Are S&P 500 firms now 5/6 “dark matter” or intangibles?

Justin Fox started it, and Robin Hanson has a good restatement of the puzzle:

The S&P 500 are five hundred big public firms listed on US exchanges. Imagine that you wanted to create a new firm to compete with one of these big established firms. So you wanted to duplicate that firm’s products, employees, buildings, machines, land, trucks, etc. You’d hire away some key employees and copy their business process, at least as much as you could see and were legally allowed to copy.

Forty years ago the cost to copy such a firm was about 5/6 of the total stock price of that firm. So 1/6 of that stock price represented the value of things you couldn’t easily copy, like patents, customer goodwill, employee goodwill, regulator favoritism, and hard to see features of company methods and culture. Today it costs only 1/6 of the stock price to copy all a firm’s visible items and features that you can legally copy. So today the other 5/6 of the stock price represents the value of all those things you can’t copy.

Check out his list of hypotheses.  Scott Sumner reports:

Here are three reasons that others have pointed to:

1. The growing importance of rents in residential real estate.
2. The vast upsurge in the share of corporate assets that are “intangible.”
3. The huge growth in the complexity of regulation, which favors large firms.

It’s easy enough to see how this discrepancy may have evolved for the tech sector, but for the Starbucks sector of the economy I don’t quite get it.  A big boost in monopoly power can create a larger measured role for accounting intangibles, but Starbucks has plenty of competition, just ask Alex.  Our biggest monopoly problems are schools and hospitals, which do not play a significant role in the S&P 500.

Another hypothesis — not cited by Sumner or Hanson —  is that the difference between book and market value of firms is diverging over time.  That increasing residual gets classified as an intangible, but we are underestimating the value of traditional physical capital, and by more as time passes.

Cowen’s second law (“There is a literature on everything”) now enters, and leads us to Beaver and Ryan (pdf), who study biases in book to market value.  Accounting conservatism, historical cost, expected positive value projects, and inflation all can contribute to a widening gap between book and market value.  They also suggest (published 2000) that overestimations of the return to capital have bearish implications for future returns.  It’s an interesting question when the measured and actual means for returns have to catch up with each other, what predictions this eventual catch-up implies, and whether those predictions have come true.  How much of the growing gap is a “bias component” vs. a “lag component”?  Heady stuff, the follow-up literature is here.

Perhaps most generally, there is Hulten and Hao (pdf):

We find that conventional book value alone explains only 31 percent of the market capitalization of these firms in 2006, and that this increases to 75 percent when our estimates of intangible capital are included.

So some of it really is intangibles, but a big part of the change still may be an accounting residual.  Their paper has excellent examples and numbers, but note they focus on R&D intensive corporations, not all corporations, so their results address less of the entire problem than a quick glance might indicate.  By the way, all this means the American economy (and others too?) has less leverage than the published numbers might otherwise indicate.

Here is a 552 pp. NBER book on all of these issues, I have not read it but it is on its way in the mail.  Try also this Robert E. Hall piece (pdf), he notes a “capital catastrophe” occurred in the mid-1970s, furthermore he considers what rates of capital accumulation might be consistent with a high value for intangible assets.  That piece of the puzzle has to fit together too.  This excellent Baruch Lev paper (pdf) considers some of the accounting issues, and also how mismeasured intangible assets often end up having their value captured by insiders; that is a kind of rent-seeking explanation.  See also his book Intangibles.  Don’t forget the papers of Erik Brynjolfsson on intangibles in the tech world, if I recall correctly he shows that the cross-sectoral predictions line up more or less the way you would expect.  Here is a splat of further references from

I would sum it up this way: measuring intangible values properly shows much of this change in the composition of American corporate assets has been real.  But a significant gap remains, and accounting conventions, based on an increasing gap between book and market value, are a primary contender for explaining what is going on.  In any case, there remain many underexplored angles to this puzzle.

Addendum: I wish to thank @pmarca for a useful Twitter conversation related to this topic.


"Another that the difference between book and market value of firms is diverging over time."

