Firms’ Ability To Combine Ideas For Innovation: The Impact On Their Stock Market Value

Some firms are more effective than others at using their own knowledge in combination with ideas from outside to generate innovation. According to research by Professor Sharon Belenzon, these differences between firms are clearly reflected in their stock market valuations.

His study, published in the March 2012 issue of the Economic Journal, analyses data on more than 1,000 US firms that register patents. It finds a strong, positive relationship between measures of effective knowledge recombination and stock market value. The relationship between patent citations and value is stronger in cumulative technology areas, such as telecoms, rather than discrete technology areas, such as drugs.

It is well known that so-called ‘knowledge spillovers’ – the exchange of ideas within and across firms – play a critical role in economic growth. The basic argument is that technological progress is often made by recombining existing ideas in novel and unexpected ways. But because knowledge frequently lies outside the boundaries of the inventing firm, it is important to understand how outside knowledge feeds and interacts with internal research and development (R&D).

Belenzon proposes a new construct of knowledge recombination in the context of sequential innovation, conceptualising new combinations of knowledge as the ability of a firm to combine its past inventions with follow-up external developments. Differences in the ability of firms creatively to reuse their own knowledge with external ideas explain a large part of the cross-firm differences in the value of intangible assets.

Using patent and citation data, Belenzon proposes a new way of measuring the re-absorption of ‘spilled’ knowledge by inventing firms. He distinguishes between two types of citations from outside inventors: internal and external.

Internal citations are made by patents connected to the firm. An example would be Microsoft citing a 2010 Intel patent that cites a 2008 Microsoft patent. In this example, Intel’s follow-up development of the original Microsoft patent is internalised by Microsoft in its later invention. External citations, by contrast, are those that do not feed back into the original inventor’s research programme at any later date.

On the one hand, spillovers encourage innovation by providing the basis for future research. On the other hand, firms don’t want to spawn research that may ultimately undermine their market position or render their own research obsolete.

The prospect of future research undermines the process of knowledge creation in the first place. This effect can be so large as to create a ‘no-growth’ trap where the incentives of early inventors to invest in R&D completely disappear.

Until now, little work has been done to examine whether this negative effect of spillovers may be mitigated. If the inventing firm could re-absorb its spilled knowledge in the future together with subsequent developments made by other inventors, it might be able to escape the no-growth trap and sustain its long-term returns.

Previous research has mostly focused on how private profits from innovation can be shared contractually between early inventors and their followers. The consensus is that explicit agreements between the first and second innovator can be beneficial, because they compensate the early innovator for their losses due to shorter patent life.

But designing and enforcing contracts that would allow enough transfer of profits and eliminate the question of incentives is arguably a very difficult task. Coordination costs, overlapping patent claims (‘thickets’) and hold-up problems are some of those issues.

This difficulty emphasises the need to deepen our understanding of how private rents can be captured by rent-seeking enterprises, especially when inventions are highly dependent on one another. By combining past firm-specific knowledge with outside follow-up developments, the firm can potentially not only mitigate loss of profits by offering new products, but also capitalise on R&D complementarities between its past research efforts and relevant outside developments.

An example that illustrates the relationship between spillovers and private rents to innovation is the Computed Tomography (CT) scanner. The CT technology was invented and patented by EMI. While it was extremely successful and profitable for EMI, it also inspired hundreds of subsequent inventions by firms such as Pfizer, Syntex, Picker and General Electric. A few years later these firms dominated the CT scanner market, forcing EMI out.

The spillovers generated by the original EMI invention were mostly external to EMI, meaning that those spillovers were not useful to EMI. While EMI was responsible for the creation of one of the most influential medical inventions of the 20th century, it lacked the capability needed to follow up its invention with outside discoveries and remain at the technology frontier.

This raises the central question that Belenzon addresses: do firms whose inventions result primarily in external knowledge spillovers have a lower stock market value than firms whose inventions result in more internal knowledge spillover?

In economics, the number of times a patent is cited provides useful information about its importance. Citations are also used to measure knowledge spillovers. Both patent quality and knowledge spillover aspects of citations can help determine the inventing firm’s profits, as well as shed light on the relationship between innovation and firm value.

Belenzon uses information on patent citations to learn about subsequent development of knowledge. Patent citations are a legal instrument used to determine the scope of patent protection. The inventor identifies prior projects that are technically related to the patent application. If patent B cites patent A, that indicates that patent A contains a piece of knowledge on which patent B builds. (Clearly, this piece of knowledge is excluded from the scope of patent B.)

Belenzon uses citations to construct sequences of patents that cite each other. He analyses each sequence to classify patents along the sequence as internal, external or self-citations.

Using data on about 1,200 American patenting firms between 1981 and 1997, he finds a strong, positive relationship between measures of knowledge recombination and stock market value. Specifically, he finds a positive relationship between market value and internal citations, and a negative relationship between market value and external citations.

Increasing the share of internal citations by the sample average and assuming that the change comes from having fewer external citations is associated with an increase in $70 million in market value. Moving from the 10th to the 90th percentile in share of internal citations is associated with an increase of about 10% of firms’ average value.

As one would expect, Belenzon finds a stronger relationship between value and citations in more cumulative, rather than discrete, technology areas – for example, telecommunications versus drugs. Internalisation is less likely to be effective in industries where inventions are more dependent on one another. In such industries, reapplying knowledge has a stronger effect on value.

‘Cumulative Innovation and Market Value: Evidence from Patent Citations’ by Sharon Belenzon is published in the March 2012 issue of the Economic Journal.

Sharon Belenzon

Duke University | +1-919-660-7845 | sharon.belenzon@duke.edu