Research and Development (R&D)

Research and Development (R&D) is the engine room of innovation. It's the set of activities a company undertakes to discover new knowledge, which it then uses to create new products, services, or processes, or to improve existing ones. Think of it as a company's investment in its own future. For technology giants, it’s the quest for the next game-changing gadget; for pharmaceutical firms, it's the painstaking search for a life-saving drug. This spending is reported as an expense on the company’s income statement, directly reducing its reported profits for the period. While essential for long-term survival and growth in many industries, R&D is also a significant cost with no guarantee of a payoff. For an investor, understanding a company's approach to R&D is crucial for distinguishing between a business that is planting seeds for a future harvest and one that is just digging expensive holes.

This question gets to the heart of a major quirk in accounting. According to standard accounting rules, R&D costs are treated as an expense in the year they are incurred. This means they are immediately subtracted from revenue, lowering a company's net income and making it appear less profitable. The logic is that the future benefits of R&D are too uncertain to be reliably recorded as an asset on the balance sheet. However, from a business and value investing perspective, R&D is clearly an investment. A company spends money today with the expectation of generating greater cash flows in the future. Legendary investor Ben Graham noted this discrepancy. By expensing R&D, a company's reported earnings can be significantly understated. A company investing heavily and successfully in its future might look less profitable on paper than a competitor that is coasting on past glories and starving its innovation pipeline. The savvy investor learns to look past the accounting treatment to see the economic reality.

A value investor doesn't just accept the R&D number at face value. Instead, they dig deeper to assess its quality and productivity. The goal is to figure out if the R&D spending is creating long-term value.

The absolute amount spent on R&D is less important than its effectiveness. A company could spend billions with little to show for it, while a smaller, more focused competitor could generate breakthrough products with a modest budget. To assess this, you should investigate:

• Product Pipeline: What new products or services are in development? Does management talk about them with clarity and strategic focus?
• Track Record: Does the company have a history of successfully launching new products that capture market share and generate profits?
• Patents: While not a perfect measure, a growing portfolio of valuable patents can indicate a productive R&D culture.

A simple but powerful metric is the R&D-to-Sales ratio, calculated as: R&D Expense / Total Sales. This ratio helps you:

• Compare with Peers: How does the company's R&D spending stack up against its direct competitors? A significantly lower ratio in a fast-moving industry could be a major red flag.
• Track Over Time: Is the company maintaining, increasing, or decreasing its R&D investment relative to its size? A sudden cutback might boost short-term profits but could jeopardize the company's long-term competitive position.

For context, a software or biotech company might have an R&D-to-Sales ratio of 15-25% or more, while a food manufacturer or a bank might be below 1%.

For a more advanced analysis, some investors “capitalize” R&D to get a truer picture of a company's earning power. This involves adjusting the financial statements to treat R&D as a capital expenditure (CapEx) rather than an operating expense. The process, in simplified terms, is:

1. 1. Adjust Operating Income: Add back the current year's R&D expense to the company's operating income.
2. 2. Create an R&D Asset: Estimate the value of past R&D investments that still have a useful life (e.g., the last 5 years of spending). This becomes a new “asset” on the balance sheet.
3. 3. Subtract Amortization: Instead of expensing the full R&D cost, you subtract an amortization charge (e.g., one-fifth of your new R&D asset).

This adjustment typically results in higher earnings and a larger asset base, which can dramatically change key valuation metrics like the Price-to-Earnings (P/E) ratio and Return on Invested Capital (ROIC), giving you a more economically realistic view of the business.

When looking at R&D, here are some signs of health and sickness to watch for.

• Consistency: The company invests in R&D steadily through both good times and bad, showing a long-term commitment.
• Productivity: There is a clear and impressive track record of turning R&D spending into successful, high-return products. The ROIC is consistently high.
• Clarity: Management communicates its R&D strategy clearly to shareholders, explaining what they are investing in and why.

• “Science Projects”: The company spends huge sums on R&D with no commercial success, essentially operating a money-losing laboratory.
• Starving the Future: A company in a competitive industry that consistently underspends on R&D compared to peers is likely sacrificing its future to flatter current earnings.
• Buying Innovation: A company that frequently makes expensive acquisitions to get new technology may be signaling that its own internal R&D is failing.