The Rise of Intangible Investments and the

Implications for Investors

Michael J. Mauboussin
Head of Consilient Research
Counterpoint Global, Morgan Stanley Investment Management
May 2021

FOR PROFESSIONAL CLIENT USE ONLY AND MAY NOT BE USED WITH THE GENERAL PUBLIC.
Agenda

• Measuring intangibles

• Dealing with intangibles – Microsoft case study

• Characteristics of intangible assets

• Implications for investors – understanding

market-expected return on investment

INTANGIBLE INVESTMENTS 2
 Cash Flow Defined

• Volume
• Pricing
Sales

Net Operating
• Expenses Operating
Profit After
• Amortization Margin
Taxes (NOPAT)
• Tax Provision
Cash
• Deferred Taxes
• Tax Shield
Taxes
minus Free Cash Flow
• Accounts Receivable
• Inventories Δ Working
Capital Cash available
• Accounts Payable for distribution to
• Net PP&E Capital all claimholders
Investment
• Leases Expenditures

Acquisitions/
Divestitures

Source: Alfred Rappaport and Michael J. Mauboussin, Expectations Investing: Reading Stock Prices for Better Returns (Boston, MA: Harvard Business School Press, 2001).

INTANGIBLE INVESTMENTS 3
 Intangible investments are expensed on the
income statement versus capitalized on the
balance sheet. Selling, general, and administrative
(SG&A) costs thus conflate investments and
expenses. We want to untangle them.

INTANGIBLE INVESTMENTS 4
Rising Intangible Investment Means More Losses

45

40
Percent of Companies with

35
Negative Net Income

30

25

20

15

10

0
1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020
Source: FactSet.
Note: Constituents of the Russell 3000® Index as of year-end; The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately
98% of the investable U.S. equity market. The Russell 3000 Index is constructed to provide a comprehensive, unbiased, and stable barometer of the broad market and is
completely reconstituted annually to ensure new and growing equities are reflected.

INTANGIBLE INVESTMENTS 5
Tangible to Intangible Investment

Categories of Intangible Assets

Type of legal property that
Broad category Type of investment might be created

Patent, copyright, design intellectual

Software development
property rights (IPR), trademark, other
Computerized information

Database development Copyright, other

R&D Patents, design IPR

Mineral exploration Patents, other

Innovative property Creating entertaining and artistic

Copyright, design IPR
originals

Design and other product

Copyright, design IPR, trademark
development costs
Training Other

Economic competencies Market research and branding Copyright, trademark

Business process re-engineering Patent, copyright, other

Source: Jonathan Haskel and Stian Westlake, Capitalism Without Capital: The Rise of the Intangible Economy (Princeton, NJ: Princeton University Press, 2017), 44.

INTANGIBLE INVESTMENTS 6
Tangible to Intangible Investment

Investment Rates in Assets, as a

Percentage of Private-Sector GDP
18

16
Investment as a Percentage of

Intangible
14
Gross Value Added

12
Tangible
10

2005
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003

2007
2009
2011
2013
2015
2017
Source: Unpublished update to Corrado and Hulten (2010) using methods and sources developed in Corrado and Hao (2013) and in Corrado et al. (2016) and Corrado et al. (2017)
for INTAN-Invest© and the SPINTAN project, respectively. The SPINTAN project was funded by the European Commission FP-7 grant agreement 612774.

INTANGIBLE INVESTMENTS 7
Components of SG&A Costs, 1984-2020

2,000
Intangible
1,800
Investments
1,600
1,400
1,200
$ Billions

1,000
Maintenance
800
SG&A
600
400
200
0
1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020
Source: Based on Luminita Enache and Anup Srivastava, “Should Intangible Investments Be Reported Separately or Commingled with Operating Expenses? New Evidence,”
Management Science, Vol. 64, No. 7, July 2018, 3446-3468. Data extended through 2018 by Anup Srivastava. Includes estimates by Counterpoint Global.
Note: Intangible investments=R&D + Advertising + Investment Main SG&A; Maintenance SG&A=Maintenance Main SG&A.

