Suppose you want to estimate the potential salary of a friend who is looking for a job based on her spending so far on educational degrees and professional certificates. The estimated salary might be substantially higher or lower than the actual income she will earn. This is because other factors will also affect her compensation, such as her actual mastery of soft and technical skills, the current job market conditions, and the industry in which she gets to work. As a result, the accumulated educational spending of your friend might be a noisy estimate for her future income.
Similarly, a company’s historical spending on research and development, personnel, and advertising can be quite a noisy estimate of the value of its internally developed intangible assets, such as branding, reputation, patents, copyrights, trademarks, and software.1 Rizova and Saito (2021) highlight several important sources of noise in the estimation of internally developed intangibles. Is that noise so severe that we are better off not 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 because no one knows the “true value” of internally developed intangibles.
For companies acquired in an M&A transaction, however, we have two values of internally developed intangibles: the value estimated with the historical cost method (“estimated intangibles”) and the value that is recognized for the transaction and subsequently appears on the acquirer’s balance sheet (“recognized intangibles”). Of these two values, recognized intangibles likely provide a more accurate measure of the “true value” of internally developed intangibles because the recognized valuation is vetted in the M&A market, a competitive capital market. We can therefore compare these two values across M&A transactions to get a sense of the noise associated with the historical cost method.
We apply this approach to more than 700 M&A deals from 2011 to 2020, worth $2 trillion, and find little agreement between estimated and recognized intangibles, both at the aggregate and individual company levels.2 To illustrate, in Exhibit 1 we plot the ratio of recognized intangibles to estimated intangibles for those transactions, which are then sorted from greatest overestimation on the left to greatest underestimation on the right. We find substantial variation in the ratio of recognized to estimated intangibles across transactions. For example, in 25% of the transactions, the recognized intangibles are more than double the estimated ones, and the ratio can be as high as 3,212. There are also 33 cases of extreme underestimation: positive recognized intangibles but zero estimated intangibles. On the other hand, in 25% of the transactions, the recognized intangibles are less than 30% of the estimated intangibles, including 54 transactions with zero recognized intangibles.