This isn't really a hypothesis, it's closer to a restatement of the fact to be explained. The figures in question (as shown by Fox source from Ocean Tomo) show nothing more or less than the divergence of *tangible* book value and market value over time.

The other thing that is going on is the trend is the trend towards more "goodwill" and other intangibles on the balance sheet, meaning there is also a growing divergence between total book value and tangible book value. This is shown on the following figure:

Thanks for some good links.

'the trend towards more “goodwill” and other intangibles on the balance sheet'

Yep - as particularly indicated in the massive self-generated acquisition bubble that was Worldcom, the asset 'good will' from one acquisition being used as a base to acquire more money for further acquisitions (this was not an accounting scandal, by the way - what sank the company were other problems with their accounting - )

You must need reading that again.

Let's say I buy a house, for $200k. Years later, it's worth $600k, but the governemnt won't let me use that valuation on my accounting. Now, I'd have a net worth of $600k, but a book woth of $200k, and no nebulous "intangible" asset to account for the difference.

It is not the government that sets accounting rule for GAP accounting. It is a private board.

Of course, tax accounting is a different issue.

You can if you die. You will get "stepped up" as you are lowered down.

If only now were 2003 to 2007 . . .

In your example, the house can be an ATM. Run, don't walk, to the bank. Obtain a mortgage loan based on the current market value, say $480K, or about 80% of the $600K market value. Then, repay other debt; buy a BMW, a yacht, or get rich in the stock market . . .

Only now, unlike say 2006, the bank will attempt (through the equivalent of a financial body-cavity search as I endured in 2013) will reasonably assure itself that actually you have the financial capacity to repay the loan per contract terms.


Bring back mark to market!

I had this same thought. I think Tyler meant to say the measurement error of what book value is attempting to measure increasing.

Doesn't this mean we're in a huge stock market bubble, maybe the biggest bubble of all time?

No, it doesn't mean that we are in a bubble. Then again, there is no proof that we are not.

Conservatism has been one of the most studied phenomena in accounting, especially since Basu (1997) brought the issue of conditional vs. unconditional conservatism to the fore. Briefly, unconditional conservatism is the practice of simply expensing certain capital expenditures immediately due to the difficulty involved in systematic allocation their costs to future periods in a meaningful way (e.g. most R&D and advertising), or of recording and maintaining other assets, such as land, at cost rather than their fair value. Conditional conservatism relates to asymmetry in the timeliness of the recognition of gains and losses. Losses are recognized as soon as they can be reasonably estimated, where as gains are often not recognized until they have been realized.

There is an ideological battle amongst financial accountants over conservatism, with increasingly many in favor of increased use of fair value accounting and against both conversationally and unconditionally conservative reporting. However, there is far more support for decreases in unconditionally conservative reporting, while many still argue that conditionally conservative reporting enhances the information value of accounting and the "quality" of reporting.

Goodwill is a product of M&A activity. The adoption of SFAS 142 significantly increased the conditional conservatism of goodwill accounting under US GAAP, but may have somewhat decreased the total conservatism of goodwill reporting. Any comparisons of accounting from before and after its adoption in 2001 need to consider its effects.

Further, firms have shown an increasing preference for off-balance-sheet arrangements such as operating leases, and for splits of firms into asset holding companies and operating firms, such as sale-lease-back of hotel properties between hotel chains and REITs.

As Tyler notes, this is a complex phenomenon with aspects that are real and others that are artifacts of accounting and finance policy. Don't look for simple explanations.

Thanks, informative post.

How much of it is tax policy driven? Off balance sheet schemes such as spin off and lease back are a way around depreciation rates.

GAAP no longer includes the conservatism principle or modifying convention. Instead, GAAP determinations are driven by the "most reasonable" and supportable approach or estimate of value.

GAAS external audit standards require value estimate calculations not only to be understood by the auditor, but valuation assumptiions, estimates, forecasts need to be critically reviewed by auditors and adjusted if assumptions, etc. were unresasonably optimistic/high or pessimistic/low.

Simply stated the "conservatism" principle was the modifying convention to select the accounting alternative that was least likely to overstate net assets (asset – liabilities) and/or net income.

