market valuation of research and development expenditures

COURSE TITLE: SEMINAR IN FINANCE COURSE CODE: MPH 622

Presentation on

The Stock Market Valuation of Research and Development Expenditures

By K.C. Chan, Josef Lakonishok, and Theodore Sougiannis

University of Illinois

Published in: The Journal of Finance, 2001, Vol. LVI (6), pp. 2431-2456.

June 1, 2011

Plan

Background & motivation

Research gap, research question & purpose

Research Methodology

Major Findings

Conclusions

Critical appraisal

Background & motivation

In perfect capital market, stock price ultimately

reflects the value of all its net assets and it is relatively

apparent when most of the assets are physical. When a

firm has large amount of intangibles, the lack of

accounting information generally complicates the task of

equity valuation.

In modern economics, a large part of a firm’s value

may reflect its intangible assets such as brand names,

R&D expenditure, advertising and alike is the one

reason for stock volatility.

(context: globalization, rapid change in IT, shift of market demand – social

networking, production to service industries, knowledge-based industries, etc)

The study is tried to explore the facts based on US

data where intangibles are generally treated as current

spending. But it may not be fully amortized in a single

year.

Why R&D has been the subject of much attention?Greater proportion (40% of S&P) of R&D based

industries in the stock market (R&D intensive = few

intangible assets)

R&D expenses in technology industry is larger than their

earnings, and

US government policy to disclose R&D spending in

financial statements.

Benchmark: Diff. in return = (Rwith R&D – Rwithout R&D)

If 0, market price fully incorporate the benefits of R&D

spending.

The future returns can be potentially influenced by the

investment on R&D and similar types of spending so that

the distortion in stock price appears.

The study focused on R&D investments because the

R&D intensive firms are difficult to value.

Future profits are tied to the success of new untested

technologies which are highly unpredictable. (Medicine for

AIDS, Cancer, .. New software, etc)

The benefits of the current efforts are usually

materialized in future, and

R&D accounting information is of limited informative.

For instance, R&D spending in some major

technology industries is larger than their earnings.

Research gap, research question &

purposeSome evidences including Porter (1992), Hall (1993),

and Hall and Hall (1993) suggested that investors have

short time horizons so they fail to anticipate the rewards

from long-term investment. (e.g. R&D, advertising,…)

On the other hand, many firms’ R&D investments are

not profitable,Jensen (1993). But, investors systematically

overlook/passion for technology stocks reflect the belief

that R&D intensive technology stocks are undervalued.

These limited earlier studies concerning the association

between future returns and R&D investments provides

basis for the study.

Research Questions:

Does the stock price appropriately incorporates the

value of the firms’ R&D investments?

Is there R&D intensity related to future stock return?

Is there volatility of stock returns is related to R&D?

Objective:

To examine whether stock prices fully value firm’sintangible assets, specifically investment in research and

development (R&D).

Population: US firms

Sample: All domestic firms listed on listed on NYSE, AMEX and NASDAQ

Data collection: Secondary sources(Financial information from COMPUSTAT and market value of common equity from the CRSP)

Study period: From 1975 to 1995

R&D expenditures relative to sales and, R&D expendituresto the market value of equity are used to measure R&Dintensity.

Methodology

Firms’ R&D capital is estimated from the past record

as per model suggested by Lev and Sougiannis (1996)

RDCit = RDit + 0.8RDit-1 + 0.6RDit-2 +0.4RDit-3 + 0.2RDit-4……….. (1)

Regression models: (Return reversal & Volatility)

Rpt – Rft = ap + bp[RMt – Rft] + spSMBt + hpHMLt + wpWMLt + dpUMDt + ept ….. (2)

Where,

(Rpt – Rft ) = Monthly return on portfolio p in excess,

(RMt – Rft ) = Excess return on the value-weighted market index,

SMBt, and HMLt are the returns on the Fama and French (1993) factor mimicking portfolios

for size and book-to-market, respectively, WMLt and UMDt are the effect of long-term and

intermediate-term past returns, respectively.

σit = γot + γ1t LNSIZEit + γ2t LNAGEit + γ3t RDSit + + eit ……………(3)

Where, σit = Stock’s return volatility, LNSIZEit = Firm’s stock market capitalization in

logarithms, LNAGEit = Firm’s age in logarithms, RDSit = R&D intensity relative to sales, and

INDijt = Dummy variables for industries.

All firms: Year

Selected Industry: SIC Code

R&D expenditure as percentage of R&D capital as percent of book valueSales Earnings Dividends Book value

All firms Sel. Ind. All firms Sel. Ind. All firms Sel. Ind. All firms Sel. Ind. All firms Sel. Ind.

