DEFINITION of 'Price-To-Innovation-Adjusted Earnings'

Price-to-innovation-adjusted earnings is a variation of the price-to-earnings ratio (P/E ratio) that includes a company's level of spending on research and development (R&D) into account. R&D refers to the work a business conducts toward the innovation, introduction and improvement of its products and procedures. R&D expenses are a type of operating expense, and can be deducted as such on a business tax return.

Accounting standards require that R&D costs are categorized as expenses, which can diminish the book value of innovative companies in industries such as software development and biotech. R&D expenditures do not necessarily guarantee future innovative success, but R&D spending is regarded as a crucial part of innovation and technological advancement.

Price-to-innovation-adjusted earnings is calculated by adding any expenditure on R&D back to earnings and then calculating the P/E ratio for that company.

Formula for calculating orice-to-innovation-adjusted earnings.

BREAKING DOWN 'Price-To-Innovation-Adjusted Earnings'

As an example of price-to-innovation-adjusted earnings, let's assume that company ABC, a company that designs and manufactures computer chips, earned $15,000,000 in profits last year. One of its major expenditures last year was R&D, $7,000,000. Company ABC's 12,000,000 outstanding shares currently trade at $15 per share.

With this information, we can calculate that ABC's earnings per share (EPS) equals $15,000,000/12,000,000 = $1.25. We can also determine that Company ABC spent $7,000,000/12,000,000 = $0.58 per share on R&D.

Using the formula above, we can, therefore, calculate that Company ABC's price-to-innovation-adjusted earnings is:

$15/($1.25+$0.58) = 8.2

The price-to-innovation adjusted ratio treats R&D costs differently in an attempt to measure a company's investment in innovation. Due to standard accounting principles, the price-to-innovation adjusted earnings ratio takes innovation expenses into account in ways market value does not. Market value is also commonly used to refer to the market capitalization of a publicly-traded company, and is obtained by multiplying the number of its outstanding shares by the current share price.

Innovative Companies

The price-to-innovation-adjusted earnings calculation is extremely useful when evaluating company performance in industries such as software development, pharmaceuticals and computers. Companies in these industries are pressured by the need to innovate. In fact, some technology companies reinvest a significant portion of their profits back into R&D, because they consider it as an investment in their continued growth. However, accounting principles hurt these companies by forcing them to deduct R&D spending from earnings. Heavy expenditures on R&D shows that a company is willing to take risks to further its growth. This calculation allows an investor to identify these innovative companies.

RELATED TERMS
  1. Return On Research Capital - RORC

    Return On Research Capital is a measure to assess the revenue ...
  2. Price-To-Book Ratio - P/B Ratio

    Companies use the price-to-book Ratio to compare a firm's market ...
  3. Price/Earnings To Growth - PEG ...

    Price/Earnings to Growth (PEG) is a stock's price to earnings ...
  4. Earnings Per Share - EPS

    Earnings per share (EPS) is the portion of a company's profit ...
  5. P/E 30 Ratio

    P/E 30 ratio means that a company's stock price is trading at ...
  6. Operating Ratio

    The operating ratio shows the efficiency of a company's management ...
Related Articles
  1. Investing

    Buying Into Corporate Research & Development (R&D)

    Investors take note: companies that cut research and development are in danger of saving today but losing big tomorrow.
  2. Insights

    And The King of R&D Spending Is

    When it comes to investing in other countries, knowing how much is being spent on research and development, and where it's be spent, is important for any investor.
  3. Investing

    R&D Spending And Profitability: What's The Link?

    Return on research capital (RORC), can help investors measure how much profit R&D spending actually generates.
  4. Investing

    Earnings Sustainability: The Key To Your Investing Future

    Learn how to analyze earnings sustainability - an important part of making sound investments.
  5. Investing

    Amazon's $23B R&D Budget Sets a Record: Recode

    Amazon's R&D spending in 2017 puts it on the top of the list of publicly traded companies.
  6. Investing

    Key Financial Ratios for Pharmaceutical Companies

    Because of the unique requirements for bringing products to market, pharmaceutical industry stocks are best analyzed by using certain key financial ratios.
  7. Tech

    Apple Is Most the Innovative Company (AAPL)

    But the real news is the R&D spending shift away from products to software and services.
  8. Investing

    Key Financial Ratios to Analyze Biotech Companies (AMGN, GILD)

    Explore the rapidly growing biotechnology industry, and learn some of the key financial ratios investors use to analyze companies in the industry.
  9. Investing

    Why Investors Believe Amazon's Long-Term Growth Story (AMZN)

    Amazon is highly valued as a growth company primarily because it has broadened e-commerce and continued technological innovation.
  10. Investing

    Pfizer's 3 Key Financial Ratios (PFE)

    Learn about three important financial ratios that help understand Pfizer, Inc. business and analyze the company's financial statements.
RELATED FAQS
  1. How much of a drug company's spending is allocated to research and development on ...

    Explore the level of spending on research and development in the pharmaceutical sector, and how it compares to R&D spending ... Read Answer >>
  2. What is the difference between forward p/e and trailing p/e?

    Understand the difference between the trailing P/E ratio, which is the standard price-to-earnings calculation, and the forward ... Read Answer >>
  3. How can a company raise its asset turnover ratio?

    Find out more about the asset turnover ratio, what it measures, how to calculate the ratio and how a company could increase ... Read Answer >>
  4. What are direct costs of sales?

    Learn about direct costs of sales and cost of goods sold (COGs), what direct costs of sales measures and how to calculate ... Read Answer >>
Trading Center