Suppose you want to estimate the potential salary of a friend who is looking for a job based on her spending so far on educational degrees and professional certificates. The estimated salary might be substantially higher or lower than the actual income she will earn. This is because other factors will also affect her compensation, such as her actual mastery of soft and technical skills, the current job market conditions, and the industry in which she gets to work. As a result, the accumulated educational spending of your friend might be a noisy estimate for her future income.
Similarly, a company’s historical spending on research and development, personnel, and advertising can be quite a noisy estimate of the value of its internally developed intangible assets, such as branding, reputation, patents, copyrights, trademarks, and software.1 Rizova and Saito (2021) highlight several important sources of noise in the estimation of internally developed intangibles. Is that noise so severe that we are better off not using the estimates? Or is it mild enough that we should add the estimates to company fundamentals, such as assets and book equity, when constructing valuation and profitability ratios? Those are challenging questions because no one knows the “true value” of internally developed intangibles.
For companies acquired in an M&A transaction, however, we have two values of internally developed intangibles: the value estimated with the historical cost method (“estimated intangibles”) and the value that is recognized for the transaction and subsequently appears on the acquirer’s balance sheet (“recognized intangibles”). Of these two values, recognized intangibles likely provide a more accurate measure of the “true value” of internally developed intangibles because the recognized valuation is vetted in the M&A market, a competitive capital market. We can therefore compare these two values across M&A transactions to get a sense of the noise associated with the historical cost method.
We apply this approach to more than 700 M&A deals from 2011 to 2020, worth $2 trillion, and find little agreement between estimated and recognized intangibles, both at the aggregate and individual company levels.2 To illustrate, in Exhibit 1 we plot the ratio of recognized intangibles to estimated intangibles for those transactions, which are then sorted from greatest overestimation on the left to greatest underestimation on the right. We find substantial variation in the ratio of recognized to estimated intangibles across transactions. For example, in 25% of the transactions, the recognized intangibles are more than double the estimated ones, and the ratio can be as high as 3,212. There are also 33 cases of extreme underestimation: positive recognized intangibles but zero estimated intangibles. On the other hand, in 25% of the transactions, the recognized intangibles are less than 30% of the estimated intangibles, including 54 transactions with zero recognized intangibles.
Exhibit 1
Your Mileage May Vary
Distribution of the ratio of recognized to estimated intangibles across 730 M&A deals, 2011–2020
The units of the vertical and horizontal axes are measured, respectively, in the multiples of recognized intangibles and in the percentiles of transactions based on the ratio of recognized to estimated intangibles. The percentile calculation considers transactions with zero recognized intangibles as those with an extremely small ratio; it considers transactions with zero estimated intangibles as those with an extremely large ratio. See Appendix for additional information.
These results are consistent with our earlier findings that estimated internally developed intangibles provide little additional information about future firm cash flows beyond what is contained in current cash flows and that capitalizing those estimates would not have yielded consistently higher value and profitability premiums.
Together this confirms that investors are likely better off not incorporating these noisy estimates into the investment process. Doing so may cause unnecessary turnover and costs without tangible benefits. In addition, there are more effective ways to account for the cross-sectional variation in internally developed intangibles. Rizova and Saito (2021) report that, for US and non-US markets, the performance impact of estimated internally developed intangibles on the value premium diminishes when controlling for sectors. Accordingly, having sector controls in value and profitability sorts might be a more robust way to account for differences in internally developed intangibles across companies.
FOOTNOTES
1 A common approach to estimate internally developed intangibles is to accumulate the historical research and development (R&D) and selling, general, and administrative (SG&A) expenses while applying constant amortization rates. See, for example, Hulten and Hao (2008), Eisfeldt and Papanikolaou (2013, 2014), Peters and Taylor (2017), Park (2019), Lev and Srivastava (2019), and Eisfeldt et al. (2020), and Rizova and Saito (2021).
2 The analysis includes deals in which both the acquirer and acquiree are US-reporting public companies and the ownership increases from zero to 100%. We compare the values of internally developed intangibles estimated via the historical cost method vs. the values of intangibles recognized for the transaction. We exclude from the latter the acquirees’ pre-existing on-balance sheet intangibles (externally acquired intangibles and goodwill) since the historical cost method is meant to estimate only the off-balance-sheet intangibles. We also exclude goodwill newly recognized by the acquirees for the transactions since such goodwill primarily reflects the future cash flows from the synergy between the acquiree and acquirer. This is not generated by the acquiree pre-acquisition.
APPENDIX
Source: Dimensional. The market data as well as M&A data are obtained from Bloomberg. Transaction-specific financial data, such as goodwill and recognized intangibles for acquirees, are obtained from the 10-K reports of acquirers. The other financial data required to compute estimated intangibles, such as total assets as well as SG&A and R&D, are obtained from Compustat.
Sectors are based on GICS classification, obtained from Bloomberg and combined as follows. GICS was developed by and is the exclusive property of MSCI and S&P Dow Jones Indices LLC, a division of S&P Global. Bloomberg data provided by Bloomberg. All rights reserved.
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