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 parts 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 of money each year in R&D. For example, in 2003, telecom equipment maker Lucent Technologies was still facing losses even though it had been 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) = ~R&D Output

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. 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.

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.

Related Articles
  1. Investing Basics

    Why do Debt to Equity Ratios Vary From Industry to Industry?

    Obtain a better understanding of the debt/equity ratio, and learn why this fundamental financial metric varies significantly between industries.
  2. Economics

    Understanding Switching Costs

    Consumers incur switching costs when they receive a monetary or other type of penalty for changing a supplier, brand or product.
  3. Investing

    What’s Holding Back the U.S. Consumer

    Even as job growth has surged and gasoline prices have plunged, U.S. consumers are proving slow to respond and repair their overextended balance sheets.
  4. Economics

    Explaining Market Penetration

    Market penetration is the measure of how much a good or service is being used within a total potential market.
  5. Economics

    Calculating the Marginal Rate of Substitution

    The marginal rate of substitution determines how much of one good a consumer will give up to obtain extra units of another good.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Morningstar Small-Cap Value

    Find out about the Shares Morningstar Small-Cap Value ETF, and learn detailed information about this exchange-traded fund that focuses on small-cap equities.
  7. Stock Analysis

    The Best Stocks to Buy for Less than $10 before Year End

    Learn about the best stocks to buy under $10. These stocks are speculative but have considerable upside given their valuation and market conditions.
  8. Investing Basics

    10 Companies That Yuppies Love

    Learn about 10 companies loved by the modern Yuppie, including how this demographic's impressive buying power has boosted these companies' earnings.
  9. Mutual Funds & ETFs

    ETF Analysis: WisdomTree SmallCap Earnings

    Discover the WisdomTree Small Cap Earnings ETF, a fund with a special focus on small-cap and micro-cap stocks with positive earnings.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares US Regional Banks

    Obtain information and analysis of the iShares US Regional Banks ETF for investors seeking particular exposure to regional bank stocks.
RELATED TERMS
  1. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  3. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  4. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  5. Net Present Value - NPV

    The difference between the present values of cash inflows and ...
  6. Long-Term Debt

    Long-term debt consists of loans and financial obligations lasting ...
RELATED FAQS
  1. How does a value added tax (VAT) impact the stages of production?

    The obvious and immediate impact of a value-added tax, or VAT, is the production cost rises at each stage along the production ... Read Full Answer >>
  2. What caused the American Industrial Revolution?

    The initial vestiges of industrialization appeared in the United States in 1790, when Samuel Slater opened a British-style ... Read Full Answer >>
  3. Which industries can benefit the most from venture capital?

    In terms of attracting venture capital, a 2013 report from advisory firm PwC indicated that companies involved in technology ... Read Full Answer >>
  4. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  5. Are Social Security payments included in the US GDP calculation?

    Social Security payments are not included in the U.S. definition of the gross domestic product (GDP). Transfer Payments For ... Read Full Answer >>
  6. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!