The very low interest rates and high liquidity brought to market in leveraged lending may be additional factors in the years of rising PE's.

I'm no expert on this, but isn't what we are talking about the difference in value of a business (actual following a takeover or theoretical as if it were to be taken over) and the value of all its productive assets? The remainder is goodwill, aka brand value. It only comes into being because prospective buyers of the company will it into existence, in other words, pay more for an existing player than it would cost to build all the company.

If it's not a bubble, then it does not look like a good sign. It seems to say "cash cow", lack of alternative investment (real estate, startups or fortune 500 dinosaurs - or else China/Inda) and a legal framework or business environment that is not encouraging new ideas. Plus you have the US economy relying on brand rather than productive power or innovation. Sounds like a coyote moment.

The federal government is less enthusiastic about enforcing antitrust laws than in the 1970s or even 1980s. For example, the domestic airline industry has recently been cartelized without much complaint:

At a basic level, what this seems to show is what the strategy literature has been arguing since the late 1980s: i.e. the resource-based view. I.e., the immobility and imperfect replicability of valuable "resources".

Account measures of assets is only going to provide you a small part of what creates value in a firm. If those assets can be copied by others, then they are less likely to provide competitive advantage, and hence won't show up in stock prices. It's the way they are bundled together, how they are managed, and how they complement each other; that it is the hard part to replicate. Intangibles in themselves aren't "dark matter" either. But they are relatively harder to replicate.

And they aren't just things like "R&D" or "brand". Lots of other things that are hard to observe and harder to replicate, like network positions, alliances, competencies in human capital recruitment and many others.

I.e., strategy matters. Not simply the stock of assets.

Is it likely that this matters more now than 30 years ago? Yes, it is. For two reasons I'd say:
1) The more high tech and knowledge based competition becomes, the greater the "ambiguity" of how resources interact inside a firm to create competitive advantage.

2) Analyst coverage and institutional ownership has also increased during this period, which allows for better valuation of more "unique" firm strategies (i.e. how these firms actually utilize the assets).

I expect this is probably a big part of the explanation.

or law firms that hire well connected elites.

'Our biggest monopoly problems are schools and hospitals'

Such a subtle dig at the Catholic Church.

How? Do Catholic schools enroll more than about 6% of the primary and secondary students in the country?

we are going2 miss some of them schools and hospitals, aye, but good 2c that they're still out there --- for all their foibles, much good done there .

teach u the principles and take care of u, wtf else u want?

i m tired of ranking on teachers. i m a teacher2 ~jebbie

the ying & yang of things, the presumed dialectical . . . , gets old. there's margins you know.

A certain "Steve" at TheMoneyIlusion wrote the definite comment on this topic, so good I cut and paste it to my facts log in my hard drive, and repeated below. Expert opinion laying waste to mere amateurs stumbling about to find the truth, akin to a master reviewing a chess position vs a non-master. - RL

Steve 5. April 2015 at 11:59

“Off topic, Robin Hanson has an excellent post discussing a graph on intangible corporate assets, which played a role in my recent post on how regulation may be increasing inequality.”

This is a fascinating topic, but I’ve found when economists do a top down analysis of intangibles it usually becomes a political Rorschach test, i.e., republicans see gov’t regulation, and democrats see corporate monopoly.

I would humbly suggest the best way to understand this issue is to pick a collection of companies, bottom up, attempt to value them, and then try to reconcile the valuation to the accounting statement.

I think what you will find is an unsatisfying collection of reasons for the growth of intangible value.

A big portion of the gap is caused by an accounting profession that has gone awry. You will see writedowns of ‘impaired’ assets, but no writeups of appreciated assets (especially in energy and finance). You will see R&D (in tech and health) and SG&A (branding consumer) that is expensed rather than capitalized. And you will see lots of real estate assets that are not just held at historic cost, but also depreciated to zero, and then leveraged to a negative by debt financed share repurchase. This is true even in real estate companies, and isn’t driven by land values.

Of course you will also see a fair amount oligopoly power, e.g., Boeing and Intel, and a fair amount of network effects, e.g., Apple and Facebook, and a fair amount of IP value, e.g., Pfizer or Disney.

