Classical Stock Valuation in the Modern Era of Intangibles

The effectiveness of valuation models such as P/B-ROE has deteriorated in tandem with the increasing importance of intangible capital investments, which are not accurately captured by accounting standards. This decline has primarily been driven by companies in high intangible intensity (II) sectors, for which cheaper companies, contrary to expectations, have been more profitable since 1983. The model's efficacy improves dramatically when book values and earnings are adjusted to capitalize intangible investments, especially among high II sectors. However, its efficacy is weaker in that group during periods when intangible spending increases. A negative correlation between sector-specific model effectiveness and the intangible intensities of the corresponding sectors confirms this finding. Our results imply that the effectiveness of the P/B-ROE model can be improved by adjusting book values and earnings for intangible capital expenditures and adapting its use to the intangible intensity of sectors. Further, we find that intangible intensity is positively related to ROE variability and the model is weakest for stocks with the highest ROE variability.