Index providers question whether book-to-price offers a suitable definition of the value factor. They argue that intangible assets such as branded capital and technological know-how are playing an increasing role but are not included in the reported book values.
Many providers prefer to combine multiple accounting metrics to define value. They argue that a combination of valuation metrics using earnings, sales, or cash flows can better capture the true value of a stock.
Such comments reflect the idea that value indices should emulate the traditional investment practice of active managers looking for stocks that are undervalued relative to their true value. However, it would be naive to think that a combination of accounting metrics could capture the true value of a stock. The value factor was never intended to give an overview of the security valuation. Instead, factor investing builds on asset valuation insights that have identified patterns in the cross-section of expected returns. Exposure to the Value Factor captures differences in expected returns between stocks that reflect risk compensation.
Value firms, in particular, tend to be riskier than growth companies because their value is mostly comprised of existing assets – not growth options. Companies with large capital stocks will have difficulty adjusting to an economic shock. This causes value firms to suffer during bad economic times.
From this perspective, leaving out intangible capital in book value is problematic if, like physical capital, it contributes to the risk. If converting intangible capital is costly, holding a large inventory of intangible capital can increase a company’s risk and result in compensation for shareholders. Empirical research has shown that investing in intangible capital is indeed costly and increases systematic risk.
Intangible capital also subjects companies to shocks in terms of financing conditions in the economy. For example, companies that rely on specialized know-how are exposed to the risk that important talent will leave the company. Such talent dependency increases companies’ risk of funding shortages, as key talent tends to leave companies in financial distress when funding conditions worsen. Likewise, highly innovative companies can have to give up R&D projects under financial stress, which leads to additional losses in bad times. In general, companies cannot use intangible assets as collateral, exposing them to tighter funding constraints during bad economic times.
The answer to the problem that reported book value excludes intangible assets is simple: we can adjust book values for unrecognized intangible assets. The scientific literature has established measures of intangible capital. Instead of dismissing the book-to-price as out of date, we can update its valuation by adding intangible capital to the book value.
Economists recognized early on that intangible capital is an integral part of a company’s capital stock. In addition to physical capital (physical and equipment goods), companies invest in knowledge capital and organizational capital.
Research and development (R&D) creates knowledge capital that leads to know-how in the form of patents, improved processes and better product quality. Hence, it can be estimated from data on R&D expenditure. Organizational capital is created through investments in training, advertising and organizational design and leads to a skilled workforce, brand recognition and customer relationships. Part of the sales, general and administrative costs can thus be used to estimate the organizational capital.
Recent research by Scientific Beta evaluates an intangible book price factor and compares it to other valuation metrics. (A version of the paper Intangible Capital and the Value Factor: Has Your Definition of Value just expired? Portfolio management magazine).
We find that the intangible book price factor generates a strong value premium of 2.09 percent per year, which also remains significant when other factors are taken into account. The intangible adjustment thus improves investment results for multifactor investors. Historically, for an investor who had exposure to six factors, including intangibles, in the book price factor, the Sharpe ratio has increased more than 10 percent.
The adjusted intangible book-to-price factor is also closely based on the risks of the standard book-to-price factor. This bias towards a risk-based statement is important for investors trying to get a premium that is likely to persist even if it becomes widely known. The intangible value factor leads to cyclical fluctuations in the market beta and the result. Value stocks with a high adjusted intangible book-to-price also have higher operational leverage than growth stocks with a low book-to-price. These observations suggest that value stocks are riskier than growth stocks.
The use of alternative valuation metrics increases the return compared to the book price. However, this improvement is explained by implicit exposures to other factors such as quality and low risk. Because of this factor overlap, switching from book price to other valuation metrics reduces the Sharpe ratio of multi-factor portfolios. Switching from book-to-price to earnings-to-price, for example, reduces the Sharpe ratio by 11 percent for an investor who puts value and profitability first. Using a composite value definition instead of book-to-price reduces the Sharpe ratio by a similar amount. When adjusting for multiple exposures, the premium of a composite value factor of -0.41 percent per year cannot be distinguished from zero.
In addition, we show that an intangible value factor offers added value for investors who are already exposed to a composite value factor. In contrast, composite value factors offer no added value for investors who are already exposed to the intangible value factor. We conclude that composite value factors are fully subsumed by an intangible adjusted value factor, rendering them unusable for investors who have access to the intangible adjusted book price factor.
The combination of different valuation metrics is an old recipe from the 1990s. Back then, investors didn’t have access to other factors like quality and low risk. But investment practices have changed. Many investors now hold portfolios that combine several factors. Therefore, including an implicit exposure to other factors in a compound definition of value will not improve investment results.
Such composite value definitions may in fact approach their expiration dates. The book-to-price, on the other hand, still looks fresh, especially when including unreported intangible capital.
Felix Goltz is Research Director and Ben Luyten is a quantitative research analyst at Scientific Beta.