Finally, a significant amount of the value gap is the result of inflation and assets held at historic cost. You would think this would show up in the 1970s, but it actually showed up mostly in the 1990s since valuations fell during high inflation and recovered when inflation fell.

If you want to do a study disentangling all these different effects, more power to you. Unfortunately, as I said before, most economists take a top down view and end up with a political Rorschach test.

Dear Tyler,
Thank you for the immensely valuable public good that is your consistently fascinating blog.

In case it is of interest to you readers, here are some links to some macro work that follows from the NBER volume that you have linked to. This work does not try to solve the market value/book value puzzle, but attempts to use national accounts conventions that are used for measuring intangibles such as software, R&D and artistic originals to measure other intangibles such as design, branding and firm training.

Carol Corrado & Jonathan Haskel & Cecilia Jona-Lasinio & Massimiliano Iommi, 2013. "Innovation and intangible investment in Europe, Japan, and the United States," Oxford Review of Economic Policy, Oxford University Press, vol. 29(2), pages 261-286, SUMMER.

To try to answer some of the fascinating points raised in your blog here are some comments:

1. the way to think about Starbucks, is, I think, via branding: that would seem a strong source of their intangible advantage. I suspect also something around "organisational capital" i.e. their knowledge of business process is important for them and many other franchise chains.

2. more generally, I don't see intangibles as merely confined to hi-tech, since intangibles is more than software and R&D. I see intangibles as a story about understanding investment in innovation in the service sector, a sector that does very little R&D.

Jonathan Haskel

Very interesting, thanks.

Your point number 2 is similar to what I was trying to get at on my recent blog post on this topic:

On point 2 an increasingly important intangible for both high tech businesses and businesses like Starbucks is tax minimisation strategies/structures.

No puzzle at all. It's one of the side effects of outsourcing.

More questions?

Book value?

You must be kidding.

Facebook acquires WhatsApp for $22 billion, adding almost all of the price to intangibles and increasing Facebook's cap by almost the same amount (i.e., little dilution). Who's kidding whom? Do companies make such acquisitions because they actually contribute "value" to the acquiring company or do they do it simply because they can (again, little or no dilution)? As I've commented many times, in the future people will look back on this era (the Silicon Valley era) in dismay: what were they thinking!

This reminds me of a question I'm sometimes asked about doctors (I represent many): why do older doctors have affairs with pretty young nurses and techs who work at the hospital? Because they can.

WhatsApp seems a particularly pure example of network effects. The WhatsApp technology could be replicated by a small team at a competent competitor for, say, a couple million $$ max (and probably much less). And it doesn't cost much to run (reportedly there were just a few dozen employees when it was acquired). And it's not even especially *good* tech. Your account is tied to a single phone and, until recently, couldn't be used on any other devices. Now you can access from the web, too, but only if your phone is simultaneously logged into the system -- which is a weird limitation that messaging apps don't have. There's not even any voice or video calling feature available yet (which, of course, other messaging clients have had forever). The $1/year subscription model seems like a stroke of genius (it doesn't sound like anything until you account for hundreds of millions of users, and then the revenue stream + growth actually almost starts to support the $22 billion valuation). But that strategy was kind of an accident -- it was adopted for other reasons.

It was an all stock deal. Leave aside the dollar value and ask whether it was worth X percentage of Facebook for them to control the only app in the world that comes even close to the same size user base as Facebook has. Competitively speaking it was not an outlandish deal.

This would be a good question to ask of someone who makes a living from buying and selling companies, like Warren Buffet and Charlie Munger. They grew up on Benjamin Graham's idea of value investing, which initially aimed to buy stocks where the price was less than book value. His original edition of Security Analysis came out in 1934, so that strategy was not a ridiculous idea at the time. Things have changed over 80 years since then, so this phenomenon (large fraction of intangibles) has not occurred overnight.

If the total value of a company were made up of tangible assets, it would be straightforward to replicate it by buying those assets. Why does one business succeed and a very similar business fail? Look at small businesses. Many come and go, but some endure, even in the face of competition by large entities. I see local hardware stores continue generation after generation, with Lowes and Home Depot within easy driving distance. The intangibles, such as the business acumen of management, hiring practices that result in good employees, must be a large part of a company's value. As David notes above, accounting measurements are not so precise, driven by inherent conservatism.

