Introduction
Intangible assets have always been a part of the economic landscape.1 They include patents, licenses, and computer software as well as branding, reputation, and goodwill. A company may develop those assets internally or purchase them externally through mergers and acquisitions (M&A). Under US generally accepted accounting principles (GAAP), costs associated with internally developed intangibles are generally expensed as incurred. This is primarily due to the higher uncertainty around the potential of those intangibles to provide future benefits and the difficulty of identifying and objectively measuring such benefits. However, when acquired through M&A, those internally developed intangibles of acquirees generally get recognized at their fair value on the balance sheet as externally acquired intangibles.
Since the values of internally developed intangibles are unobservable, recent studies estimate them by accumulating a company’s spending on research and development (R&D) and selling, general, and administrative (SG&A) expenses and applying constant amortization rates.2 As Rizova and Saito (2021) highlight, however, the estimation of internally developed intangibles contains noise. In this article, we examine the severity of this noise. Is it so severe that we are better off without 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 since no one knows the “true value” of internally developed intangibles. However, for companies acquired in an M&A transaction, we have two values of internally developed intangibles to compare: the value estimated with the historical cost method (“estimated intangibles”) and the value recognized by the acquirer for the transaction (“recognized intangibles”).
It is reasonable to expect that recognized intangibles provide a more accurate measure of the “true value” of internally developed intangibles than estimated ones since the recognized valuation is vetted in the M&A market, a competitive capital market. Therefore, a comparison of these two values across M&A transactions can give us a sense of the noise generated by the historical cost method. For example, The Priceline Group acquired OpenTable, Inc. in 2014, recognizing intangibles of $1.4 billion, about 18 times bigger than the estimated intangibles of $80 million. From the valuation perspective, the estimated intangibles had a small impact on OpenTable, Inc.’s price-to-book ratio, 6.3 unadjusted vs. 4.6 when we add the estimated intangibles to book equity. However, when we add recognized intangibles to book values, the price-to-book ratio changes to 0.9, so the “true” impact of intangibles might have been much larger.
We apply the idea illustrated in this example to more than 700 M&A deals from 2011 to 2020 and find little agreement between estimated and recognized intangibles, both at the aggregate and individual company levels. This suggests that investors are unlikely to benefit from using estimates of internally developed intangibles based on the historical cost method. We discuss these results in detail in the next section. Then we focus on two case studies to examine what drives such a high level of noise.
Quantifying the Noise
We analyze M&A data from Bloomberg with a deal completion date from January 2011 to December 2020. The analysis only includes deals in which both the acquirer and acquiree are US-reporting public companies and the ownership increases from zero to 100%. The final sample has a total of 730 transactions.
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 acquirers for the transactions since such goodwill primarily reflects the future cash flows from the synergy between the acquiree and acquirer.3 This is not generated by the acquiree pre-acquisition.
We report the summary statistics of our sample in Exhibit 1. Almost $2 trillion of transactions occurred in the US M&A market from 2011 to 2020 based on the aggregate market capitalization of the acquirees. The sheer dollar value of the transactions provides strong motivation for price discovery and is likely to bring the values of recognized intangibles closer to the “true values” of the acquirees’ internally developed intangibles. The exhibit also shows that estimated intangibles differ substantially from recognized ones, even at the aggregate level. The ratio of aggregate intangibles to assets is 0.15 for estimated intangibles vs. 0.40 for recognized intangibles. The same is true at the sector and size group levels. Across all groups, recognized intangibles tend to be larger than estimated ones. This may be due to a selection bias. Companies might be more likely to be acquired when there is less uncertainty around the future benefits of their intangibles, e.g., after a Food and Drug Administration (FDA) approval of a drug under development. As a result, internally generated intangibles with more promising future cash flows might be more likely to become externally acquired intangibles via M&A.
