“Bubble-Like Stock Valuations Miss $3.4 Trillion in Hidden Assets” – or Why Intangibles Matter

Last week, in Bubble-Like Stock Valuations Miss $3.4 Trillion in Hidden Assets, Bloomberg detailed how traditional accounting can make a company’s fundamentals “look a lot worse than they are.” In the article, New York University’s Professor Baruch Lev weighs in. “You get numbers which are highly inflated for some companies and are understated for other companies.”

As companies’ intangible investments are on the rise, “spending on research and sales as a percentage of revenue rose to 14 percent in 2017 for S&P 500 stocks, compared with 7 percent a decade ago,” data compiled by Bloomberg show. Bloomberg’s findings are real, and in fact join a long history of research documenting the rise in intangible investment spending. Lev captured the trend in a chart in his 2017 article, Time to Change Your Investment Model.

The problem is, as Bloomberg accurately reports, under an accounting rule implemented in 1974, intangibles are expensed rather than capitalized, and “Not recognizing intangible assets can push down both profits and book value in businesses that depend on research and marketing, which are increasingly important in the global knowledge economy.”

As a result, this discrepancy has prevailed for decades. In the 1990s Lev conducted a series of studies analyzing 20 years of financial data and discovered an association between a firm’s level of knowledge capital and subsequent stock performance. Further research advanced the findings and in 2005, Lev proved the existence of a market efficiency — attributable to missing information about corporate knowledge investments – that leads highly innovative companies to deliver persistent abnormal returns.