INTANGIBLE INVESTMENTS 8
Average Composite Intangible Intensity, 1994-2018

Industry Intangible Intensity Rank

Pharmaceuticals, Biotechnology, & Life Sciences 19.9
Software & Services 18.7
Media & Entertainment 18.6
Telecommunication Services 16.6
Health Care Equipment & Services 16.3
Household & Personal Products 14.6
Technology Hardware & Equipment 13.4
Semiconductor & Semiconductor Equipment 12.3
Consumer Services 11.5
Commercial & Professional Services 11.5
Retailing 10.8
Consumer Durables & Apparel 10.1
Food, Beverage, & Tobacco 9.9
Capital Goods 9.0
Automobiles & Components 7.4
Food & Staples Retailing 6.1
Materials 5.9
Transportation 4.8
Energy 4.5
Real Estate 4.1
Utilities 3.8

Source: Amitabh Dugar and Jacob Pozharny, “Equity Investing in the Age of Intangibles,” Financial Analysts Journal, Vol. 77, No. 2, Second Quarter 2021.
Note: An average ranking of U.S. industries over a 25-year period based on several measures of intangible intensity.

INTANGIBLE INVESTMENTS 9
Microsoft’s Free Cash Flow, 2019-2020
($ Billions) 2019 2020
Operating income (EBIT) 43 53
Amortization of intangibles 2 2
Operating lease payments 1 1
EBITA 46 56

Income tax provision 4 9

Deferred taxes 6 (1)
Tax shield 0 0
Cash taxes 11 8

Net Operating Profit after Tax (NOPAT) 35 48

Change in working capital (4) (1)

Additions to property and equipment * 17 19

Depreciation 10 11
Capital expenditures, net 7 8

Acquisitions 2 3

Investment (I) 6 10

Free cash flow 29 38

* = includes assets acquired under capital leases.

Source: Microsoft Corporation.

INTANGIBLE INVESTMENTS 10
Quantifying Microsoft’s Intangible Investments

Intangibles on the Income Statement

Percent
Allocated to Intangible
Item Amount Intangible Investment
Research & Development $19.3 billion 100 $19.3
Sales & Marketing $19.6 70 $13.7
General & Administrative $5.1 20 $1.0
Total $44.0 billion $34.0 billion

Source: Charles R. Hulten, “Decoding Microsoft: Intangible Capital as a Source of Company Growth,” NBER Working Paper 15799, March 2010, Microsoft Corporation.

INTANGIBLE INVESTMENTS 11
Reclassifying Microsoft’s Intangible Investments
Without Adjustments With Adjustments
($ Billions) 2019 2020 ($ Billions) 2019 2020
Operating income (EBIT) 43 53 Operating Income (EBIT) 43 53
Amortization of intangibles 2 2 Amortization of intangibles 2 2
Operating lease payments 1 1 Operating lease payments 1 1
EBITA 46 56 EBITA 46 56
Income tax provision 4 9
Income tax provision 4 9
Deferred taxes 6 (1)
Deferred taxes 6 (1)
Tax shield 0 0
Tax shield 0 0
Cash taxes 11 8 Cash taxes 11 8

Net Operating Profit after Tax (NOPAT) 35 48 NOPAT 35 48

Change in working capital (4) (1) Intangible investment 31 34

Amortization of intangibles 25 27
Additions to property and equipment * 17 19
Intangible investment, net 6 7
Depreciation 10 11
Capital expenditures, net 7 8 Adjusted NOPAT 41 56

Acquisitions 2 3 Change in working capital (4) (1)

Investment (I) 6 10 Additions to property and equipment * 17 19
Free cash flow 29 38 Depreciation 10 11
Capital expenditures, net 7 8
* = includes assets acquired under capital leases.
Acquisitions 2 3
Investment 6 10

Intangible investment 31 34
Amortization of intangibles 25 27
Intangible investment, net 6 7

Adjusted investment 12 17

Free cash flow 29 38

Source: Microsoft Corporation. * = includes assets acquired under capital leases.

