Great companies invest in innovation. Those that roll the dice on research and development (R&D) tend to generate bigger profits than those that don't. But be careful: the world of R&D is full of questionable spending, uncertain results and payoffs that can be hard to measure. Thus, factoring R&D expenditures into profitability and share valuation is no simple affair. (For background reading, see Buying Into Corporate Research & Development.)

Tutorial: An Introduction To Fundamental Analysis

R&D Spending and Profitability
R&D spending by itself doesn't guarantee profitability and strong stock performance. Some companies see a payoff from spending heavily on R&D when projects are deemed to be successful. On the other hand, companies can also suffer from poor performance losses even after investing a great deal of money each year in R&D.

What investors need to be able to assess is the productivity of R&D dollars. To that end, I would like to introduce an R&D return metric that measures the profitability of a technology company's R&D spending. Known as return on research capital, or RORC, the metric effectively measure the proportion of profits that are generated from R&D spending in a previous period, such as the past year.

It's worthwhile to look around for companies with high RORC. The metric shows whether a firm is profiting from new R&D spending or not. At the same time, it gives investors a sense of whether recent R&D investments are contributing to financial performance or whether the company is just coasting on older innovations.

Calculating RORC
RORC tells us how much gross profit is generated for every dollar of R&D spent in the previous year. The calculation for ROC is very simple: we take the current year's gross profit dollars and divide it by the previous year's R&D expense.

The ratio looks like this:

Current Year Gross Profit
Previous Year R&D Expenditures

The numerator, or gross profit, is normally located on the current year's income statement. Sometimes companies choose not to explicitly state gross profit on their income statement. If that's the case, we can derive gross profit by subtracting cost of goods sold from revenues.

Meanwhile, you will usually find a firm's R&D on the income statement as well, but due to inconsistencies between GAAP and IFRS accounting standards, they can also be capitalized on the balance sheet. Although the two methods converge, there are discrepancies what should be regarded as an expense or an asset.

Using gross profit instead of operating profit or net profit as gross profits, arguably, offers the best representation of the incremental profitability produced by a company's R&D efforts. The calculation also assumes a one-year average investment cycle for R&D. So, last year's R&D expenditure turns into this year's new technology products, producing this year's profits.

Testing RORC
To see how the RORC works as a tool for assessing R&D productivity, let's try it on a couple of well-known technology companies, California-based Apple (Nasdaq:AAPL) and Finland's Nokia Corporation (NYSE:NOK). For each company, we will calculate RORC based on fiscal 2009 gross profit returns from fiscal 2008 R&D expenditures.

According to Apple's 2009 10-K, its 2009 gross margin is $13.14 billion. In its financial statements, Apple offers R&D expenditures for 2009 and the previous two years. In 2008, Apple spent 1.109 billion on R&D. Applying the RORC ratio, you'll see that for every dollar that Apple spent on R&D in 2008, it generated $11.84 in 2009 gross profit.

Apple RORC = $13140 billion
$1.109 billion
=$11.84 Gross Profit Per R&D Dollar

Applying the same methodology using Nokia's 2009 annual report, the consolidated income statement shows that Apple produced gross profit of 13.264 billion euros. The same statement shows that Nokia's 2008 R&D expenditure amounted to 5.968 billion euros. These numbers show that Nokia produced 2.22 euros of gross profit for every euro that it spent on R&D. In March 2009, one euro converted to $1.32.

Nokia RORC = ¬13.264 billion ($17.508 billion)
¬5.968 billion ($7.877 billion)
= ¬2.22 Gross Profit Per R&D Euro ($4.44 Gross Profit Per R&D Dollar)

It's pretty clear that in 2009, Apple's RORC massively outperformed Nokia's for the same period. To explain the difference, you need to understand the significant differences in the two companies' technology businesses.

Apple was able to exploit its R&D across multiple products, each with a distinct end market - Mac desktop and laptop computers, iPod handheld entertainment devices iPhone mobile phones, plus Apple TV products. What's more, Apple technologies were all built to compliment one another. As a result, an R&D investment to, say, enhance the iPhone operating system, benefited its smartphones but also its iPod Touch device. Arguably, Apple's ability to apply fairly concentrated R&D to a broad spectrum of markets is what lay behind the company's very high return on research capital.

Nokia, by contrast, represents an alternative business model. Nokia's R&D efforts were spread across three distinct software operating systems that benefited only a single end market (mobile handsets). So, when Nokia spent an additional R&D euro on a single product, it was only benefiting a subset of its overall handset opportunity, and not all its other handset product markets.

Does the Market Reward a High RORC?
Judging by the 2009 share values of Apple and Nokia, it appears that the market does reward companies that deliver with superior return on research capital. At the end of March 2009, Apple had a share price of about $113. Nokia, meanwhile, traded at about $12 per share. Fifteen months later, Nokia was trading in the $8.50 range, while Apple experienced a rapid push in upward momentum to trade around the $250 mark. The growth that Apple experienced in the aforementioned time period was largely a result of solid innovations and a high return on research capital.

At the end of the day, the productivity of R&D is what drives technology company profits, and ultimately their share prices. RORC offers investors a useful method of tracking technology companies' R&D productivity and also gives investors a clue as to where those companies' share values are headed. (Evaluate the past performance before investing in these types of gadget funds. To learn more, see Technology Sector Funds.)

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