Research and development (R&D) is fundamental to a company's long-term success: R&D fuels new products, market share, high margins and rates of growth. In hard times, however, companies can be tempted to cut back on the expenses devoted to the scientific and technological work that underlie new products, processes and services - these expenditures can be among the most capital intensive part of a company's cost structure. But investors should take note: firms that cut R&D too much are in danger of saving today to the detriment of growth tomorrow.

Importance of R&D
Granted, in an economic downturn fewer products are sold as the demand for them weakens, so some overall cost cutting makes sense. But investors should recognize that when the cycle turns upward, companies with new products coming out of the development pipeline are better positioned to profit than those companies that slashed R&D in the previous recession. In addition, big R&D budgets are normally an indicator of ample financial resources, so a telling sign of a company in trouble is earnings growth through severe cuts in R&D.

R&D isn't just important for high-tech industries. Consider Procter & Gamble's leadership in detergents and disposable diapers, or Gillette's edge in shaving. Putting a premium on real growth rather than trying to boost earnings through cost cutting, each of these two companies rose to the top on the strength of R&D investments that rival those of any Silicon Valley firm.

That said, R&D by itself doesn't guarantee a good investment. Some companies see a payoff from spending heavily on R&D. Apple Computer, for instance, devoted large amounts to R&D during the company's unprofitable years of 1996 and 1997, but Apple saw earnings skyrocket with the 1998 launch of its successful iMAC product line. In stark contrast, some companies can continue to suffer spiraling losses even after investing a great deal money each year to R&D. For example, in 2003, telecom equipment maker Lucent Technologies was still facing losses even though it was throwing more than $4 billion a year into R&D since 1998.

Measuring R&D
Financial expert/writer, Kenneth Fisher, touts the price-to-research ratio (PRR), which is the market value of the company divided by its research-and-development expenditure over the last twelve months. Fisher suggests buying companies with PRRs between five and 10 and avoiding companies with PRRs greater than 15. By looking for low PRRs, investors should be able to spot companies that are redirecting current profits into R&D, thereby better ensuring long-term future returns.

Technology investment guru Michael Murphy offers the price/growth flow model. Price/growth flow attempts to identify companies that are producing solid current earnings while simultaneously investing a lot of money into R&D. To calculate the growth flow, simply take the R&D of the last 12 months and divide it by the shares outstanding to get R&D per share. Add this to the company's EPS and divide by the share price.

Measuring R&D Effectiveness Is Key
Unfortunately, while the Fisher and Murphy models both do a great job of helping investors identify companies that are committed to R&D, neither indicates whether R&D spending has the desired effect - the successful creation of profitable products. When evaluating R&D, investors should determine not only how much is invested but how well the R&D investment is working for the company.

Companies often cite patent output as a tangible R&D success measure. The argument goes that the more patents filed, the more productive the R&D department. But, in reality, the ratio of patents per R&D dollar tends to represent the activity of a company's lawyers and administrators more than its engineers and product developers. Besides, there is no guarantee that a patent will ever turn into a marketable product.

One way, however, to perceive the proficiency of R&D is to calculate the percentage of sales that come from products introduced over a period of time, say the preceding three years. For the calculation, investors need annual sales information for specific new products. If lucky enough to get that kind of data from company reports, investors can do the calculation this way:

New product sales (previous three years) / Total sales (previous three years)

The resulting percentage gives investors a sense of R&D success as well as R&D output and offers a useful metric for comparing R&D performance with peer companies.

Investors should also pay attention to R&D expenditure/sales. According to Michael Murphy, good growth-flow companies spend at least 7% of their sales revenue on R&D. On the other hand, what is deemed a healthy R&D/sales ratio depends on the industry and the company's stage of development.

Pharmaceuticals, software, and hardware companies, for instance, tend to spend a lot on R&D while consumer product companies typically spend proportionately less. In 2003, Johnson & Johnson, for example, reported spending about 10 cents per sales dollar on R&D, but drug company Pfizer spent 15% of expected sales on R&D; software giant Microsoft spent 16%; and network-equipment maker Cisco Systems spent 18%. For smaller, early-stage software and biotech companies the number can easily stretch as high as 80%.

Conclusion
By closely analyzing R&D spending, investors can identify those companies that are able to keep on top of product cycles with innovations, squeeze profits from those innovations, and pour money back into R&D to secure future growth. Measuring the amount spent on R&D, however, is not enough: investors need to determine how well the company is making use of its R&D expenditures and producing competitive products.

by Ben McClure, (Contact Author | Biography)

Ben is director of McClure & Co., an independent research and consulting firm that specializes in investment analysis and intelligence. Before founding McClure & Co., Ben was a highly-rated European equities analyst at London-based Old Mutual Securities.