Market
Value/ Book Comprehensiv Value(8/31/200
Value
e Value
0)
1.77
0.96
16.29
2.18
17.53
15.15
2.09
3.63
9.13
1.48
6.57
3.30
2.72
1.87
3.18
3.30
12.16
3.75
12.57
8.01
3.47
7.73

0.50
0.55
3.07
0.75
1.85
2.40
0.99
0.75
1.08
0.81
1.11
0.81
1.40
0.46
0.67
1.27
1.34
1.52
2.08
1.77
1.00
1.78

11,407
5,496
13,940
7,746
202,719
48,465
19,418
6,081
27,007
10,322
29,257
16,922
82,396
9,205
6,594
55,150
116,073
18,486
89,911
17,154
118,288
96,184

13

Figure 2

15

3.

What Drives Intangible Capital?

Intangible (intellectual) capital is driven by diverse factors: innovation, human capital,

organizational processes, customer and supplier relations, to name some major ones. For most of
these drivers (e.g., customer satisfaction), there are no standardized, public information
available. I, therefore, limit the analysis here to the several intangibles drivers which are
publicly available: R&D, advertising (brand support), capital expenditures, information systems,
technology acquisition.
Table 3, based on data for about 2000 companies, spanning the period 1989-1999,
identifies five major drivers of intangibles-driven earnings (IDE): R&D, advertising (brand
enhancement), capital expenditure (intangibles embedded in physical assets), information
technology, and technology acquisitions. It is clear from the table that these are indeed driverstheir intensity is positively correlated with the ratio of IDE to sales.3
In current work (conducted with Towers Perrin and Feng Gu of Boston University), we
find that various measures reflecting human resource practices (e.g., extent of incentive-based
compensation, termed LPCT in Table 4, employee training, etc.), are also strongly correlated
with intangibles earnings and capital. This is reflected in Table 4.
This is just the beginning of a detailed identification and quantification of the drivers of
intangible capital, and in turn, corporate value. Business and investment decisions are predicated
on the understanding and quantification of the major drivers of corporate value and growth.

This work is conducted with Feng Gu of Boston University.

16

Table 3

17

Table 4

18

4. Do They Work?
Given the proliferation of new measures and indicators, proposed to managers and investors, its incumbent on the proponents of such
measures not only to argue that they are needed and useful, but to prove empirically that they indeed are doing the job. Such a proof is
unfortunately missing from most of the proposed measures and analytical techniques.
Below, are comprehensive statistical tests indicating the superiority of the intangibles metrics as indicators of enterprise performance
over conventional ones. A frequently used methodology in finance and accounting research to gauge relevance of information and data is to
correlate the proposed information with the consequences of investors decisions, such as reflected in stock price changes. A weak correlation
indicates that the decision makers (e.g., investors) did not find the information very useful, and vice versa for a strong correlation.
Following this approach, I correlated (with Feng Gu) annual stock returns (stock price changes adjusted for dividends), reflecting
investors decisions, with the annual growth in firms intangibles-driven earnings, over the period 1989-1999 (about 2,000 companies in each
year). For comparison purposes, I did the same for the annual growth in reported cash flows (from operations) and earnings, two of the most
widely used corporate performance measures.
Figure 3 shows the clear superiority of intangibles-driven earnings (IDE), over accounting earnings and cash flows. Specifically,
while the correlations between stock returns and reported cash flows or earnings are 0.11 and 0.29, respectively (so much for cash is king),
the correlations between returns and IDE (based on sales growth) is 0.40, and between returns and IDE (based on analysts forecasts) is 0.53.
Thus, both version of intangibles-driven earnings, with and without analysts forecasts, beat earnings and cash flows in the return correlation
race.

19

The conclusion: the earnings stream generated by intangible assets (IDE) provide substantially more relevant information to investors
than reported earnings and cash flows. The reason: while total earnings, or cash flows reflect the performance of all assets, some of which
(e.g., various kinds of physical assets) dont contribute to growth, IDE focuses on the contribution of intangiblesthe major growth
contributes. Also, while earnings and cash flows are strictly historic (backward-looking) measures, IDE explicitly reflect growth
expectations.4
While I cannot perform similar statistical analyses on managerial decisions, analogous to the capital market analysis reported here, it
stands to reason that the intangibles metrics reported here will also provide new and useful information for corporate managers. The reason:
most corporate decisions are guided by accounting metrics, such as earnings and return on investment measure, which appear inferior to the
intangibles metrics.

For those interested in a regression analysis, supplementing the univariate correlations of Figure 3, Table 5 provides the appropriate estimates, where annual stock returns
are regressed on reported earnings (level and change) and various configurations of the intangibles metrics.

