Heterogeneity in Intangible Capital, Long-Run Risk, and Return of Research and Development

With the rapid growth of information technology (IT), intangible capital accumulated through investment in Research and Development and other expensed investment becomes an increasingly important component of productive assets. However, under the current U.S. accounting standards, most of the investments in intangible capital are expensed rather than capitalized, which complicates the valuation of corporate securities and assessment of risk and return of investments. We exploit the return heterogeneity of firms with different book-to-market ratios (B/M) and research and development (R&D) expenses to study the nature of intangible capital and find that there exists heterogeneity in the intangible capital in terms of their role in the process of production and risk. Intangible investments include not only R&D expenses (developing intangible capital) to discover new technology but also investments to improve the existing process of production (embodied intangible capital). Embodied-intangible-capital intensive firms invest more aggressively in physical capital, earn a lower expected return, and have lower B/M (higher market value). In contrast, R&D intensive firms tend to invest more in developing intangible capital, and they are riskier, having weaker earnings and lower profitability. Hence, investors demand a higher risk premium for firms with more developing intangible capital