Putting a Price on Innovation: Measuring a Firm’s Ability to Adapt

By

A company’s success depends on its ability to develop innovative solutions to problems, and a company’s culture will determine how well those solutions are implemented. However, innovation and culture are difficult qualities to define and hard to measure. Some analysts compensate for this difficulty by using more easily measured substitutes, such as research and development (R&D) spending, when valuing a company’s future prospects.

Barry Jaruzelski, creator of the Global Innovation 1000 Study, has been analyzing R&D investment at the biggest-spending public companies in the world. He published the first version of his annual study in 2005, and he warns against confusing dollar amounts spent on research with the future profits that could result from that research. According to Jaruzelski, his study’s long-standing finding is that that a company’s financial performance and innovativeness do not correlate with how much it spends on R&D.

Anne Marie Knott, professor of strategy at Olin Business School, agrees that R&D spending alone is not a good indicator of a company’s performance. “The trouble is,” she wrote in Harvard Business Review, “it’s also hard to measure strategic alignment and culture, let alone link them to profitability or market value.” Knott has developed a measure for R&D productivity that she calls RQ, short for research quotient.

Knott’s RQ equation uses a standard regression analysis to define the relationship between a firm’s spending on inputs and its revenues from output. Knott notes that “economists have been calculating capital and labor productivity for years — that is, determining the marginal value of increasing either one.” She argues that R&D productivity can be determined using the same method. Both the RQ equation and the Global Innovation 1000 Study show that the link between research and innovation is not as simple as more research dollars leading to more innovative breakthroughs.

A 2014 report from Bernstein Research found that tech companies with the lowest R&D spending were some of the best performers on Wall Street, further complicating the relationship between research spending and financial performance. And companies that change their R&D strategies make things even murkier. In some cases, a struggling company could enhance future prospects by spending less money on unproductive research, but in other cases a firm may be committing economic suicide by closing down lines of research before they can deliver new profits.

Clayton Christensen, the professor of business administration at Harvard Business School credited for creating the phrase “disruptive innovation,” has concerns about firms making short-term choices to boost their financial performance. “Because of the way we measure things, it doesn’t make sense to do what makes sense.” Christensen warns that too often companies are pursuing short-term oriented “efficiency innovations” rather than long-term, disruptive innovations that increase overall economic growth and job creation.

Equity analysts trying to assign value to companies are left with challenging questions when looking at a firm’s R&D spending — whether enough money is being spent on research, whether a firm could benefit from changing the amount of money dedicated to R&D, and whether changes to an R&D strategy offer the potential for long-term improvement or merely pursuit of the world’s dumbest idea.

At the 68th CFA Institute Annual Conference in Frankfurt, Knott will lead a master class on measuring and valuing the productivity of R&D investment. Online registration for the event is closed, but you can follow social media highlights from the event and watch select conference presentations online.

If you liked this post, consider subscribing to the CFA Institute Annual Conference blog.


All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo credit: ©iStockphoto.com/jane_kelly

This entry was posted in Equity Investments, Event Details, Investment Topics, News, Quantitative Methods, Speakers and tagged , , . Bookmark the permalink.

Leave a Reply

Your email address will not be published. Required fields are marked *