INTANGIBLE INVESTMENTS 12
Recalculating Microsoft’s ROIC
($ Billions)
($ Billions)
Operating
Operating Approach
Approach (Traditional)
(Traditional) Operating
Operating Approach
Approach (with
(with Adjustments)
Adjustments)
2019 2020
2019 2020 20192020
2019 2020
Cash
Cash * * 3 3 3 3 Cash
Cash * * 3 3 3 3
Accounts
Accounts receivable,
receivable, netnet 30 30 32 32 Accounts
Accounts receivable,
receivable, netnet 30 30 32 32
Deferred
Deferred income
income taxes
taxes 0 0 0 0 Deferred
Deferred income
income taxes
taxes 0 0 0 0
Inventories
Inventories 2 2 2 2 Inventories
Inventories 2 2 2 2
Other
Other current
current assets
assets 10 10 11 11 Other
Other current
current assets
assets 10 10 11 11
Total
Total current
current assets
assets 44 44 48 48 Total
Total current
current assets
assets 44 44 48 48
- NIBCLs
- NIBCLs 64 64 69 69 - NIBCLs
- NIBCLs 64 64 69 69
NetNet working
working capital
capital (19)(19) (20)(20) NetNet working
working capital
capital (19)(19) (20)(20)
Property
Property andand equipment,
equipment, netnet 36 36 44 44 Property
Property andand equipment,
equipment, netnet 36 36 44 44
Operating
Operating lease
lease right-of-use
right-of-use assets
assets 7 7 9 9 Operating
Operating lease
lease right-of-use
right-of-use assets
assets 7 7 9 9
Goodwill
Goodwill 42 42 43 43 Goodwill
Goodwill 42 42 43 43
Intangible
Intangible assets,
assets, netnet 8 8 7 7 Intangible
Intangible assets,
assets, netnet 8 8 7 7
Other
Other long-term
long-term assets
assets 15 15 13 13 Other
Other long-term
long-term assets
assets 15 15 13 13
Invested
Invested capital
capital 89 89 96 96
Capitalized
Capitalized intangibles,
intangibles, netnet 71 71 78 78

Invested
Invested capital
capital 89 89 96 96 Adjusted
Adjusted invested
invested capital
capital 160160 174174
NOPAT
NOPAT 35 35 48 48 NOPAT
NOPAT 41 41 56 56
Invested
Invested capital
capital (average)
(average) 80 80 92 92 Invested
Invested capital
capital (average)
(average) 148148 167167
ROICROIC 43%43% 52%
52% ROIC
ROIC 27%27% 33%33%
* = *2=percent
2 percent of sales.
of sales.

Source: Microsoft Corporation.

Note: NIBCLs is non-interest-bearing current liabilities.

INTANGIBLE INVESTMENTS 13
Microsoft’s ROIC Before and After Adjustments

600

500

400
Percent

300 ROIC

200

100
Adjusted ROIC
0
2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020
Source: Microsoft and Counterpoint Global.
Note: Invested capital is the average of the current and prior year.

INTANGIBLE INVESTMENTS 14
Characteristics of Intangible Assets – Two Dimensions

• Rivalry: Tangible assets are rival and intangible assets are non-rival
• Excludability: Tangible assets are excludable and intangible assets are
partially excludable

Intangible Tangible

Nonrival Rival
Public Goods Commons Goods
• National defense • Fresh water
Nonexcludable • Intellectual resources • Timber
• Over-the-air TV • Public waterways
• Open-source code • Bike sharing

Club Goods (“Near Public”) Private Goods

• Wi-Fi • Food
Excludable • Cable TV • Clothing
• Patents • House
• Copyrighted computer code • Cars

Source: Paul M. Romer, “Endogenous Technological Change,” Journal of Political Economy, Vol. 98, No. 5, Pt. 2, October 1990, S71-S102.

INTANGIBLE INVESTMENTS 15
Characteristics of Intangible Assets – Four S’s
• Scalability: High upfront costs but low incremental costs (drugs, software, music)
− Network effects (ridesharing, social networks, complementary products)
“A telephone—without a connection at the other end of the line—is not even a toy or scientific
instrument. It is one of the most useless things in the world. Its value depends on the
connection with the other telephone—and increases with the number of connections.”
- American Telephone and Telegraph Company (AT&T), 1908 annual report

• Sunkenness: Tangible assets retain more resale value due to their standardization

$1.3 billion $15 billion $15 million

Source: Jonathan Haskel and Stian Westlake, Capitalism Without Capital: The Rise of the Intangible Economy (Princeton, NJ: Princeton University Press, 2017), 56-88,
Chris6d / CC BY-SA (https://creativecommons.org/licenses/by-sa/4.0), and RadioShack.

