The idea of using the difference between the market value of the firm and accounting book values as an indicator of market power and/or valuable intangible assets stems from the pioneering work of Nobel laureate James Tobin. Tobin introduced the so-called q ratio, defined as the ratio of the market value of the firm divided by the replacement cost of tangible assets. For a competitive firm in a stable industry with no special capabilities, and no barriers to entry or exit, one would expect q to be close to one (q
1). In a perfectly competitive industry, any momentary propensity for q > 1 due to an unanticipated rise in demand or decrease in costs would be quickly erased by entry or established firm growth. In a perfectly competitive industry, any momentary propensity for q < 1 due to an unanticipated fall in demand or increase in costs would be quickly erased by exit or contraction among established firms. In the absence of barriers to entry and exit, the marginal value of q would trend towards unity (q
1) over time in perfectly competitive industries. Similarly, a firm that is regulated so as to earn no monopoly rents would also have a q close to one. Only in the case of firms with monopoly power protected by significant barriers to entry or exit, or firms with superior profit-making capabilities, will Tobin’s q ratio rise above one, and stay there. In the limit, the theoretical maximum Tobin’s q ratio is observed in the case of a highly efficient monopoly. If q > 1 on a persistent basis, one can argue that the firm is in possession of market power or some hard-to-duplicate asset that typically escapes measurement using conventional accounting criteria.
Tobin’s q ratio surged during the 1990s, and some made the simple conclusion that monopoly profits had soared during this period. In the early 1990s, however, the overall economy suffered a sharp recession that dramatically reduced corporate profits and stock prices. By the end of the 1990s, the economy had logged the longest peacetime expansion in history, and both corporate profits and stock prices soared to record levels. Corporate profits, stock and Tobin’s q ratios for major corporations took a sharp tumble over the 2000-03 periods as the country entered a mild recession. Therefore, much of the year-to-year variation in Tobin’s q ratios for corporate giants can be explained by the business cycle. At any point in time, more fundamental changes are also at work. Leading firms today are characterized by growing reliance on what economists refer to as intangible assets, like advertising capital, brand names, customer goodwill, patents, and so on. Empirically, q > 1 if valuable intangible assets derived from R&D and other such expenditures with the potential for long-lived benefits are systematically excluded from consideration by accounting methodology. The theoretical argument that q
1 over time only holds when the economic values of both tangible and intangible assets are precisely measured. If q > 1 on a persistent basis, and Tobi’(s q is closely tied to the level of R&D intensity, one might argue successfully for the presence of intangible R&D capital.
In Table 12.3, q is approximated by the sum of the market value of common plus the book values of preferred stock and total liabilities, all divided by the book value of tangible assets, for a sample of corporate giants included in the Dow Jones Industrial Average (DJIA). To learn the role played by R&D intensity as a determinant of Tobin’s q, the effects of other important factors must be constrained, including: current profitability, growth, and risk. Current profitability is measured by the firm’s net profit margin, or net income divided by sales. Positive stock-price effects of net profit margins can be anticipated because historical profit margins are often the best available indicator of a firm’s ability to generate superior rates of return during future periods. Stock-price effects of profit margins include both the influences of superior efficiency and/or market power. Because effective R&D can be expected to enhance both current and future profitability, the marginal effect of R&D intensity on Tobin’s q becomes a very conservative estimate of the total short-term plus long-term value of R&D when such impacts are considered in conjunction with the stock-price effects of current net profit margins. Revenue growth will have a positive effect on market values if future investments are expected to earn above-normal rates of return and if growth is an important determinant of these returns. While growth affects the magnitude of anticipated excess returns, a stock-price influence may also be associated with the degree of return stability. Influences of risk are estimated here using stock-price beta. With an increase in risk, the market value of expected returns is anticipated to fall.
A. Explain how any intangible capital effects of R&D intensity can reflect the effects of market power and/or superior efficiency.
B. A multiple regression analysis based upon the data contained in Table revealed the following (t statistics in parentheses):
Q = 1.740 + 0.041 Profit Margin + 0.018 Growth - 0.421 Beta + 0.057 R&D/S
(2.33) (1.74) (0.31) (-1.43) (2.15)
R2 = 41.1%, F statistic = 4.36
Are these results consistent with the idea that R&D gives rise to a type of intangible capital?