However, not all recognized intangibles after an acquisition are higher than their estimated counterparts before the acquisition. There is substantial variation in the ratios of recognized to estimated intangibles across transactions, as shown in Exhibit 2. The estimated intangibles are either extremely large or extremely small relative to the recognized ones in many transactions. For example, in 25% of the transactions, the recognized intangibles are more than double the estimated ones (the 75th percentile for the ratio is 2.58), and the ratio can be as high as 3,212. On the other hand, in 25% of the transactions, the recognized intangibles are less than 30% of the estimated intangibles. In addition, there are 33 transactions with positive recognized intangibles and zero estimated intangibles (extreme cases of underestimation) and 54 transactions with zero recognized intangibles and positive estimated intangibles (extreme cases of overestimation).
EXHIBIT 1
Summary of the M&A Sample, 2011–2020
EXHIBIT 2
Distribution of Ratio of Recognized to Estimated Intangibles Across 730 M&A Deals, 2011–2020
To further investigate the divergence of estimated and recognized intangibles, we plot the two values for each acquired firm in our sample in Exhibit 3. When the two values are compared in dollar terms, we see a linear relation (Exhibit 3, Panel A). This is not surprising, however, as larger companies tend to have more assets and smaller companies tend to have fewer assets, which mechanically creates a positive correlation between estimated and recognized intangibles. Therefore, a cleaner way of examining the relation between estimated and recognized intangibles is to scale them by a measure of the transaction size.
Panel B of Exhibit 3 plots the two values for each transaction scaled by total assets. Data points close to the 45-degree line would indicate that the two values of internally developed intangibles are in good agreement. However, that is not what we observe in the data. The scattered data points reveal a substantial amount of noise in the estimates, which suggests they likely contain little information about the amount of intangibles capital that companies have. Furthermore, the plot does not show 43 extreme observations where either estimated or recognized intangibles are more than four times the total assets of the acquiree. These transactions are an additional indication of noise.4,5
EXHIBIT 3
Internally Developed Intangibles Estimated via Historical Cost Method vs. Recognized by Acquirer, 2011–2020
Panel A: Log of Unscaled Intangibles in USD Millions | Panel B: Scaled by Total Assets of Acquiree
Are there segments of the market where the noise in the estimated intangibles is smaller? Exhibit 4: Panel A breaks down the sample by the market capitalization of the acquiree. We see that, for larger companies, the historical cost method tends to more consistently underestimate the values of internally developed intangibles and that the dispersion between estimated and recognized intangibles is narrower.6 That said, the ratio between recognized and estimated values within large cap acquirees still varies from zero all the way to 180. In other words, even if we had an expectation that large companies’ intangibles tend to be underestimated, we still would not have a reasonable multiple to systematically “true up” the estimates.
We also break down the sample by sector since the prevalence of intangibles on a balance sheet can vary substantially across sectors and tends to be higher in technology and health care.7 As shown in Panel B, there are no discernable patterns even within those sectors.
EXHIBIT 4
Internally Developed Intangibles Estimated via Historical Cost Method vs. Recognized by Acquirer, 2011–2020
Panel A: By Size Group
Panel B: By Sector
Panel C: By Component
Knowledge Capital Estimated for Acquiree | Organizational Capital Estimated for Acquiree
Lastly, in Panel C, we examine the two components of estimated internally developed intangibles separately: knowledge and organizational capital. Because the expense data that underlie the calculation of those components face different challenges, focusing on one component at a time may reveal a clearer relation between recognized intangibles and estimated ones. The biggest challenge associated with estimated knowledge capital is the poor coverage of R&D data, which is only roughly 50% of the market even today (see, for example, Rizova and Saito 2021). The biggest challenge associated with estimated organizational capital is the ambiguity in the breakdown of operating expenses into cost of goods sold (COGS) and SG&A, which tends to vary across companies and data sources. We do not uncover any discernable patterns by separating the two components. There is a weak tendency for the estimated knowledge capital to underestimate the recognized intangibles, but again, the dispersion is too large to provide a robust adjustment based on estimated knowledge capital.