Wouldn't an investor get a juicy return by replicating Apple? Its price to book value is about 6, and it has been below 3 in the last 5 years. But Apple gets a lot of its value by being unique. Two Apples just wouldn't cut it - which Apple would the techno-snob buy?

I think Buffett would find this whole conversation pretty silly.

"Our subsidiaries spent a record $15 billion on plant and equipment during 2014, well over twice their depreciation charges. About 90% of that money was spent in the United States. Though we will always invest abroad as well, the mother lode of opportunities runs through America. The treasures that have been uncovered up to now are dwarfed by those still untapped."

Thank you Brian; I haven't read the BH report in the last few years. A quick scan shows that there is a large gap between book and market value of BH. I don't know if WB has an explanation, but I will look. If you can point me to a specific explanation, I would appreciate it.

Thanks, I've long wondered why when Home Depot and Loews entered New England that it was the regional firms that lost rather than the local mom & pop hardware stores.

...and you still don't know

In 2011, "There is a literature on everything" was Cowen's first law:

I admit Cowen's second law has a nicer ring to it, but it's a little late.

the literature sucks on almost everything

I believe Edward Prescott has argued for the importance of intangible investment and capital in a number of papers.

Such investment has been a driver of economic growth, and GDP and investment have been understated for that reason.

Also, he argued that the stock market was not overvalued in 1929 or 1999; high valuations were supported by a high value of intangible capital.

by Tyler Cowen on June 27, 2011 at 9:15 am in Economics, Education | Permalink
Cowen’s First Law: There is a literature on everything.
So is it the 1st or 2nd law? How many are they and what are they?

"Cargo cult" business management.

If we build something that externally looks like Google, it should generate lots of profit.

Google has "intangibles" on its balance sheet for $4.6B - a little more than 1% of its market cap.

Book value Market value because if it did, there would be nothing for accountants to do. Well, not quite, they could still provide cashflow statements which would be useful, but neither balance sheets nor income statements are very useful any more to valuing corporations. The reason (IMHO) is that the accounting profession over the years have bent to the call of special pleadings by all manner of companis that one-size-fits-all accounting won't work, so that GAAP needs to "evolve" to cover special circumstances. At that point, companies can pick and choose parts of GAAP to make their companies loook as good as possible -- if asset-light, look like you have a lot of revenue. If revenue light, show pro forma profits, etc. etc. Once the accounting profession is captured, their statements, while accurate, are not informative. At that point there's a disconnect between what they do and market value.

Apparently I couldn't add angle brackets for "is not equal to." The previous post should begin "Book Value is not equal to market value because...."

About half of the S&P 500's constituent stocks by weight are in three sectors: IT, Health Care and Consumer Discretionary. I don't have the data in front of me but it was almost certainly very different with more weight given to heavy industry forty years ago. IT, health (think pharmaceuticals, especially), and consumer discretionary are notable because the "assets" of companies in this sector are notoriously difficult to value. Companies in these sectors depend on name brands, intellectual property, trade secrets, and, in IT, the hazy quality of getting the most skilled people in the industry to be devoted to you in exchange for generous stock options. That and strong-arming them into signing non-competition agreements.

I don't think Sumner's brand reason is stated strongly enough. Building a household brand these days is very difficult. Fractured media, thanks to the exposition in choices of channels and digital content, makes it very, very hard to reach a significant share of the US population for a reasonable price.

Walking through the grocery store or mall, there are very few brands which have been created since the internet went mainstream. Ones which have succeeded are generally media brands themselves (Google, Facebook), build events rather than advertising (Red Bull), or are built atop brands which existed prior to the internet emergence ( Dr. Dre).

To replicate an S&P 500 brand would take years of very skilled media planning and shrewd, licensed relationships with existing brands. And even then: it's kind of a crap shoot.

widening gap between book and market value

"This time it's different."

