Ruminations on R&D

Great companies invest in innovation. Those that roll the dice on research and development (R&D) programs tend to generate bigger profits than those that don't. But take note, Fools: The world of R&D is full of questionable spending, unqualified results, and payoffs that can be hard to measure. Factoring R&D into stock evaluations and analysis is not a simple affair.

The world's top technology companies are cranking up R&D spending. Chip makerIntel (Nasdaq: INTC) says it will spend $4.8 billion this year, up nearly 10% over last year. Hewlett-Packard (NYSE: HPQ) has a $4 billion R&D budget lined up, even though cutbacks are happening in just about every other department at the PC and printer manufacturer.

The reasoning is simple: Inventions and discoveries don't come cheap. Firms that stay ahead with new technology stay on top of sales; those that don't lose market share. Companies with new products coming out of the R&D pipeline are going to be better positioned for profits than those firms that pare down their R&D.

It's 'RD work
There are plenty of big R&D spenders. But how do you know which ones to pick?

That's a hard question. Consider that wireless messaging specialistResearch In Motion (Nasdaq: RIMM) kept its R&D spending high even through its unprofitable years (1998 and 1999). If you bought Research In Motion stock back then, you would have been on board for the release of its Blackberry handset and services -- and rewarded with handsome returns.

On the other hand, if you thought Sun Microsystems' (Nasdaq: SUNW) roughly $2 billion annual R&D spending since 1999 would create big returns, you'd be wrong. You would have lost almost all of your investment.

The "price-to-growth flow" ratio can be a quick-and-easy investment analysis tool. To calculate the growth flow, simply take the R&D of the last 12 months and divide it by the number of shares to get R&D per share. Add this to the company's earnings per share and divide by the share price. It sounds complicated, but the ratio tells you which companies produce solid current earnings while simultaneously investing a lot of money into R&D.

Of course, like most short cuts, the ratio isn't perfect. It can't tell you whether you are looking at effective R&D spending, like Research In Motion's, or fruitless R&D, like that produced at Sun Microsystems.

Getting it right
Effectiveness is hard to measure. The number of patents filed is frequently used as proxy for R&D spending performance, or even to foretell success. IBM (NYSE: IBM) broke a record for the number of patents granted in a year with 3,415 in 2003. Hewlett-Packard scientists generate 11 patents a day, up from two a day in 2002. Mind you, the ratio of patents per dollar of R&D spending probably better reflects the strength of patent attorneys than successful R&D.

However, patents don't necessarily translate into money-making products. Think of Xerox (NYSE: XRX). For years, the company's PARC research center developed one breakthrough technology after another, but failed to make money on them. Its inventions, like the laser printer and the mouse, are now in the hands of competitors.

Then there's pharmaceuticals giant Merck (NYSE: MRK). Despite devoting $3 billion a year and about 10,000 people to R&D and filing thousands of patents annually, the pharmaceuticals giant has produced only three new drugs in the past three years.

Investors need to be able to assess the yield of R&D dollars. Here is one way: Measure the proportion of sales that come from products launched in the last three years. It shows whether a firm is producing innovative products, or just coasting on old ones.

A good signal that a company is milking rather than growing is when it markets services while reducing R&D. Think of Unisys (NYSE: UIS). Once an office computing systems pioneer with sales driven by leading-edge products, Unisys now derives 75% of its revenue from business services and consulting.

Investors should also pay attention to the ratio of R&D expenditures to sales. Of course, typical ratios vary by industry. Pharmaceuticals, software, and hardware companies, for instance, tend to spend a lot on R&D, while consumer product companies typically spend much less. In 2003, Johnson & Johnson (NYSE: JNJ), for example, reported spending about 10 cents per sales dollar on R&D, but drug company Pfizer (NYSE: PFE) spent 15% of expected sales on R&D; software giant Microsoft (Nasdaq: MSFT) spent 16%. For smaller biotech companies like MedImmune (Nasdaq: MEDI), the number can easily stretch over 100%.

Still, not all companies are the same. Dell (Nasdaq: DELL) metes out only 2% of sales on R&D, but continues to keep investors very happy. Then there is CiscoSystems (Nasdaq: CSCO). The networking giant maintains healthy R&D spending of about 16% of sales, but also adds clever acquisitions to complement in-house research, which makes measuring the effectiveness of Cisco's R&D spending a tad more tricky.

Companies that heap money into R&D tend to grow faster and have higher profit margins than companies that cut corners. But, more often than not, R&D promise is usually built into the share price. Big R&D spenders have high multiples to start with, so even when they do start to reap profits from R&D, the shares don't outperform.

The price of research
It ought to be worthwhile to sniff around stocks with low price-to-research ratios (PRR). When a company's stock is so beaten down that the R&D budget becomes a significant component of share price, investors get lots of research for their money. At the same time, PRR ought to help investors spot companies that are re-directing current profits into R&D, better ensuring long-term future returns.

But low PRRs are rarities. You might think beaten-down telecom equipment maker Lucent (NYSE: LU) would offer an attractive PRR. The stock got clobbered by the telecom collapse; demand for its products is still slow and not expected to explode anytime soon; and the company still spends more than $2 billion on R&D. But think again. The stock trades on a PRR of 10. That's no bargain.

Let's face it. If you want to use R&D to discover new investment ideas, expect to pull your sleeves up. It's not enough to know the amount spent on R&D. You need to know if the R&D money is well spent. Don't think that, too, will be easy.

Dell is a Motley Fool Stock Advisor recommendation. Tom and David Gardner offer two of their favorite investment ideas each month to subscribers. You can check it out for six months with a money-back guarantee.

Fool contributor Ben McClure hails from the Great White North. He owns shares in Dell. The Motley Fool is investors writing for investors .