One implication of the growth of the “knowledge economy” is that the composition of the assets of a modern corporation has shifted towards intangibles and away from tangibles. Intangible assets account for one third to half the market value of US corporate securities and R&D expenditures alone account for over 3% of non-financial corporate revenues.1 The importance of intangible assets is growing in European firms as well. The figure below reports the share of intangible assets in total assets for a balanced panel of publicly-listed firms in low-tech and high-tech sectors (chemicals and drugs, computers and computer equipment, electrical machinery, instruments, telecommunication services, software and other business services).
However, even this figure understates the true share of intangible assets because accounting standards do not allow R&D capitalisation, and because only intangible assets which are actually on the balance sheet are measured. In the US, the generally accepted accounting principles (GAAP) set by the Financial Accounting Standard Board (FASB) prescribe that R&D costs are treated as current expenditures rather than investments. R&D costs cannot be capitalised according to the International Accounting Standard Committee (IASC) Foundation either. Only development costs (under given conditions) and in-process R&D acquired through merger or acquisition (IPR&D) can be capitalised because their value is determined by the exchange price.
In the absence of any kind of book value of R&D-related intangible assets (including internally-generated patents), economists in a number of countries have used the relationship between the market value of the firm that performs the R&D and obtains the patents to estimate the contribution of the assets thus created to current and future corporate earnings.2 Performing this exercise for European firms is problematic because of the limited availability of data on R&D spending. With the exception of the UK, reporting R&D expenditures is not required by accounting and fiscal regulations across most European countries even for publicly-listed corporations. For this reason, the evidence on the market valuation of R&D and patents in European firms has been quite limited. Nevertheless, the question is important in the context of the Lisbon agenda because one reason for underperformance in R&D can be a failure of financial markets to properly value the innovation investments that are being made, leading to underinvestment on the part of firms.
In a recent paper we measure the impact of R&D and patent stocks on the market-to-book ratio (Tobin's q) of a sample of publicly-listed European firms which do report R&D data.3 We find that Tobin’s q is positively and significantly associated with R&D and patent stocks, but that in the case of patents, only those inventions protected in both EPO (European Patent Office ) and USPTO (US Patent and Trademark Office) - or at the USPTO alone - seem to be valued. That is, for patents to generate value above and beyond the R&D that went into producing the inventions, they need to be on inventions that are worth protecting outside of Europe as well as inside.
The value of R&D and patents
R&D investment is an input to innovative activity and the output is highly uncertain, so it is useful to have reliable indicators of R&D outcomes. Because of their objectivity (they are the result of standards applied by patent offices that are intended to be uniform across technologies) and accessibility, patents have become the most popular and widely-used indicator of R&D ‘success’. But the distribution of patents’ economic value is very skewed, with only a few patents yielding significant value to their owners and many being nearly worthless ex post. This is why empirical work on this field sometimes makes use of a number of indicators of patent ‘quality’, such as citations received (forward citations), the number of technical fields covered by the patented invention, and patent family size (the number of different patent systems in which protection for a single invention is sought). Such measures can be used to “weight” the patent counts for each firm in order to partially correct for the variability in patent value. Under the assumption that financial markets possess (and use) all relevant information needed to correctly estimate the future net cash flows generated by the stock of a firm’s assets, additions to the firm’s R&D and patent assets should affect its market value.4
Our estimates on a sample of 1,060 firms observed during the period 1991 through 2002 show that the ratio between R&D stock and tangible assets is positively and significantly related to Tobin’s q across different specifications of the market value equation, with an estimated coefficient of about 0.7. Thus an additional euro of R&D spending generates on average 0.7 euros in market value, a number that is remarkably similar to that estimated for US firms during the same time period. The average estimated elasticity of market value with respect to R&D is about 0.2 and the average R&D stock-assets ratio is 0.51 with a standard deviation of 0.74. Using these figures, the estimates imply that a firm which is one standard deviation above the mean has a market value that is about 30% higher than the average firm.
In all specifications, a firm’s patent stocks are significantly related to value, above and beyond the R&D stock, but with some interesting variations that depend on the jurisdictions in which the patent was taken out. We looked at patents taken out at the EPO, the USPTO, and at both offices. Patents taken out only at the EPO are not value-relevant when we include patents taken out in both jurisdictions in the regression, and those patents are clearly more valuable than those taken out only in the US. The interpretation is that when an invention is successful enough to be worth patenting outside of Europe, it returns value to the firm above and beyond the R&D that went into making it.
To give an idea of magnitudes, our estimates imply that a one standard deviation increase in the stock of EPO patents with US equivalents relative to R&D is associated with about an 11% increase of market value, and similarly a one standard deviation increase in the stock of US patents with EPO equivalents (relative to R&D stock) yields a 10% increase in market value.
We also explored the use of forward citations and a composite index of patent ‘quality’ based on forward citations, family size, and the number of technical fields covered by the patent to improve the value-relevance of our patent measures. We found that these measures did not yield any significant impact on the market value of the firm when they were applied to EPO-only or USPTO-only patents, but that the quality measures did yield an additional, albeit small, premium for patents taken out in both jurisdictions.
Our research shows that intangible assets are a fundamental determinant of corporate financial value and competitive advantage. Our findings are in line with other studies on US firms showing that investors view R&D as an asset rather than as an expense.5
Not surprisingly, the US FASB’s proposal to capitalise IPR&D was initially opposed by executives of high-tech firms that are frequently engaged in M&As. Resistance to capitalisation of IPR&D is explained by the fact that under the traditional accounting regime, most of the value of the IPR&D assets could be written off to expense by the acquiring firm and the negative impact of amortisation on future earnings was reduced.
The revision of international accounting standards recently started is a rational choice because R&D capitalisation increases the efficiency of market prices and resource allocation (it helps filling the gap between the book value of assets and the stock value). However, a first and perhaps more important step towards a greater market transparency and a better evaluation of intangible assets would be requiring European publicly-listed firms to disclose their R&D expenses.
1 Nakamura, L. (2001). 'What is the US gross investment in intangibles?(At least one trillion dollars a year!)'. Federal Reserve Bank of Philadelphia Working Paper 01-15; Blair, M. and Wallman, S.M. H. (2001), 'Unseen Wealth: Report of the Brookings Task Force on Intangibles', Brookings Task Force On Intangibles, Brookings Institution Press, Washington DC.
2 For a survey of such efforts, see Hall, B. H. (2000), Innovation and Market Value, in R. Barrell, G. Mason and M. O’Mahoney (eds.), Productivity, Innovation, and Economic Performance, Cambridge University Press, pp. 177-198.
3 Hall, B. H. , Thoma G. and Torrisi S. (2007), ''The market value of patents and R&D: Evidence from European firms, Working paper 13426, National Bureau of Economic Research, Cambridge, Mass.
4 Hall B. H., A. Jaffe, and M. Trajtenberg (2005), Market Value and Patent Citations, Rand Journal of Economics, 36: 16-38; Lanjouw, J. O., and M. Schankerman (2004). Patent Quality and Research Productivity: Measuring Innovation with Multiple Indicators. Economic Journal. 114: 441-465.
5 Lev. B., Nissim, D. and Thomas, J. (2005) 'On the informational usefulness of R&D capitalization and amortization'. Columbia Business School, Columbia University, and Stern School of Business, NYU, April.