INTANGIBLE INVESTMENTS 16
Characteristics of Intangible Assets – Four S’s
• Spillovers: Intangible assets are more easily imitated, but copyrights offer protection

• Synergies: Innovation arises from combining technologies that already exist

Source: Jonathan Haskel and Stian Westlake, Capitalism Without Capital: The Rise of the Intangible Economy (Princeton, NJ: Princeton University Press, 2017), 56-88,
Kirk Goldsberry and Jeff Dahl / CC BY-SA (https://creativecommons.org/licenses/by-sa/4.0).

INTANGIBLE INVESTMENTS 17
Back to Basics

Corporate value = steady-state + present value of growth opportunities (PVGO)

NOPAT PVGO is a function of:

WACC • Return on investment – WACC spread
(how good?)
• Magnitude of investment
(how much?)
• Duration that opportunities to create
value will persist
(how long?)
Source: Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business, Vol. 34, No. 4, October 1961, 411-433.

INTANGIBLE INVESTMENTS 18
PVGO = Corporate Value – Steady-State
Year 1 2 3 4 5 6 7 8 9 10 11

NOPAT 100.0 108.0 116.6 126.0 136.0 146.9 158.7 171.4 185.1 199.9 215.9
Investment 32.0 34.6 37.3 40.3 43.5 47.0 50.8 54.8 59.2 64.0
Free cash flow 68.0 73.4 79.3 85.7 92.5 99.9 107.9 116.5 125.9 135.9

PV of free cash flow 63.6 64.1 64.7 65.3 66.0 66.6 67.2 67.8 68.5 69.1
S PV of free cash flow 662.9

Continuing value 3,084.2

S PV of free cash flow 662.9

PV of continuing value 1,567.8

Corporate value 2,230.8

Steady state = $100 = $1,428.6

.07
Corporate value = $2,230.8

PVGO = $802.2

Source: Counterpoint Global.

Note: Assumes 8% NOPAT growth, 25% ROIIC, 7% cost of capital, and a continuing value using a perpetuity; Σ=sum of.

INTANGIBLE INVESTMENTS 19
PVGO = PV of Inflows – PV of Outflows

Year Base 1 2 3 4 5 6 7 8 9 10 11
NOPAT 100.0 108.0 116.6 126.0 136.0 146.9 158.7 171.4 185.1 199.9 215.9
D NOPAT 8.0 8.6 9.3 10.1 10.9 11.8 12.7 13.7 14.8 16.0 Sum
D NOPAT capitalized 114.3 123.4 133.3 144.0 155.5 167.9 181.4 195.9 211.5 228.5 Inflows
PV D NOPAT capitalized 106.8 107.8 108.8 109.8 110.9 111.9 112.9 114.0 115.1 116.1 1,114.1

S PV of D NOPAT capitalized
Sum
Investment 32.0 34.6 37.3 40.3 43.5 47.0 50.8 54.8 59.2 64.0 Outflows
PV of investment 29.9 30.2 30.5 30.8 31.0 31.3 31.6 31.9 32.2 32.5 312.0

Inflows
- Outflows
=Total SVA
Shareholder value added 76.9 77.6 78.3 79.1 79.8 80.6 81.3 82.1 82.8 83.6 802.2

PVGO = Σ SVA = PV of inflows (NOPAT + Δ continuing value) – PV of outflows

Source: Counterpoint Global.

Note: Assumes 8% NOPAT growth, 25% ROIIC, and 7% cost of capital; Δ=change in; Σ=sum of.

INTANGIBLE INVESTMENTS 20
Market-Expected Return on Investment

Year Base 1 2 3 4 5 6 7 8 9 10
Present value of investments (outflows) discounted at the cost of capital

Investment 32.0 34.6 37.3 40.3 43.5 47.0 50.8 54.8 59.2 64.0
PV of investment 29.9 30.2 30.5 30.8 31.0 31.3 31.6 31.9 32.2 32.5

S PV of Investment 312.0

Present value of NOPAT (inflows) discounted at the MEROI

NOPAT 100.0 108.0 116.6 126.0 136.0 146.9 158.7 171.4 185.1 199.9 215.9
D NOPAT 8.0 8.6 9.3 10.1 10.9 11.8 12.7 13.7 14.8 16.0
D NOPAT capitalized 49.3 53.3 57.5 62.1 67.1 72.5 78.3 84.5 91.3 98.6
PV D NOPAT capitalized 42.4 39.4 36.7 34.1 31.7 29.4 27.3 25.4 23.6 21.9

S PV of D NOPAT capitalized 312.0

Market expected return on investment 16.2%

Market-expected return on investment (MEROI) is the return at which

the PV of inflows equals the PV of outflows

Source: Counterpoint Global.

