The majority of a firm’s assets, such as inventories or equipment, are physical, and their value can be easily recorded into the books. On the other hand, the firm also owns assets like workforce skill or production methods that are less tangible and have uncertain value. One of the aptest examples of such intangible assets are expenditures on Research & Development.
One of the research papers investigating whether the market appropriately accounts for firms’ expenditures on R&D has been conducted by Chan et al. (1999). In this research, the authors have found that two similar firms, one with significant R&D expenditures and the other with absent R&D, might appear to be equally expensive when considering traditional measures such as price-to-earnings or price-to-book ratios. However, the market tends to underestimate the future opportunities associated with the first firm’s R&D spending relative to the growth opportunities of the second. Simply relating the amount of the past 5 years’ R&D expenditures to the firm’s market equity value, the researchers show that stocks of firms with a high amount of R&D expenditures relative to their Market cap earn greater average returns in the future.

Under the efficient market hypothesis, the investor should be able to recognize the value of less-tangible assets. However, in conditions of an inefficient market, the presence of such intangible assets could possibly lead to mispricing. One of the reasons for possible mispricing lies in the US GAAP and IFRS accounting standards. Under these standards, the costs of R&D must be expensed in the same fiscal year as they occur and therefore could significantly influence the reported earnings of a company in the current year. However, the R&D expenditures usually represent a long-term investment that implies a possible future revenue and cash flow.