The core of an analyst’s role is to determine how well a management team uses capital, and research and development (R&D) spending is a particularly difficult use of capital to evaluate. There are no clear-cut solutions on how best to go about it — a company may display strong returns on their R&D efforts in the form of patents or sales growth, but how do we know if any of the capital put to work was wasted? R&D has an unknown lag effect (the results are hardly instantaneous), accounting standards vary across the globe, and unless a company has one product, outsiders do not know which dollars funded successful products.
Management teams have many opportunities to deploy shareholder capital, and evaluating some of those uses can be a straightforward exercise. If a company builds new stores, we have metrics like “same store sales” that allow us to determine what those stores add to earnings and cash flow. Acquisitions need a few years to be evaluated, but it’s not rocket science to figure out whether or not management used shareholder capital well. (A lot of studies suggest that acquisitive companies destroy value, so you can take a shortcut, which I don’t recommend, by avoiding companies that grow via acquisition.)
Unlike other uses of capital, investment analysts face stiff headwinds when assessing whether a company uses its research and development (R&D) budget effectively. One concern is lag time. We can ask a company’s investor relations department to estimate the lag between new idea and new product, but we don’t always have transparency into what the company is developing. Lag is less of a concern when companies spend on R&D consistently on an annual basis, but we may have to account for serendipity; the famous 3M case about the adhesive that ultimately created the “Post-it” note is a good example.
In companies that are R&D intensive, such as healthcare firms in Biotech and Pharma, analysis gets complicated — especially if a company has yet to turn a profit. Nanostring Technologies (NSTG) runs a business that I cannot comprehend, but a quick check on some R&D figures suggests they are near the top of their industry in R&D as a percentage of sales. Over the past five years, NSTG has cumulatively spent US$47.7 million dollars on R&D, representing about 52% of its revenues. Meanwhile, we don’t know if those efforts have been commercially successful, because the company has amassed an accounting loss of more than US$103 million over the same period.
Profitable companies pose different challenges. Amgen (AMGN) consistently spends 20% of its revenues on R&D, but it’s tough to pin down how its R&D expenses are faring. It has a current portfolio of 13 products, it is running clinical trials, and it is no doubt working on other projects. Returns are also challenging to observe in isolation; they may be due to improved marketing efforts, or cost containment, or successfully opening up a new market.
Another challenge is to normalize the accounting treatment of R&D across an industry; some companies report spending using IFRS, while others follow US GAAP accounting standards. In the US, companies are required to expense R&D, whereas companies reporting under IFRS can capitalize R&D (PDF). To account for this, and to recognize that R&D has a future value that can be amortized over time, the prevailing wisdom is to capitalize the expense (PDF) in valuation models — a difficult, yet worthwhile exercise.
Other aspects of R&D valuation can be tackled with different approaches. Olin Business School Professor Anne Marie Knott has developed a way to measure how R&D expenses affect a company through a metric she calls the “Research Quotient.” Knott explained her model in Harvard Business Review, and it helps analysts estimate the optimal level of R&D spending for a company in a way that allows them to be forward looking.
At the 68th CFA Institute Annual Conference in Frankfurt, Knott will explain her equation in a master class on Valuing Innovation: Measuring and Valuing the Productivity of R&D Investment. Her presentation will be one of the practitioner-relevant sessions designed to provide in-depth introductions to important investment topics. Online registration for the event is closed, but you can follow social media highlights from the event and watch select conference presentations online.
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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: Stephen Campbell, 2014