As businesses increasingly invest in innovation, traditional valuation measures may be overlooking an important source of economic value.

Is traditional value investing keeping pace with the modern economy?

Value investing has long been built on a simple principle: identifying companies whose market prices appear cheap relative to their fundamentals. For decades, investors have relied on established valuation metrics, including price-to-earnings (P/E) and price-to-book (P/B) ratios, to identify potentially undervalued businesses from their more expensive peers.

In particular, the P/B ratio has played a key role in shaping traditional value investing. By assessing a company's market value with its accounting book value, the metric provides a standardised measure of how much investors are willing to pay relative to net assets recorded on the balance sheet. In factor-based investing, this principle is applied on a systematic basis by consistently betting on stocks with low P/B ratios and against those with high ratios. Thus, systematically exposing the investor to the value style of investing.

However, as the nature of corporate investment evolves, an increasingly important question emerges: do traditional valuation metrics still adequately reflect the economic resources that generate a company's future earnings?

The changing nature of corporate investment

Historically, businesses derived much of their productive capacity from tangible assets such as factories, machinery and equipment. These investments are often capitalised on balance sheets, allowing their value to be recognised across their useful life, in line with accounting principles such as US GAAP. Today's modern economy, however, is increasingly shaped by a different type of investment. These days companies deploy significant resources towards software development, technological innovation, intellectual property and research. Over time, these intangible assets have generated competitive advantages and profitability for companies, yet their accounting treatment differs considerably from that of tangible assets.

For example, consider NVIDIA, which has spent years investing in research and development (R&D) to advance its graphics processing units (GPUs) and CUDA software platform. First launched in 2006, CUDA allowed developers to use NVIDIA’s graphics chips for much more than just displaying images, opening up new applications in areas like scientific research and artificial intelligence (AI). Although these investments did not initially translate into substantial revenues, they laid the foundations for NVIDIA's leadership in accelerated computing. More recently, as demand for AI has surged, particularly with the emergence of large language models (LLMs), NVIDIA was uniquely positioned to capitalise on years of accumulated technological expertise and intellectual property, converting its earlier R&D investments into a significant driver of the firm’s profitability.

Much of this investment may be classified as R&D, generating knowledge, technologies and intellectual property that can provide economic benefits into the future. Through time, the accumulated value of these investments can be thought of as ‘innovation capital’, representing a stock of technological expertise and intellectual property.

The rise of innovation capital

Over the past two decades, the growing importance of intangible investments, or innovation capital, has fundamentally changed how businesses create value. While physical assets remain essential, particularly amid the rapid expansion of AI infrastructure, an increasing proportion of competitive advantage is derived from assets that are less visible on company balance sheets.

The chart below shows the rising average share of innovation capital as a % of total assets and the ratio of R&D expense to total costs (COGS), across a US Large and Mid-cap equity universe.

As illustrated in the chart, the importance of R&D has grown considerably. Estimated innovation capital has increased from approximately 18% to 32% of total assets, while annual R&D expenditure relative to the cost of goods sold (COGS) has more than doubled, rising from around 3% to over 7%. Together, these trends highlight the growing emphasis businesses place on research and innovation, as well as the increasing contribution of accumulated intangible investment to their asset bases. This shift, therefore, suggests the importance of recognising innovation capital when assessing a company's underlying economic value, particularly as traditional accounting measures may not fully capture these investments.

Revisiting Sector Valuations

Adjusting for innovation capital can alter traditional P/B valuations, with the impact varying across sectors. The chart below compares average P/B ratios before and after incorporating innovation capital. The largest reductions are observed in sectors such as Health Care, Technology and Consumer Staples, where sustained investment in R&D plays an important role in driving long-term value creation. Accounting for these investments therefore makes such sectors appear relatively more attractive from a value perspective.

Meanwhile, sectors such as Energy and Utilities experience minimal adjustments, reflecting their more asset-heavy business models and greater reliance on tangible assets.

Conclusion

As innovation capital continues to play a crucial role in driving corporate value, traditional valuation measures must evolve to reflect the changing nature of the modern economy. Though conventional P/B ratios remain useful, their reliance on reported book equity may overlook the accumulated benefits of years of investment in research and innovation. Therefore, incorporating innovation capital into these measures offers a more comprehensive view of a company's underlying economic value, particularly for asset-light, R&D-intensive businesses. For systematic value investors, this enhances the strategy and better captures the economic resources underpinning future corporate profitability, potentially uncovering value opportunities that conventional metrics may miss.

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Important Information

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