Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ====== R&D ====== R&D (an abbreviation for [[Research and Development]]) is the lifeblood of innovation within a company. It represents the set of investigative activities a business undertakes to discover and create new products or services, or to significantly improve its existing ones. Think of it as the corporate version of a mad scientist's lab, but with a much clearer goal: to secure future profits and stay ahead of the competition. For a value investor, R&D isn't just another line item on the [[income statement]]; it's a critical investment in the company's future growth and competitive staying power. While accountants treat it as an immediate expense, which can make a company's current profits look smaller, a savvy investor learns to look deeper. High, effective R&D spending can be a sign of a forward-thinking management team building a wider [[economic moat]] that will protect the business for years to come. ===== The Two Faces of R&D: Expense vs. Investment ===== Understanding R&D requires wearing two hats: the accountant's green eyeshade and the investor's forward-looking spectacles. The view through each is starkly different, and the truth for an investor lies somewhere in between. ==== The Accountant's View: An Immediate Cost ==== According to standard accounting rules like [[GAAP]] and [[IFRS]], companies must treat most R&D costs as an operating expense in the period they are incurred. This means the money spent on designing the next iPhone or developing a new drug is immediately subtracted from revenue, reducing the company's reported [[net income]]. This conservative approach is designed to prevent companies from filling their [[balance sheet]] with speculative [[assets]] that might never generate a dime. The downside? A company investing heavily for a brighter future can look less profitable //today// than a competitor that is coasting on past glories. ==== The Value Investor's View: Fuel for the Moat ==== A true value investor sees R&D not as a cost, but as a crucial, albeit tricky, form of investment. Successful R&D creates incredibly valuable [[intangible assets]]—patents, proprietary processes, and brand-new product lines—that are the bedrock of future success. For technology and pharmaceutical giants, the R&D budget is the primary engine of future [[free cash flow]]. This is why legendary investors like [[Warren Buffett]] adjust a company's reported earnings to get a truer picture of its economic reality. To calculate what he calls "[[owner earnings]]", he adds back certain non-cash charges. In the same spirit, viewing R&D as a growth investment rather than a simple maintenance cost allows you to better assess a company's long-term earning power. ===== How to Analyze R&D Spending ===== Simply seeing a big R&D number isn't enough. You need to assess its //effectiveness//. Is the company getting a good return on its innovation dollars? ==== R&D to Sales Ratio ==== This is the most common starting point. You calculate it by dividing the annual R&D expense by the company's total revenue. * **Formula:** R&D Expense / Revenue This ratio reveals a company's "innovation intensity." There is no single "good" number; context is king. You should compare the ratio to the company's own history (is it consistent?) and, more importantly, to its direct competitors. A software company might spend 20% of its sales on R&D, while a food manufacturer might spend less than 1%. A sudden, unexplained drop in this ratio for a tech firm could be a major red flag. ==== R&D Yield ==== This is a more powerful, value-focused metric that tries to answer the question: "How much bang are we getting for our R&D buck?" It measures the productivity of the spending. A simple way to estimate it is to compare the growth in [[gross profit]] over a period to the total R&D spent in that same period. For example, if a company's gross profit grew by $500 million over the last five years, and its total R&D spending over that time was $100 million, its R&D Yield is a very healthy 5x. This helps you separate companies that spend wisely from those that just throw money at the lab wall to see what sticks. ===== Red Flags and Important Nuances ===== R&D is powerful, but it's not without its risks. Keep an eye out for these potential issues. ==== Beware of "Diworsification" ==== Coined by famed investor [[Peter Lynch]], "diworsification" describes the tendency of companies to wander into new, unrelated business areas where they have no expertise. R&D spending should ideally be focused on strengthening a company's core business and widening its existing economic moat. When a software company suddenly starts a massive R&D project to develop a new line of beverages, it's often a sign that management has run out of good ideas and is about to destroy shareholder value. ==== Industry is Everything ==== It cannot be stressed enough: R&D spending is highly industry-specific. Meaningful analysis is only possible when comparing a company to its direct peers. * **High R&D Industries:** Technology, Pharmaceuticals, Biotechnology, Aerospace. In these fields, innovation is the price of admission. Not spending on R&D is a death sentence. * **Low R&D Industries:** Utilities, Banking, Insurance, Consumer Staples (e.g., soap or soda). Here, competitive advantages are typically built on brand, scale, regulatory hurdles, or cost efficiency, not constant product reinvention. Comparing the R&D budget of a pharmaceutical company to that of a railroad is a classic apples-and-oranges mistake that tells you nothing of value.