1975 SIC 737 1.70 16.60 36.10 207.10 84.10 2833.00 4.13 27.50 10.55 54.90

1980 SIC 283 1.78 11.90 34.40 92.20 87.60 192.00 5.08 21.10 12.55 53.30

1985 SIC 357 3.01 7.10 83.70 159.30 145.80 1242.40 8.11 21.00 21.25 55.90

1990 SIC 38 3.40 5.60 79.40 89.80 148.90 276.90 9.59 13.00 25.76 36.60

1995 SIC 36 3.75 4.90 65.30 58.20 165.20 242.20 10.88 10.30 28.73 25.60

SIC 48 3.70 98.10 80.20 13.70 36.40

SIC 37 3.60 125.50 297.50 16.60 46.10

SIC 737: Computer programming, software, & services, SIC 283: Drugs & Pharmaceuticals, SIC 357: Computers & office equipment, SIC 38: Measuring instruments, SIC 36: Electrical equipment excluding computers, SIC 48: Communications & SIC 37: Transportation equipment.

Yellow = Low

Red = HighFindings:The magnitude of figures suggests that expensing in R&D outlays has

grown sharply.R&D spending is heavily concentrated in technology and science

oriented industries.

Table IIntensity of R&D activity for all firms doing R&D and for selected industries

Major findings1975-1995

Table IIThe impact of expensing R&D spending on earnings and BV for selected industries

Selected Industry: SIC CodePanel A: Earnings Panel B: Book value of equity

Earnings as % of MV

Adj. Earnings as % of MV BV as % of MV

Adj. BV as % of MV

SIC 737 1.93 4.28 14.54 22.52

SIC 283 3.67 4.79 16.05 24.6

SIC 357 4.46 5.73 33.65 52.46

SIC 38 4.11 4.53 28.4 38.81

SIC 36 5.44 6.43 30.76 38.64

SIC 48 2.49 2.98 17.84 24.33

SIC 37 5.99 7.21 45.22 66.05

SIC 737: Computer programming, software, & services, SIC 283: Drugs & Pharmaceuticals, SIC 357: Computers & office equipment, SIC 38: Measuring instruments, SIC 36: Electrical equipment excluding computers, SIC 48: Communications & SIC 37: Transportation equipment.

Finding:In the highly R&D intensive industry, the practice of immediately expensing R&D outlays can have substantial distortive effect on accounting information.

P/E 51.8% 23.4%

P/E 27.2% 20.9%

P/E 6.9% 4.4%

P/E 6.2% 4.1%

Note: Adjustment are made as per the amortization equation. (estimated R&D)

1995

Table III Returns and Characteristics of portfolios classified by R&D Expenditure Relative to Sales

Portfolio ranked by R&D intensity (R&D/Sales) 5 (High) Average R&D (1-5) Non- R&D

Average annual return before formation 0.2254 0.2049 0.2025

1 yr after portfolio formation 0.1815 0.2015 0.1987



Aver. annual return over 3 yrs after port. 0.1952 0.1965 0.1950

Annual earnings growth over 5 post-formation yrs 0.1424 0.1018 0.1015

Findings:Firms that carry out

R&D is on average no

difference in returns

from those of firms

without R&D.

Glamour stocks with

low B/M ratio earn on

an average lower than

average

The average annual growth rate

in earnings is virtually the same

for stocks with R&D and

without R&D.

Table IVReturns and Characteristics of Portfolios Classified by R&D Expenditure Relative to Equity

Market Value

Portfolio ranked by R&D intensity (R&D/Sales) 5 (High) Average R&D (1-5) Non- R&D

Average annual return before formation 0.0989 0.2031 0.2025




Aver. annual return over 3 yrs after port. 0.2619 0.1969 0.1950

Annual earnings growth over 5 postformaion yrs 0.1713 0.0943 0.1015

Findings:Portfolio results based on

R&D relative to market value

indicated that even though,

high R&D spending directly

depresses earnings, there may

be prospects of regaining the

profitability in subsequent

years.

Investor clientele for

R&D intensive

technology companies

may be an additional

factor in determining

stock prices.

There may be potentially more

severe underpricing when R&D

intensive stocks experience poor

performance.

same

Return reversalExcess return after

portfolio formation is

high (6.12%) when

adjusting the size and

B-M.

Finding:

Provide further evidence that past losers who spend heavily in R&D tend to be undervalued.

The abnormal performance is concentrated in stocks with relatively low past returns.