20

Figure 3

21

Table 5

22

5. Can They Predict?

The statistical validation tests reported in Section 4 were contemporaneous; namely stock
return correlated with same year growth in intangibles-driven earnings. Contemporaneous
correlations indicate the relevance of an information item to investors. But if the item is
widely available, despite it being relevant, you will not be able to use it to gain superior
investment returns (the information is already priced).
To test whether intangibles measures can be used to gain abnormal returns one must
use a multiperiod predictive test. Such a preliminary test is reported in Table 6. With Marc
Bothwell of Credit Swiss Asset Management, I estimated for each of the 105 companies in
Table 1, its market-to-comprehensive value (M/C) indicator for August 31, 2000. (Recall
that the M/C ratio is a modified market-to-book ratio, where the value of intangible capital is
added to the denominator). We then correlated the M/C values with the subsequent stock
performance of these companies (during September 1, 2000 through December 31, 2000; a
period of sharp stock price declines).5 We found a strong negative correlation, confirming
that companies with above-average M/C values (i.e., overvalued by investors, according to
the intangibles measures) were subsequently downgraded by investors, and vice versa for
companies with below-average M/C value (undervalued companies).
Table 6 indicates that the 53 companies with below-median M/C values (undervalued)
gained, on average, 7% in the subsequent period, while the 52 stocks with above-median
M/C (overvalued) lost, on average, 15.5% during September-December 2000.
The market-to-comprehensive measure thus appears to distinguish between undervalued
and overvalued stocks. With Feng Gu (Boston University) I derive even stronger results for a
much longer period:1989-1999, and a larger sample of about 2,000 companies. The M/C
5

These numbers appear in the right, and third from right columns in Table 1.

23

investment scheme is profitable during the three-years after portfolio formation and easily
beats the widely used measure of Market-to-Book.
Table 7 provides portfolio returns for three investment strategies: book-to-market (B/M),
comprehensive-to-market based on analysts forecasts (C/M), and comprehensive-to-market
based on a sales growth model (AC/M).6 In each case, the sample companies (about 2000
companies, over 1989-1999) are classified into five portfolios according to increasing size of
B/M or C/M. The portfolio return data for one, two, and three years subsequent to portfolio
formation indicate: (a) For each year and portfolio strategy, returns are monotonically
increasing from the first to the fifth portfolios, a finding documented in finance literature for
the B/M portfolios. (b) The increases are steeper for the C/M than for B/M portfolios, see the
right column of Q5 Q1 Difference in the three panels of Table 7. (c) The total returns are
also higher for the C/M strategy than for the B/M strategy (e.g., for portfolio Q5, the 36
months return is 71.8% for C/M vs. 62.1% for B/M). (d) There are no distinguishable
differences in performance between the two versions of C/M; with and without analysts
forecasts. This is graphically indicated by Figure 4.
Tables 8-10 pit directly the B/M strategy against the C/M portfolio choice. In a series of
5x5 classifications, five by B/M and five by C/M, for 12 months ahead (Table 8) and 24 and
36 months subsequent to portfolio formation (Tables 9 and 10), one can observe the
generation of returns for one strategy, when the other is held constant (movement across rows
or columns). It is clear from each of the three tables that the significant returns are exhibited
across rows, from low to high C/M portfolios (see returns on the right column: CM Q5-Q1).
Once the C/M portfolios are accounted for, the B/M portfolio strategy does not generate

In empirical work, the inverse of the multiples (e.g., book-to-market) is preferred , to avoid negative values
in the denominator.

24

substantial returns (bottom row in Tables). Thus, the C/M strategy subsumes the well known
B/M (Value) strategy. Results for AC/Mthe intangibles-based comprehensive value
based on sales growth model (in contrast with the C/M which is based on analysts forecasts),
are essentially identical to those using analysts forecasts presented in Tables 8-10.
Finally, Tables 11-12 present tests of C/M (or AC/M) portfolio returns adjusted for
various risk factors: beta, size, book-to-market, and the return momentum. This is the
well-known 4-factor model in finance research. The numbers in the tables are risk-adjusted
monthly return. It is clear that for both C/M and AC/M, the portfolio returns are sharply
increasing from low C/M (AC/M) to high C/M (AC/M) portfolios. The abnormal returns are
economically very meaningful. For example, the monthly return for portfolio Q4, 0.236
(Table 11), translate to an annual return of over 3.0 percent above risk benchmark.
Summarizing, the extensive, large sample empirical tests reported in this section indicate
that the market-to-comprehensive value metric, based either on analysts forecasts or on a
sales growth model, exhibit a consistent ability to generate subsequent abnormal stock
returns, whether evaluated against a market-to-book strategy, or a combination of risk
factors.

25

Table 6

Market Value / Comprehensive Value

(8/31/2000) and Subsequent Stock
Performance (8/31/2000-12/31/2000)
Master Table
Weighted
Subsequent
Market Value /
Return
Comprehensive Averages for
Value
Group
low
7.0%
high
-15.5%

Count in
Sample
53
52

26

Table 7

27

Figure 4

28

Table 8

29

Table 9

30

Table 10

31

Table 11

32

Table 12

33

6.

Takeaway Points

The Intangibles Scoreboard adds an essential, and hitherto missing, valuation tool for
managers and investors concerned with intangible (intellectual) assets, and with the optimal
resource allocation of intangible and physical assets.
R&D, advertising, information technology and various human resource practices were
empirically identified as drivers of intangible capital, and in turn corporate value.
Intangibles measures provide more relevant information than conventional performance
measures, as indicated by the strength of correlations with stock returns.
Intangibles measures successfully distinguish between over-and under-valued stocks, as
indicated by the research presented above.
Lastly, the data and findings reported above are based on publicly
available information, and uniform return and discount rates. It can be expected that
substantially improved valuations will be obtained by tailoring the intangibles measures to
the specific circumstances of companies, subsidiaries, or stocks.

34