Taken together, our findings imply that the noise in internally developed intangibles estimated via the cost method is so high that the estimates have little relation with the values recognized by the acquirers for the M&A transactions.
Examining the Source of Noise
Having seen the considerable amount of noise in the estimates of internally developed intangibles across companies, we now delve into specific examples to better understand the source of that noise. As Rizova and Saito (2021) point out, there are many sources of noise, ranging from the lack of a competitive valuation process to data availability and quality, and to the assumptions behind the estimation method. For example, the estimation method does not account for the cross-sectional variation in how firms convert SG&A and R&D spending into profits. A lot of this spending may never materialize into tangible benefits, in which case the estimated internally developed intangibles might be too high. At the same time, some successful R&D projects can be worth much more than the accumulated costs, in which case the estimated internally developed intangibles might be too low.
While it is generally challenging to attribute the noise to specific sources, we use the M&A data as well as the pre-acquisition financials of the acquirees and the post-acquisition ones of the acquirers to gain some insights into the main drivers of the noise. We focus on deals in 2015 since this gives us at least five years of post-acquisition data. At the same time, by choosing more recent acquisitions, we also benefit from the general trend of increasing disclosure of transaction details over time. We present two case studies.
Case 1: Abbvie’s Acquisition of Pharmacyclics
In May 2015, Abbvie completed the acquisition of Pharmacyclics Inc. for $20.8 billion, net of liabilities of $7.1 billion. Abbvie recognized $26.2 billion of intangibles, attributing $7.6 billion to goodwill for potential synergies and $18.6 billion to other intangibles (rights, licenses, and in-process R&D) related to its cancer drug. In contrast, the estimate of the internally developed intangibles based on the historical cost method is just $364 million as of the last fiscal year-end before the transaction. What might be causing the large discrepancy?
One possible driver is the length of the public presence of the target company. The value of the estimated intangibles depends on the timing of an IPO since the estimate is based on the accumulation of publicly available R&D and SG&A data. In other words, all else equal, this approach could assign a larger amount of internally developed intangible capital to firms with a longer public presence than to firms with a shorter presence. This is unlikely to be a driver of the discrepancy for this deal, however, since the Pharmacyclics IPO was in October 1995, 20 years before the transaction.
Another possible driver is the data coverage. Even if a company has a long history of public presence, its R&D and SG&A might not be consistently reported on financial statements or captured by data vendors. This is unlikely to be a driver of the noise for this transaction, however, because Pharmacyclics’ R&D data are consistently available since its IPO. The SG&A data are missing throughout the history, but the value of its cancer drug, the main source of the recognized intangibles, should be primarily related to R&D, not SG&A.
A third possible driver is the success of its cancer drug that made the investment worth much more than the estimated cost. Pharmacyclics developed and commercialized its cancer drug by entering into a collaboration agreement with Janssen, a pharmaceutical company and a subsidiary of Johnson & Johnson, in December 2011. The firm had a series of breakthroughs prior to the business combination with Abbvie. For example, from 2013 to 2015, both the FDA and European Commission approved multiple drug indications related to its cancer drug, which led to respective revenues of $82 million, $260 million, and $730 million in 2012, 2013, and 2014. Most of these revenues stemmed from the upfront payment and milestone payments from Janssen. These revenues might have prompted Abbvie to evaluate the Pharmacyclics’s intangibles at $18.6 billion upon the acquisition.
Did these intangibles lead to large future economic benefits as Abbvie envisioned? Between 2015 and 2020, Abbvie’s financials show a total revenue of $18.7 billion from its cancer drug alone. This is more than the value of the intangibles recognized back in 2015 and twice the goodwill. Furthermore, there have been no impairments of the recognized intangibles or goodwill.
This example shows that, while the historical cost method assumes a one-to-one conversion of the spending on intangibles into tangible benefits, certain successful projects can generate much more revenue than the original spending. After all, that should be the hope of every project; no one starts a project with the hope of breaking even or losing money.