Table VExcess returns of portfolios classified by R&D intensity, and by past 3-year return

Classified by Excess return in year after portfolio formationAverage excess return over 3

post-formation years

R&D relativeto sales

Past 3-yearreturn First year Second year Third year

1 (Low) 1 (Low) 0.0085 -0.0120 -0.0172 -0.00692 (High) -0.0164 -0.0180 -0.0081 -0.0142

2 1 0.0282 0.0178 0.0028 -0.00692 -0.0004 -0.0065 0.0029 -0.0014

3 1 0.0477 0.0173 0.0094 0.02482 -0.0071 0.0172 0.0176 0.0092

4 1 0.0492 0.0357 0.0253 0.03682 0.0177 0.0085 0.0106 0.0122

5 (High) 1 (Low) 0.0219 0.0482 0.0618 0.04402 (High) -0.0150 0.0120 0.0062 0.0010

Abnormal performance of the past

losers. Notable result in average column

Table VIExcess returns of portfolio classified by R&D intensity, and by past 3-year return

Finding:The large returns on the portfolio with high R&D intensity relative to market is not entirely due

to risk and, return reversals associated with past losers.

Rpt – Rft = ap + bp[RMt – Rft] + spSMBt + hpHMLt + wpWMLt + dpUMDt + ept

Portfolio a b s h w d R2

First year after

portfolio formation

1 (Low) -0.14 0.98* 0.68* -0.09* -0.03 -0.02 0.96

2 0.05 0.96* 0.74* -0.10* -0.07* -0.06 * 0.96

3 0.16 1.01* 0.76* -0.10* -0.08* -0.09 * 0.95

4 0.26* 1.02* 0.81* -0.11* -0.18* -0.08 * 0.95

5 (High) 0.55* 1.04* 0.96* -0.10 -0.32* -0.10 * 0.92

Second year after

portfolio formation

1 (Low) -0.10 0.96* 0.61* -0.07* -0.07* -0.07 * 0.97

2 0.04 0.95* 0.75* -0.06 -0.04 -0.09 * 0.96

3 0.21* 1.00* 0.71* -0.09* -0.11* -0.09 * 0.95

4 0.39* 1.00* 0.79* -0.16* -0.15* -0.10 * 0.94

5 (High) 0.52* 1.02* 0.93* -0.16* -0.30* -0.05 0.93

Third year after

portfolio formation

1 (Low) -0.04 0.93* 0.62* -0.05 -0.07* -0.07 * 0.96

2 0.04 0.95* 0.66* -0.01 -0.06 -0.07 * 0.95

3 0.26* 0.97* 0.63* -0.14* -0.15* -0.10 * 0.95

4 0.19* 1.02* 0.79* -0.10* -0.14* -0.18 * 0.95

5 (High) 0.53* 1.01* 0.89* -0.23* -0.29* 0.00 0.93

Annual spread 8.28%

Annual spread 7.44%

Annual spread 6.84%

* Indicates t-statistics is greater than 2.00 or 5% level of significance

Finding:Advertising intensive firms with poor past performance recover in subsequent year, and no

difference on average between advertising and non-advertising firms..

The evidence also suggests that there is an association between

R&D and return volatility.

Table VIIReturns and Characteristics of Portfolios Classified by Advertising Expenditure Relative to

Equity Market Value

Portfolio ranked by R&D intensity (R&D/Sales)

1 (Low) 2 3 4 5 (High) Non-Adv..

Average annual return before formation 0.3146 0.2286 0.1978 0.1769 0.1402 0.1981

1 yr after portfolio formation 0.1651 0.1958 0.2179 0.2246 0.2276 0.1946



Aver. annual return over 3 yrs after port. 0.1597 0.1958 0.2160 0.2162 0.2363 0.1895

(0.16+0.20+0.22+0.22+0.24)/5 = 20.48% is almost equal to 18.95%

High level of spending on R&D may lead to

mispricing of stock from expensing rather than

capitalizing R&D costs, if investors fail to make

adjustment. The evidence does not support a direct link

between R&D spending and future stock returns.

Thus, the major conclusion of the study is that

companies with high R&D to equity market value,

which tend to have poor past returns earn large excess

returns, a similar relation exists between advertising and

stock returns, and there is positive association between

R&D intensity and stock return volatility.

Conclusions

The study follow the simple analysis concerning the

relatively unexploited area in finance. The industry

wise differences on the effects of intangibles provide

the useful insight for the investors, managers,

academicians and researchers. The evidences of return

reversal for R&D intensive poor past performers,

opined the new scope for future works.

Critical appraisal

Thank you.

I am very much thankful to Respected Prof. Dr. RadheShyam Pradhan, Prof. Dr. Manohar Kr Shrestha, Prof.Dr. Kamal Das Manandhar, Prof. Dr. Rajan B. Paudeland my dear colleagues from the bottom of my heart,for their proper guidance, generous support anduseful comments.Sudarshan Kadariya, M. Phil in Management

market valuation of research and development expenditures

Economy & Finance