Intangible (Intellectual) Assets
By Baruch Lev
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.
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.
causal chain: increased intangible
investment ---- valuation difficulties - stock volatility, makes the study of
intangibles crucially important to managers and investors.
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.
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
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.
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.
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.
intangible assets are non-physical sources of value (claims to future
benefits), generated by innovation (discovery), unique organizational designs,
or human resource practices.
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.
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.
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.
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.
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.
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).
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
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?
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)
Disillusionment and disappointment are bound to follow mismanagement and
Bardes Professor of Accounting and Finance, Stern School of Business, New York
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.
 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.