Effects of Capitalizing Intangibles on Factor Models of Stock Returns

Under current U.S. accounting rules, many investments in innovation, human resources and brand that are crucial to long-term competitiveness immediately reduce operating profits and earnings (are expensed rather than capitalized). Does failure to incorporate such intangible investments in firm investment and valuation ratios (book-to-market, profitability and return on equity) harm equity investment decisions? In their January 2021 paper entitled “Intangible Capital in Factor Models”, Huseyin Gulen, Dongmei Li, Ryan Peters and Morad Zekhnini study impacts of capitalizing intangible investments on three widely used factor models of stock returns: 3-factor (market, size, book-to-market);  5-factor (adding profitability and investment); and, q-factor (market, size, investment, profitability). They focus on effects of intangibles on book-to-market ratio, investment and profitability. Using accounting data and stock returns for a broad sample of U.S. firms during July 1977 through December 2018, they find that: (more…)