Intangible Capital in Factor Models

Abstract

The transition from a traditional manufacturing-based economy to a knowledge- and service-based economy over recent decades resulted in a considerable rise in intangible capital, most of which is not reported on companies’ balance sheets. As a result, balance-sheet-based valuation ratios, investment measures, and other firm characteristics that do not incorporate off-balance-sheet (OBS) intangible capital suffer from significant measurement error problems. We incorporate a new measure of OBS intangible capital into firm characteristics such as book-to-market, investment, and profitability to address these measurement errors. These OBS intangible adjustments improve the performance of the Fama-French three- and five-factor models and the Hou, Xue, and Zhang (2015) model, especially during recent decades. We further find that the value factor is no longer redundant in empirical factor models based on the Fama and French (2015) and Hou, Xue, and Zhang (2015) frameworks.

Keywords: Intangible Investment/Capital, Factors, Factor Models

JEL Classification: G10, G11, G31, G32, O30, O34