Note: Assumes 8% NOPAT growth, 25% ROIIC, and 7% cost of capital; Δ=change in; Σ=sum of.

INTANGIBLE INVESTMENTS 21
Discounted Cash Flow Model for Microsoft, FY 2004-2020

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

NOPAT 5.8 10.8 11.3 13.0 16.9 15.6 18.7 23.2 17.4 23.0 23.8 23.6 22.2 23.6 32.9 34.7 47.9 59.5
Investment -0.4 -0.5 -0.2 3.0 6.7 5.4 1.4 0.2 7.5 2.8 3.1 4.9 1.2 34.3 4.4 6.3 10.2
Free cash flow 6.2 11.3 11.5 10.0 10.2 10.2 17.3 23.0 9.9 20.2 20.7 18.7 21.0 -10.7 28.5 28.4 37.7

PV of free cash flow 5.7 9.4 8.8 6.9 6.5 5.9 9.2 11.1 4.4 8.2 7.6 6.3 6.4 -3.0 7.3 6.6 8.0
S PV of free cash flow 115.3

Continuing value 625.4

S PV of free cash flow 115.3

PV of continuing value 133.4
Corporate value 248.7

Plus: cash 62.1

Minus: debt 0.0
Shareholder value 310.8
Shareholder value per share $28.56
Closing price on July 1, 2003 $26.15

Source: Microsoft and Counterpoint Global.

Note: In billions of U.S. dollars; Σ=sum of.

INTANGIBLE INVESTMENTS 22
 MEROI for Microsoft as of Beginning of Fiscal 2004

Year Base 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
NOPAT 5.8 10.8 11.3 13.0 16.9 15.6 18.7 23.2 17.4 23.0 23.8 23.6 22.2 23.6 32.9 34.7 47.9 59.5
D NOPAT 5.0 0.5 1.7 3.9 -1.3 3.1 4.4 -5.8 5.6 0.8 -0.2 -1.4 1.4 9.3 1.8 13.2 11.6 Sum
D NOPAT capitalized 52.1 5.6 17.6 41.5 -13.9 33.0 46.6 -60.7 58.9 8.4 -1.9 -15.1 14.7 97.6 19.3 138.4 122.3 Inflows
PV D NOPAT capitalized 47.5 4.7 13.4 28.8 -8.8 19.1 24.7 -29.3 26.0 3.4 -0.7 -5.1 4.5 27.4 4.9 32.3 26.1 218.9

Sum
Investment -0.4 -0.5 -0.2 3.0 6.7 5.4 1.4 0.2 7.5 2.8 3.1 4.9 1.2 34.3 4.4 6.3 10.2 Outflows
PV of investment -0.4 -0.5 -0.2 2.1 4.3 3.1 0.8 0.1 3.3 1.1 1.1 1.6 0.4 9.6 1.1 1.5 2.2 31.2

Inflows
- Outflows
=Total SVA
Shareholder value added 47.9 5.1 13.6 26.8 -13.1 16.0 23.9 -29.4 22.7 2.3 -1.8 -6.7 4.1 17.7 3.8 30.9 23.9 187.7

Present value of investments (outflows) discounted at the cost of capital

Investment -0.4 -0.5 -0.2 3.0 6.7 5.4 1.4 0.2 7.5 2.8 3.1 4.9 1.2 34.3 4.4 6.3 10.2
PV of investment -0.4 -0.5 -0.2 2.1 4.3 3.1 0.8 0.1 3.3 1.1 1.1 1.6 0.4 9.6 1.1 1.5 2.2

S PV of investment 31.2
Present value of NOPAT (inflows) discounted at the MEROI

NOPAT 5.8 10.8 11.3 13.0 16.9 15.6 18.7 23.2 17.4 23.0 23.8 23.6 22.2 23.6 32.9 34.7 47.9 59.5
D NOPAT 5.0 0.5 1.7 3.9 -1.3 3.1 4.4 -5.8 5.6 0.8 -0.2 -1.4 1.4 9.3 1.8 13.2 11.6
D NOPAT capitalized 18.3 2.0 6.2 14.6 -4.9 11.6 16.4 -21.3 20.7 3.0 -0.7 -5.3 5.2 34.3 6.8 48.7 43.0
PV D NOPAT capitalized 14.4 1.2 3.0 5.6 -1.5 2.8 3.1 -3.1 2.4 0.3 0.0 -0.3 0.2 1.2 0.2 1.1 0.7

S PV of D NOPAT capitalized 31.2

Market expected return on investment 27.1%

Source: Microsoft and Counterpoint Global.

