Adjusting for Innovation

Question: Is research and development an operating expense or an investment? I'm guessing most of you would say it's an investment. Then explain to me why, as explained in a recent Forbes' article, GAAP treats R&D as an annual expense, not an investment to be capitalized and depreciated.

Let's think for a moment. Is research spending necessary for Intel (Nasdaq: INTC) to manufacture microprocessors or Cisco (Nasdaq: CSCO) to produce routers? Only in the sense that prior R&D spending benefits current product, implying that current R&D spending will benefit future production. Quoting Forrest Gump, "I may not be a smart man," but in this sense, R&D seems more like an investment than an operating expense.

The Forbes authors came up with a novel approach to deal with this conundrum. They suggest adjusting earnings by adding back R&D expenses, arriving at what they call innovation-adjusted earnings. I like this idea, but would take it a step further. Assuming R&D is an investment, you could add it back to operating cash flow, leading to what I'm calling Innovation-Adjusted Free Cash Flow (IAFCF). Here's the simple formula:

IAFCF = (operating cash flow + R&D expense) - capital expenditures

I think of free cash flow as a decision point, where the company asks, "What should I do with this cash?" The options are numerous, including big dividends, share buybacks, paying down debt, making acquisitions, or funding R&D.

How might this affect valuation of some leading technology companies? In fiscal 2004, Microsoft (Nasdaq: MSFT) generated $14.6 billion in operating cash, had $7.8 billion in R&D expenses, and $1.1 billion in capital expenditures. Under the strict definition, free cash flow was $13.5 billion, or about $1.24 per share. Using our adjusted formula...

Microsoft IAFCF = ($14.6 + $7.8) - $1.1 = $21.3 billion or $1.95 per share.

Essentially, Microsoft is punished $0.71 per share today for R&D expenses that may not generate sales for years to come. Other companies are forced to underreport free cash flow as well. IBM's (NYSE: IBM) 2003 free cash flow jumps from $5.79 to $8.67 per share, adjusted for innovation, while Oracle (Nasdaq: ORCL) generated $0.83 of IAFCF in fiscal 2004 vs. $0.58 of traditional free cash flow.

By no means is IAFCF a perfect tool, but looking at R&D as an investment might help explain the relatively high multiples technology companies command. While not necessarily cheap, tech companies don't appear quite so overvalued when you adjust for investment in innovation.

Fool contributor Chris Mallon owns shares of Microsoft through his private investment partnership.