A firm’s financial statement comprises two distinct types of assets. Tangible assets are mostly physical in nature, and include vehicles, land, plants, equipment, and furniture, as well as financial assets like stocks, bonds, account receivables, and cash which have a concrete contractual value. On the other hand, intangible assets aren’t physical. They include patents, copyrights, trademarks, goodwill, brand value, human capital, R&D, software, and data. Intangibles do have a monetary value since they represent future potential revenue, but they’re more difficult to value because, unlike tangibles, their costs and market values are hard to determine.
The economic value of intangible assets has truly exploded over the past several decades. According to a 2019 research report , the overall value of the S&P 500 in 1975 was $715 billion, of which 17% was intangible. By 1995, intangibles had risen to 68% of a $4.6 trillion S&P value. The value of intangibles continued to climb in our 21st century digital economy, reaching 84% of the $25 trillion overall S&P value in 2018. The reason for this fast rising valuations is that intangible capabilities are a major source of a company’s long-term competitive strengths, and are generally quite complex to build and replicate. Yet, conventional accounting treats these capabilities not as company investments but as expenses, which means that their funding isn’t reflected as capital on balance sheets.
“For digitally-focused firms, investments in the intangible assets needed to realize value from new technologies – like cumulative investment in skills training, new decision-making structures within the firm, management practices, and software customization – often account for significantly greater total costs than the technologies themselves,” notes Digital Capital and Superstar Firms, an NBER working paper published in December, 2020.
The paper is focused on the digital capital that’s required to create value out of a company’s investments in hardware, software, and other IT assets that are recorded as tangible capital investments on a company’s financial statement. It introduces a set of methods for quantifying the value of digital capital investments, as well as their impact on a company’s long term productivity and growth.
In the industrial economy of the 19th and 20th centuries, the largest companies by market cap were mostly based on manufacturing and oil extraction, - with IBM, Exxon Mobil, Procter & Gamble, GE and 3M the five largest in 1975. But, more recently, so-called superstar firms have achieved their market caps mostly based on their digital assets, - with Apple, Alphabet, Microsoft, Amazon, and Facebook the five largest in 2018. Raw materials, physical plants and inventory are far less of a factor today compared with the ability to achieve economies of scale and network effects through investments in digital capital.
Two of the NBER paper co-authors, Erik Brynjolfsson and Daniel Rock, were also co-authors of a related 2018 paper that nicely explains how digital capital investments complement investments in general purpose technologies like IT. General purpose technologies “are the defining technologies of their times and can radically change the economic environment. They have great potential from the outset, but realizing that potential requires larger intangible and often unmeasured investments and a fundamental rethinking of the organization of production itself.”
As we’ve learned over the past two centuries, there’s generally been a significant time lag between the broad acceptance of a major new technology and its ensuing impact on companies, governments and other institutions. Even after reaching a tipping point of market acceptance, it takes considerable time, - often decades, - for these new technologies and business models to be widely embraced across economies and societies, - and for their full benefits to be realized.
The reason is that is that the life cycle of such historically transformative technologies is composed of two distinct periods, investment and harvesting. Since these technologies are general purpose in nature, they require massive complementary investments, such as business process redesign, co-invention of new products and business models, and the re-skilling of the workforce. Moreover, the more transformative the technologies, the longer it takes for them to reach the harvesting phase when they are widely embraced by companies and industries across the economy. The decades-long time lags between the investment and harvesting periods has led to a kind of productivity paradox that’s puzzled economists seeking to reconcile exciting technological breakthroughs with slow near- and mid-term productivity growth.
For example, US labor productivity grew at only 1.5% between 1973 and 1995. This period of slow productivity coincided with the rapid growth in the use of IT in business, giving rise to the Solow productivity paradox, a reference to Nobel Prize MIT economist Robert Solow's 1987 quip: “You can see the computer age everywhere but in the productivity statistics.” But, starting in the mid 1990s, US labor productivity surged to over 2.5%, as Internet-based applications and business process re-engineering helped to spread productivity-enhancing digital capital across firms and the economy. Similarly, productivity growth did not increase until 40 years after the introduction of electric power in the early 1880s, because It took until the 1920s for companies to figure out how to restructure their factories to take advantage of electric power with new manufacturing innovations like the assembly line.
Given their intangible nature, how can you measure the digital capital investments made by different firms across industries and regions? Since the development of digital capital requires that firms invest in the human capital that’s required to create value from their IT systems, the 2020 NBER paper used LinkedIn profiles to track the employment of IT workers by individual firms between 1987 and 2016, - making a number of adjustments to account for sampling differences across occupations, regions, and industries. This made it possible to link the value derived by individual firms from their digital capital investments to economic outcomes such as productivity and growth, and revealed four important facts about the impact of digital capital:
- The market value of digital capital varied significantly over time, rising sharply during the dot-com boom of the late 1990s and then falling in the subsequent dot-com bust of the early 2000s.
- The value of digital capital began to rise again around 2010 with the introduction of new IT innovations like mobile devices, cloud computing, big data, data science and AI. With the exception of the dot-com period, digital capital has been rising steadily and substantially over the nearly 30 years (1987-2016) analyzed, and now account for over 25% of the value of a firms’ assets.
- Digital capital has grown disproportionately in a small subset of global superstar firms, which the paper defines as those in the top decile of its sample data based on market value. Superstar firms are increasingly pulling away from the rest in their digital capital accumulation but not nearly as much in their concentration of physical assets.
- Digital capital accumulation is a good predictor of a firm’s productivity about three years in the future, growing larger over longer time periods. The contribution of digital capital to a firm’s growth is approximately double that of its stock of IT capital.
“One interpretation of our findings is that translating organizational innovations into productive capital requires significant investment in organizational re-engineering and skill development,” notes the paper in conclusion. “Therefore, even if firms have the appropriate absorptive capacity, knowledge of how to construct digital assets will not automatically generate productive digital capital any more than access to the blueprints of a competitor’s plant will directly lead to productive capacity.”
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