Note: In billions of U.S. dollars; Δ=change in; Σ=sum of.

INTANGIBLE INVESTMENTS 23
 MEROI for Microsoft as of Beginning of Fiscal 2004

Year Base 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
NOPAT 10.6 12.2 12.8 15.3 20.5 17.8 20.0 25.3 19.4 25.9 26.8 26.0 23.1 26.0 37.9 40.6 55.1 59.5
D NOPAT 1.5 0.7 2.4 5.2 -2.6 2.1 5.3 -5.9 6.5 1.0 -0.8 -2.9 2.9 11.9 2.7 14.5 4.4 Sum
D NOPAT capitalized 16.2 6.9 25.7 54.4 -27.5 22.6 55.4 -61.8 68.0 10.3 -8.7 -30.3 30.3 124.8 28.4 152.4 46.4 Inflows
PV D NOPAT capitalized 14.8 5.8 19.6 37.8 -17.5 13.1 29.3 -29.8 30.0 4.2 -3.2 -10.2 9.3 35.0 7.3 35.6 9.9 190.9

Sum
Investment 4.4 0.9 1.3 5.3 10.3 7.6 2.7 2.3 9.5 5.6 6.1 7.3 2.2 36.7 9.4 12.2 17.4 Outflows
PV of investment 4.1 0.7 1.0 3.7 6.5 4.4 1.4 1.1 4.2 2.3 2.3 2.4 0.7 10.3 2.4 2.9 3.7 54.0

Inflows
- Outflows
=Total SVA
Shareholder value added 10.8 5.0 18.6 34.1 -24.0 8.7 27.9 -31.0 25.8 1.9 -5.4 -12.6 8.6 24.7 4.9 32.7 6.2 136.9

Present value of investments (outflows) discounted at the cost of capital

Investment 4.4 0.9 1.3 5.3 10.3 7.6 2.7 2.3 9.5 5.6 6.1 7.3 2.2 36.7 9.4 12.2 17.4
PV of investment 4.1 0.7 1.0 3.7 6.5 4.4 1.4 1.1 4.2 2.3 2.3 2.4 0.7 10.3 2.4 2.9 3.7

S PV of investment 54.0
Present value of NOPAT (inflows) discounted at the MEROI

NOPAT 10.6 12.2 12.8 15.3 20.5 17.8 20.0 25.3 19.4 25.9 26.8 26.0 23.1 26.0 37.9 40.6 55.1 59.5
D NOPAT 1.5 0.7 2.4 5.2 -2.6 2.1 5.3 -5.9 6.5 1.0 -0.8 -2.9 2.9 11.9 2.7 14.5 4.4
D NOPAT capitalized 8.5 3.6 13.5 28.6 -14.5 11.9 29.1 -32.5 35.7 5.4 -4.6 -15.9 15.9 65.6 14.9 80.1 24.4
PV D NOPAT capitalized 7.2 2.6 8.2 14.7 -6.3 4.4 9.1 -8.6 8.0 1.0 -0.7 -2.2 1.8 6.4 1.2 5.6 1.4

S PV of D NOPAT capitalized 54.0

Market expected return on investment 18.1%

Source: Microsoft and Counterpoint Global.

Note: In billions of U.S. dollars; Δ=change in; Σ=sum of.

INTANGIBLE INVESTMENTS 24
Implications for Investors

Earnings Relevance Has Declined

Top Spenders Bottom Spenders

90%
Earnings Relevance (R-Squared)

80%

70%

60%

50%

40%

30%

20%

10%

0%
1950s 1960s 1970s 1980s 1990s 2000-2016

Source: Baruch Lev, “Ending the Accounting-for-Intangibles Status Quo,” European Accounting Review, Vol. 28, No. 4, September 2019, 717.

