What Are Price-To-Innovation-Adjusted Earnings?

Price-to-innovation-adjusted earnings is a variation of the price-to-earnings ratio (P/E ratio) that takes 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.

Key Takeaways

  • Price-to-innovation-adjusted earnings is a variation of the price-to-earnings ratio (P/E ratio) that takes 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.
  • 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.

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.

Understanding 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 million in profits last year. One of its major expenditures last year was R&D, $7 million. Company ABC's 12 million outstanding shares currently trade at $15 per share.

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