Case 2: Reynolds American’s Acquisition of Lorillard
It is not only in health care that we see companies’ intangibles evaluated at more than their historical cost. For example, Reynolds American Inc. completed the acquisition of Lorillard, Inc. for $25.8 billion (net of $15.6 billion in liabilities) in June 2015. They recognized $9.9 billion of goodwill for synergies and deferred taxes and $27.4 billion of other intangibles ex goodwill, primarily for trademarks. In contrast, the estimate based on the historical cost method is just $743 million as of the last fiscal year-end before the transaction.
Prior to the acquisition, Lorillard was booking steadily positive net income of around $1 billion with a net profit margin of around 25%. Its main product, Newport cigarettes, was the second-largest selling cigarette brand in the US. Post-acquisition, Lorillard was integrated into R.J. Reynolds, an operating subsidiary of Reynolds American Inc. The annual revenue of R.J. Reynolds increased from shy of $7 billion over a few years before 2015 to more than $10 billion after 2015, which is primarily attributed to this acquisition. Further, its US cigarette market share increased from 26% pre-acquisition to 32% post-acquisition.
This example highlights at least two of the limitations of the historical cost method of estimating internally developed intangibles. First, a fixed amortization rate used in the historical cost method means that any intangibles created a long time ago would mechanically lose most of their values over a fixed time frame implied by the amortization rate. This is not a suitable assumption for an established trademark like Newport and, more generally, for intangibles that stay valuable much longer. Second, the estimation method assumes a one-to-one conversion of expenses into the net present value of future benefits.
Conclusion
In this study, we show that estimating internally developed intangibles and putting them on the balance sheet might not be a fruitful endeavor. Using M&A data, we compare the estimates derived with the historical cost method to the values vetted in the M&A market and recognized on the balance sheet of the acquirer firms after the transaction. We document a high level of dispersion between the estimated intangibles and the recognized ones. Estimated intangibles can be much smaller or much larger than recognized intangibles, depending on the transaction. Indeed, recognized intangibles are more than twice the values of estimated intangibles for 25% of the sample and less than 30% of estimated intangibles for another 25% of the firms. The sources of noise can also differ for each transaction. This is consistent with our 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 does not yield consistently higher value and profitability premiums.
Therefore, investors are likely better off not incorporating these noisy estimates into the investment process, as doing so may cause unnecessary turnover and costs without tangible benefits. In addition, there are more effective alternatives 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
- FAS 142 defines intangibles as assets (not including financial assets) that lack physical substance.
- See, for example, Hulten and Hao (2008), Eisfeldt and Papanikolaou (2013, 2014), Peters and Taylor (2017), Park (2019), Lev and Srivastava (2019), Eisfeldt et al. (2020), and Rizova and Saito (2021).
- Goodwill may also reflect the acquiree’s internally developed intangibles that are deemed unidentifiable. Given the numerical breakdown of goodwill into the synergies and other portions is usually unavailable and the future cash flows from synergies is the most common attribution of goodwill, we subtract goodwill for the comparison. In addition, FAS 141 provides the detailed guidance on the recognition criteria and examples of identifiable intangibles, requiring acquirers to make every effort to “recognize all acquired intangible assets meeting the criteria in paragraph 39 of this Statement so that they are not subsumed into the amount initially recognized as goodwill.”
4. The results are similar when we scale intangibles by the market capitalization of the acquiree as of the month-end right before the transactions.
- The threshold of four is set based on approximately the 99th percentile within the sample based on the ratio of estimated intangibles to total assets.
- The maximum ratio of recognized to estimated intangibles is 180, 55, and 3,212, respectively, for large, mid, and small caps.
- See, for example, Rizova and Saito (2021). Available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3697452.
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, such as total assets as well as SG&A and R&D, required to compute estimated intangibles, 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.
DISCLOSURES
The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
The Priceline Group, OpenTable, Inc., Abbvie, Pharmacyclics Inc., Reynolds American Inc., and Lorillard, Inc. securities may be held in accounts managed by Dimensional.
UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.