Could part of this just be a difference in accounting? Didn't the rules around amortization change quite a bit during the mid 2000s? Maybe companies have been more aggressively amortizing their physical assets, but they can't very much count those in book value. So you buy a truck for 100k and amortize 50% in year 1 (you can't amortize as aggressively after that) and you make 50k from the truck's output. Now book value after this year is completely flat, but maybe sophisticated financial investors understand better what's happening?

I know that amazon has managed to grow book value quite a bit over time even though they have most of their assets in computer and technology which has a very fast amortization schedule, but possible that these things are providing them value for longer than these values suggest?

File under "markets in nothing"?

Tyler, with regards to your point on the American economy being less levered than it appears on paper - this could be true. A reasonably switched on accountant will be able to talk to certain items, primarily 'loans' or 'borrowings' not attributable to a bank, that appear on the balance sheets of companies that reduce net assets, but really should be eliminated on consolidation. Most relate to offshore entities. All you need to look at is the amount of cash holdings by American companies that are based in a foreign jurisdiction. It's at an all-time high in nominal value and as a portion of gross cash holdings. Even if you do see a 'bank' loan - some of these 'loans' are simply the matching deposits of the ultimate holding company in a foreign jurisdiction - it's a loan from the holding company to the bank who loans it to the subsidiary on the parent entity's behalf. So the real net debt position of the S&P 500 is a mirage - that's why they have due diligence processes. Free cash flow compared to the cost of capital is probably a better proxy.

However, in terms of the build up of the 'unattributable' value of companies on the S&P 500, consideration should be given to the impact of QE and, as Stanley Druckenmiller puts it, the shift of money into assets that would otherwise have a lower strike price if not for the purchases of MBS and long dated government bonds by the Federal Reserve. This has effectively shifted the supply curve of invest-able assets to the left (for all entities that invest savings excluding the Federal Reserve), increasing the price of the remaining pool of assets. The quality and performance of those assets could worsen and they would still have a higher price with the amount of QE created by the Federal Reserve. Once QE stops, the stocks should re-price and close the gap between book value and market value.

I'll say it again: this doesn't seem anything more than the statement "strategy matters". Seems like people weren't paying attention in their MBA classes.

The whole point of firms is to compete on the basis of what is "unobservable" and "irreplicable". If all they did was compete on the book value of "assets", then there'd be nothing for managers to do. All you would need is to gather more "valuable assets", and then you win in competition.

But why doesn't Delta Airlines out-compete Southwest? It has a much bigger fleet of airlines and other tangible resources.

Why does Southwest enjoy 62,000% growth over its history compared to Delta's 99% growth? If all they had were a fleet of airplanes, hangars, mechanics and pilots...there should be no difference between them. What else does Southwest do to out-compete Delta and other airlines? does a lot of other stuff that can't be captured in the book value of its assets.

And it does a lot of stuff that Delta can't replicate. Either because it can't figure out how Southwest does it, or because Southwest has a first-mover advantage, or because Delta is actually tied down by it's assets which can't be redeployed in the same way as Southwest.

I.e....if strategy matters...managers matter! Why do top managers get paid so much? This is why!

So I don't see the "puzzle" here. This is what is taught in Strategy 101 in any MBA program.

+1 Economists don't take accounting or get MBA's

Another view from "on the ground":

- The big issue here is with the methodology, (market cap - tangible book value) which is extremely sensitive to equity valuations. The graph starts at a point (1973) when equity valuations were at their lowest in decades. Buffett in 1977 wrote that the DJIA P/B was 2.3x in 1965, and went as low 0.84x in 1974.

The implication is that if we started this analysis in 1965 instead of 1975, we would have found the market was 57% "dark matter" in 1965 ((2.3-1)/2.3), before declining to -19% dark matter at the market bottom in 1974, and now we're at 60%-85% in 1995-2015. Now it looks like we have an anomaly in the 1970s instead of a steady rise.

- In that same article ("How Inflation Swindles The Equity Investor"), Buffett argues that a meaningful portion of this decline was a reaction to rising inflation, which acted as a massive stealth tax hike on income from capital. It should have been no surprise that the market value of stocks and bonds tanked during this time period, and recovered in the 1980s and 1990s when inflation subsided.

