Intangible Capital and the Value Factor: Has Your Value Definition Just Expired?

Abstract

Many index providers claim that the book-to-price ratio is no longer a sufficient descriptor of the value factor. They argue that it has become outdated because reported book value ignores investments into intangible assets. As a solution, they propose including other valuation ratios, such as earnings-to-price, sales-to-price, cash flow-to-price, or dividend yield. However, this solution overlooks a superior alternative: Intangible capital can be estimated and added to the book value. In this article, the authors compare these alternative solutions. Beyond a naïve analysis of performance, they ask (1) whether improvements persist when considering implicit exposure to other factors and (2) whether they align with a risk-based explanation for the value factor. The authors show that including unrecorded intangibles in the book value increases the value premium and aligns with risk-based explanations. By contrast, other valuation ratios do not add investment value beyond picking up implicit exposure to factors other than value. Such valuation ratios also fail to improve the alignment of value strategies with risk-based explanations.

TOPICS: Factor-based models, style investing, analysis of individual factors/risk premia

Key Findings

• • Intangibles are largely ignored when using book-to-price as a value factor proxy. Two different remedies have been proposed: using alternative valuation ratios or adjusting the book value to include intangibles.

• • Alternative valuation ratios do not add investment value beyond picking up implicit exposures to other factors. The intangible adjustment, however, does add investment value for multifactor investors.

• • The intangible-adjusted book-to-price factor aligns well with a risk-based explanation for the value premium, whereas some alternative valuation ratios fail to pass this hurdle.