INTANGIBLE INVESTMENTS 25
Implications for Investors

Returns to the Unadjusted and Adjusted Value Strategy

(Based on Price/Earnings), 1970-2018

Source: Baruch Lev and Anup Srivastava, “Explaining the Recent Failure of Value Investing,” NYU Stern School of Business Working Paper, March 31, 2020.

INTANGIBLE INVESTMENTS 26
 Appendix

INTANGIBLE INVESTMENTS 27
Practical Application

You can estimate the MEROI in three steps:

1. Create a discounted cash flow model that captures the expectations

reflected in a company’s current stock price;

2. Calculate the present value of future investments, including intangibles,

discounted at the cost of capital;

3. Determine the discount rate that equates the present value of the
capitalized annual NOPAT changes with the present value of the future
investments.

INTANGIBLE INVESTMENTS 28
Economic Profit Is the Link Between ROIC and Valuation

Economic profit (EP) = (ROIC–WACC) * Invested Capital

PV of EP + PV of continuing value + invested capital = corporate value

Given the same assumptions, the FCF and EP models produce identical
corporate value

INTANGIBLE INVESTMENTS 29
FCF and Economic Profit Are Equivalent
Free cash flow model
Year 1 2 3 4 5 6 7 8 9 10 11

NOPAT 100.0 108.0 116.6 126.0 136.0 146.9 158.7 171.4 185.1 199.9 215.9
Investment 32.0 34.6 37.3 40.3 43.5 47.0 50.8 54.8 59.2 64.0
Free cash flow 68.0 73.4 79.3 85.7 92.5 99.9 107.9 116.5 125.9 135.9

PV of free cash flow 63.6 64.1 64.7 65.3 66.0 66.6 67.2 67.8 68.5 69.1
S PV of free cash flow 662.9

Continuing value 3,084.2

S PV of free cash flow 662.9

PV of continuing value 1,567.8

Corporate value 2,230.8

Economic profit model

Year 1 2 3 4 5 6 7 8 9 10 11
Beginning capital 1,000.0 1,032.0 1,066.6 1,103.9 1,144.2 1,187.7 1,234.7 1,285.5 1,340.4 1,399.6 1,463.6
Investment 32.0 34.6 37.3 40.3 43.5 47.0 50.8 54.8 59.2 64.0
NOPAT 100.0 108.0 116.6 126.0 136.0 146.9 158.7 171.4 185.1 199.9 215.9
Capital charge 70.0 72.2 74.7 77.3 80.1 83.1 86.4 90.0 93.8 98.0
Economic profit 30.0 35.8 42.0 48.7 56.0 63.8 72.3 81.4 91.3 101.9
PV of EP 28.0 31.2 34.3 37.2 39.9 42.5 45.0 47.4 49.6 51.8
S PV of economic profit 28.0 59.3 93.5 130.7 170.6 213.1 258.1 305.5 355.1 406.9

Continuing value 1,620.6

S PV of economic profit 406.9

PV of continuing value 823.8
Plus: Beginning capital 1,000.0
Corporate value 2,230.8

Source: Counterpoint Global.

Note: Assumes 8% NOPAT growth, 25% ROIIC, and 7% cost of capital; Σ=sum of.

INTANGIBLE INVESTMENTS 30
IRRs Can Be Misleading

A. Simple IRR (One Outflow, One Inflow)

Year 0 1 2 3 4 5
-75.0 0.0 0.0 0.0 0.0 185.5
IRR = 20%
B. IRR with Annual Inflows
Year 0 1 2 3 4 5
-75.0 25.0 25.0 25.0 25.0 25.0
IRR = 20%
C. IRR Assuming Annual Inflows Earn the Cost of Capital
Year 0 1 2 3 4 5
-75.0 0.0 0.0 0.0 0.0 143.8
IRR = 14%

Source: Counterpoint Global.

INTANGIBLE INVESTMENTS 31
Amazon.com

Source: Amazon.com and Counterpoint Global.

INTANGIBLE INVESTMENTS 32
Important Disclosures
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INTANGIBLE INVESTMENTS 33
The Rise of Intangible Investments and the
Implications for Investors

Michael J. Mauboussin
Head of Consilient Research
Counterpoint Global, Morgan Stanley Investment Management
May 2021

FOR PROFESSIONAL CLIENT USE ONLY AND MAY NOT BE USED WITH THE GENERAL PUBLIC.