- Also, some of this decline was probably irrational, and the stock market didn't reflect the price at which assets were changing hands when sold whole. Again, Buffett was buying the Washington Post in 1973 at 20% of the price that newspapers and TV stations were being sold whole. Similarly, in 2009, it was possible to buy pieces of companies (stocks) cheaply, but very few whole companies changed hands at low values.

- Investors don't focus as much on book value anymore, so the accounting authorities aren't that interested when it is understated. When companies capitalize expenses, they raise book value to a more accurate level but also inflate current earnings. Since investors today focus mostly on earnings, accountants want to make sure companies don't have too much latitude to inflate it. For example, recall AOL a couple of decades ago improperly capitalizing marketing expenses. So, conservatism causes book value to be very deflated.

- Many types of intangible assets are similar in economic substance to tangible assets. R&D has been cited - it doesn't usually get capitalized but it is very real, and no one would argue that startup biotech firms today are reaping monopoly rents, for example. I recall that pharma analysts would usually go back and capitalize R&D to give a sense for true historical returns on capital, and by the mid-00s, the big pharma companies were trading at a discount to "adjusted book", because their returns lately had been so poor. Of course, since R&D isn't capitalized, they were trading at huge premiums to reported book.

Marketing is less cited, but it has similar economic characteristics. If Coke stopped spending $3.5bn a year on advertising, profits would probably decline over time. If DirecTV stopped spending $3bn a year on subscriber acquisition, the company would surely disappear in just a few years. Same for Verizon, or any number of consumer-facing businesses. If we capitalized marketing, we would add tens of billions to book value for these companies. There are very good reasons we don't allow companies to capitalize marketing, but in the analysis we're doing here it's important to keep in mind.

- I think a big piece of the residual can be chalked up to the growing amount of debt, which confounds this type of analysis. Lots of huge companies now have zero or negative tangible book value (like Coke or DirecTV), but that's mostly a result of debt. If you add debt to the the numerator and denominator, you get a very different ratio of "dark matter". Like for example, DirecTV has tangible book of -$10B today but a market value of $43B. if we add back their $20B of debt, that's tangible book of $10B vs market value of $63B. So that's 84% dark matter instead of 123%. And if we go a step further and capitalize marketing, we get a much lower ratio than 84%.

I don't think the adjustment Robin Hanson did completely captures it either, because it looks like he's using the evolution of debt/equity instead of the evolution of debt/tangible equity. There's a widening gap between equity and tangible equity over time because of purchase accounting rules, since purchase accounting should account for the most of the goodwill and intangibles found on corporate balance sheets today and we no longer allow for pooling.

- The main takeaway is that since investors have de-emphasized book value in most industries, book value has become a worse and more inconsistent measure of value. Who is going to complain that a metric no one looks at is misstated?

- The industries that come to mind where book value is emphasized are banks, brokers, and insurance companies, and as a whole they trade at a much lower P/B multiple than they did before the financial crisis.

Excellent comment.

If you take a different view on what prices mean (equalizing information rather than value) then this dark matter puzzle may only be selection bias (a larger economy represented by relatively fixed-size stock index where the largest and most sustained growth companies end up traded on exchanges or listed in the S&P500):

"Forty years ago the cost to copy such a firm was about 5/6 of the total stock price of that firm. So 1/6 of that stock price represented the value of things you couldn’t easily copy, like patents, customer goodwill, employee goodwill, regulator favoritism, and hard to see features of company methods and culture. Today it costs only 1/6 of the stock price to copy all a firm’s visible items and features that you can legally copy."

Well that's a startingly daft misinterpretation of what market cap minus tangible book value means.

"Forty years ago the cost to copy such a firm was about 5/6 of the total stock price of that firm. So 1/6 of that stock price represented the value of things you couldn’t easily copy, like patents, customer goodwill, employee goodwill, regulator favoritism, and hard to see features of company methods and culture. Today it costs only 1/6 of the stock price to copy all a firm’s visible items and features that you can legally copy."


Well, I can't really improve on Tom's response. This is... this is not good. I'm leaving now.

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