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 q-factor model, especially during recent decades. We further find that the value factor is no longer redundant in these empirical factor models. This paper was accepted by Lukas Schmid, finance. Funding: The authors are grateful for financial support from the 2019 EDHEC Scientific Beta “Advanced ESG & Factor Investing” Research Chair. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2022.01261 .