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February 19, 2018

Intangible (Intellectual) Assets

By Baruch Lev

This is the first in a series of essays about intangible assets, their unique capacity to create value and growth, and their increasing importance in the management and valuation of business enterprises.  The first essay will naturally focus on the economic attributes and unique characteristics of intangibles.  Future essays will deal with measurement and valuation issues, and implications for managers and investors.

In a recent Op-Ed article in the New York Times (October 22, 2000, p. 15), MIT's prominent economist Paul Krugman wrote:

"In the past, businesses primarily invested in the tangible means of production, things like buildings and machines.  The value of a company was at least somewhat related to the value of its physical capital... But now businesses increasingly invest in intangibles... The intangibility of a company's most important assets makes it extremely hard to figure out what that company is really worth.  That may partially explain the nauseating volatility of stock prices."

Note, please, the major observations made by Krugman:

  • Corporate investment in intangibles dominates investment in physical assets, providing the major driver of growth.

  • Intangibles, and intangible-intensive companies are difficult to value.

  • These difficulties contribute to stock price volatility and investor bewilderment.

This fundamental causal chain:  increased intangible investment ---- valuation difficulties - stock volatility, makes the study of intangibles crucially important to managers and investors.

What are intangible assets?  Like other assets, they are sources of future benefits (cash flows, cost savings), but unlike tangible assets, intangibles don't have a physical embodiment.[1]

There are three major nexuses of intangibles, distinguished by their relation to the generator of the assets:  innovation, organizational practices, and human resources.  The bulk of Merck & Co.'s intangibles were obviously created by its massive and highly successful innovation (R&D) effort ($2.0 billion R&D in 1999), conducted internally and in collaboration with other entities.  This is similar to Microsoft, DuPont, and Amgen, whose major intangibles were created by discovering and improving products and services.  In contrast, Dell's major value drivers are related to the second intangibles nexus - a unique organizational design, implemented through direct customer marketing of built-to-order (BTO) computers, via telephone and the Internet.  Cisco's Internet-based product installation and maintenance system, which generated (according to its CFO) $1.5 billion in savings during the past three years, is another example of an intangible created by a unique organizational design.  Increasingly, supply chains and unique distribution channels generate intangibles in the form of organizational capital.

Brands, a major form of intangible prevalent in consumer product sectors - electronics (Sony), food and beverages (Coca-Cola), and more recently in Internet companies (AOL, Yahoo! and Amazon) - are often created by a combination of innovation and organizational structure.  Coke's highly valuable brand is the result of a secret formula and exceptional marketing savvy.  The unique products created and acquired by AOL during the 1990s are responsible for its brand, along with massive marketing (customer acquisition) costs.

The third nexus of intangibles, those related to human resources, is generally created by unique personnel and compensation policies, such as investment in on- and off-the-job training, incentive-based compensation, and collaboration with universities and research centers.  Such human resource practices enable employers to reduce employee turnover, provide positive incentives to the workforce, and facilitate the recruitment of highly qualified employees (e.g., biotech scientists).  Specific organizational designs, such as Xerox's Eureka system, which is aimed at sharing information among the company's 20,000 maintenance personnel, enhance the value of the human resource-related intangibles by increasing employee productivity.

It should be noted that the demarcation lines between intangible assets and other forms of capital are sometimes blurry.  Intangibles are frequently embedded in physical assets (e.g., the software operating machine tools) and in labor (tacit knowledge of employees), leading to interaction between tangible and intangible assets in the creation of value.  These interactions pose serious challenges to the measurement and valuation of intangibles.

Summarizing, intangible assets are non-physical sources of value (claims to future benefits), generated by innovation (discovery), unique organizational designs, or human resource practices.

How large are intangible assets?  This is difficult to answer accurately, but Leonard Nakamura, an economist with the Federal Reserve Bank of Philadelphia, estimated that the value of U.S. annual investment in intangibles in the late 1990s reached a staggering $1.0 trillion. (If you question the believability of this figure, note that the investment in R&D, just one source of intangibles, surpassed $200 billion in 1999.)  Using a different perspective:  The average market-to-book ratio of the S&P 500 companies (market value of companies divided by their book value - balance sheet value of net assets) was about 5.5 at the end of 2000, implying that out of every $5.5 of market value, only $1.0 represents physical and financial assets reported on corporate balance sheets.  It is clear:  The value of intangible capital in developed economies is huge.

What is so unique about intangibles?  How are they different than conventional assets?  First and foremost, an intangible, in the economic parlance, is a nonrival asset; namely, the use of an intangible asset by a given person or task doesn't prevent others from using the intangible at the same time. When I trade on eBay, I don't preclude you from trading, too.

Consider AMR Corp.  When its subsidiary American Airlines deploys an airplane (a physical, rival asset) in the New York -- San Francisco route, the same airplane and its crew (a human resource) cannot, of course, be deployed at the same time in the Chicago -- Dallas route.  This limitation on the use of physical and human assets restricts severely the value that can be created by such assets.[2]

In contrast, consider Sabre, until recently another subsidiary of AMR Corp.  Sabre started as American Airlines reservation system, and later became a public company and the system most widely used by travel agents and airlines.  Sabre is an intangibles-intensive enterprise.  Its major assets are proprietary software programs, and its highly valued brand.  In contrast with American Airlines' airplanes and crews, Sabre's intangible assets are nonrival - like eBay, they can be used at the same time by one, one thousand, one million or more users.

When Sabre's reservation system services one user, it does not give up the service of another user; no opportunity foregone, no economic cost.  While the available number of airplanes and seats represent the capacity of American Airlines, the only capacity constraint on Sabre is the potential size of the market.  The sky is the limit.

No wonder then that at the end of 1999, the market value of Sabre was roughly 2/3 the total value of its parent AMR Corp., implying that AMR's reservation system was worth twice the value of the remainder part of AMR - the second largest airline in the world (American).

This nonrival attribute of intangibles (drugs, software programs, brands) - the ability to service at negligible incremental cost an almost unlimited number of customers - is a potential source of enormous value.  This is often referred to as the scalability of intangible (intellectual) assets.

But if it's so good, why is it so bad?  Why did the stock prices of many intangible-intensive tech companies collapse during the last 12 months?  Why are so many people disillusioned with companies that invested heavily in intangibles, such as R&D, technology, customers?

The short answer: Here as elsewhere, there is no free lunch. The value-creation (scalability) potential of intangibles comes at a high price, generally overlooked by new economy and information revolution gurus.  Intangibles are substantially more difficult to measure, manage, and value than physical and financial assets.  Consequently, after making significant investments, (e.g., Motorola and partners' $5 billion investment in the Iridium project), managers often fail to exploit to the fullest the potential of intangible capital.  Few firms, for example, sell or license patents not under development; they just let them expire.  Similarly, investors using conventional valuation tools generally misprice (overvalue, and often undervalue) intangible-intensive enterprises.  Disillusionment and disappointment are bound to follow mismanagement and misvaluations.

* Philip Bardes Professor of Accounting and Finance, Stern School of Business, New York University.

[1] Intangible assets are also referred to as knowledge assets (particularly be economists) and as intellectual capital.  The term intellectual property refers to intangibles whose property rights (ownership) are legally protected, such as patents, copyrights, and trademarks.

[2] The rivalous property of physical and human assets, the fact that various alternative uses (e.g., flight routes) compete for the use of the asset, creates the economic cost of the asset.  This is the well-known concept of "opportunity or alternative cost":  The cost of an asset is the benefit from the best opportunity foregone.

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