A recent article in the Financial Analysts Journal suggests that, even if investors were perfectly informed, could accurately forecast corporate earnings and invest at optimal times, their excess returns would be lower than expected due in large part to the treatment of intangible assets. This according to a recent article in The Economist.
The authors argue that hypothetical returns have been falling because of the rising importance of intangible investments (such as trademarks and software development), which may be driving value growth. “Accountants have struggled to adapt,” the article says, adding that if a company buys an intangible asset such as a patent, it is classified as an asset on the company’s balance sheet, but if an intangible is developed within a business it is classified as an expense. So, companies focused on innovation through acquisition may appear more profitable than a company pursuing the same innovation internally. The article argues that reported earnings, therefore, are “no longer such a good measure of a company’s profits, and thus may not be a useful guide to future share performance.”
To test the theory, the authors divided companies into quintiles based on levels of intangible investment, and found that the more firms spent on intangibles, “the lower the excess return available to those who correctly forecast the earnings.”