The Stock Market and Investment in the New Economy: Some Tangible Facts and Intangible Fictions

In the Old Economy, the value of a company was mostly in its hard assets—its buildings, machines, and physical equipment. In the New Economy, the value of a company derives more from its intangibles—its human capital, intellectual property, brainpower, and heart. In a market economy, it's no surprise that markets themselves have begun to recognize the potent power of intangibles. It's one reason that net asset values of companies are so often well below their market capitalization.

—Vice President Al Gore, speech at the Microsoft CEO Summit, May 8, 1997

I think there is such an overvaluation of technology stocks that it is absurd . . . and I'd put our company's stock in that category.

—Steve Ballmer, president of Microsoft Corporation,quoted in the Wall Street Journal, p. C1, September 24, 1999

Broadly speaking, there are two opposing views about the relationship between the stock market and the new economy. In one view, expressed in the quotation from Vice President Gore, intangible investment helps explain why companies' market values are so much greater than the values of their tangible assets. In the other view, expressed, ironically, by the president of one of the leading firms in the new economy, stock market valuations have become unhinged from company fundamentals.¹ Whatever the motivations of Gore and Ballmer in making these comments, their perspectives frame the debate about the relationship between the stock market and the new economy.

One way to start thinking about this relationship is in terms of the theory of stock market efficiency. When the stock market is strongly efficient, the market value of a company is, at every instant, equal to its fundamental value, defined as the expected present discounted value of future payments to shareholders. If we abstract from adjustment costs and market power, we can highlight the central role that strong stock market efficiency plays: it equates the company's market value to its enterprise value—that is, the replacement cost of its assets.

However, the most readily available measure of enterprise value in a company's accounts, the book value of tangible assets, is typically just a fraction of the company's market value. For companies in the new economy, book value is an even smaller fraction of market value, because these companies rely more on intangible assets than old economy companies do. Hence, the rest of this enterprise value must come from adjusting for the replacement cost of tangible assets and including intangible assets. When price inflation, economic depreciation, and technical progress are modest, the difference between the replacement cost and the book value of tangible assets is relatively small.² This means that intangibles account for the remaining difference.

Unfortunately, it is difficult to gauge whether intangibles do in fact make up the difference, because they are, by their very nature, difficult to measure. For this reason, the Financial Accounting Standards Board (FASB) calls for a conservative treatment of intangibles: companies must select methods of measurement that yield lower net income, lower assets, and lower shareholders' equity in earlier years than other measures would. Thus expenditures for research and development (R&D), advertising, and the like are expensed rather than treated as assets, even though they are expected to yield future profits.³ The stock market forms an expected value of these future profits, but the assets generating them will never show up on the balance sheet.⁴ Consequently, many researchers argue that the fundamental accounting measurement process of periodically matching costs with revenues is seriously distorted, and that this reduces the informativeness of financial information.⁵

The practical appeal of thinking in terms of strong efficiency is that the purported growth of intangible capital that characterizes the new economy provides a ready explanation for the recent sharp rise in stock prices. Some researchers have even argued that the value of intangible assets can be inferred from the gap between market capitalization and the measured value of tangible assets.⁶ The practical drawback, however, is that this makes the inferred valuation...