Intangible Investments, Tangible Results

Investing in intangible assets has a tangible effect on a company's performance, according to a recent unpublished study. The study suggests that investments in research and development (R&D) and in advertising, although they generally reduce short-term profits, can significantly boost a company's long-term valuation.

A total of 3,500 companies tracked between 1964 and 1998 enjoyed a 4.3% rise in their mean market-to-book ratio with each 1% increase in R&D spending. And a 1% increase in advertising spending produced a 1.8% rise in the market-to-book ratio. Market-to-book ratio takes a company's combined tangible and intangible value (market value) and compares it with tangibles alone (book value). Examples of intangible assets are R&D and technological know-how, patents, brand names, product quality and intellectual capital. Although intangibles generally are not recorded on the balance sheet, they are assets nevertheless: They have the potential to generate future economic benefits to the organization.

Surprisingly, results did not vary by industry sector — even in high-technology companies that spend heavily on R&D and advertising. “Extra dollars invested by either high- or low-tech companies produce the same bang for the buck,” explains S.P. Kothari, one of the study's authors. “The market routinely rewards these firms because it expects future growth in earnings and cash flow.”

Because current accounting rules for R&D and advertising mean those investments have an immediate negative impact on quarterly financial performance, many managers are tempted to forgo them —particularly in difficult economic times. To counteract that tendency, companies should design specific incentives for managers to invest in R&D and other sources of long-term value. The incentives can take the form of tying a larger portion of senior managers' and R&D managers' total compensation to stock-price performance. Another way for companies to encourage managers to support innovation would be to use nonfinancial performance measures (for example, an increase in the number of patents that are highly regarded in the marketplace) in lieu of earnings-based performance measures.

The study addresses only investments in R&D and advertising, but managers may be able to extrapolate from the observed benefits to other intangibles as well. For example, the long-term value of brand names in fields as diverse as auto manufacturing and consumer goods is widely documented. And as Kothari notes, market valuation of all intangibles — including patents, brand names, intellectual capital, technological know-how and product quality — reached more than twice the value of tangibles in the late 1990s.

Of course, not all investments in intangibles pay off in higher valuations. And any investment involves risks. But the knowledge that the stock market often rewards such investments should inspire senior managers to determine which intangibles offer the best opportunities for their companies.

The study, “Value of Investments in Intangibles,” is the work of MIT Sloan School of Management accounting professor S.P. Kothari and Barry Libert, a Boston-based management consultant. The research was conducted with support from the Sloan School's New Economy Value Research Lab and Arthur Andersen, now Accenture.