ALEXANDRIA, VA (October 18, 1999) -- Sometimes it is easy to get way down the proverbial rabbit trail with our analysis of companies without ever considering the most basic questions, such as:

"How does this company make money?"

"What business is this company in?"

These questions act as a roadbed upon which the basis of our understanding should be built. To take this metaphor further, only once this roadbed is engineered, graded and laid, is a highway built. You could skip this part and just throw out the same high-quality asphalt upon unimproved terrain, but without the advance spadework, the road is virtually guaranteed to be substandard.

The Foolish foundation for investing is built around the same principle. Do your homework, ask the right questions, kick the tires, and above all, understand what the company does and how it makes money.

One such question I use centers upon a company's research and development (R&D) efforts. R&D is the process by which a company updates, revitalizes, and renews its product base. R&D can be among the most capital-intensive components of a company's cost structure, but just as all assets or earnings are not created equally, not all expenses are either. A true sign of a company in distress is one in which you see earnings growth bolstered by severe cuts in R&D. I would rather see a company miss its earnings estimates for a quarter or even a year and maintain "in-line" R&D investment than the other way around, because by reducing its development efforts, the company is in effect mortgaging its future potential earnings for the sake of current ones. ("In-line" means that if a company's R&D outlays have risen on average by 4% per year, that there would be an additional 4% growth for the current year.)

But just because a company throws tremendous resources at research and development does not mean that it is deriving proportionate returns from its investment. Apocryphal stories abound about the billions in potential market cap given away by Xerox, Bell Labs, and National Semiconductor by virtue of developing but not utilizing technologies later used by another company.

Fortunately, there are a few ways that we can track the efficacy of a company's R&D efforts. Phillip Fisher, the author of Common Stocks & Uncommon Profits, uses Research & Development efficacy as one of his "fifteen points to look for" in evaluating a company. Warren Buffett uses a method he calls the "one dollar premise," which is also known as "capital efficacy." Either is quite sufficient. For those who are unfamiliar, Fisher's process is to get down to the core points of the operations, any consideration of the common stock is taken only after one has reached satisfactory determinations on the business itself. To my mind, Fisher is a severely underrated investment mind, and his teachings underpin the philosophies of Charlie Munger of Berkshire Hathaway (NYSE: BRK.A) as well as the Rule Maker's own Tom Gardner.

For this example, I'll use one of my favorite Rule Maker companies -- Pfizer (NYSE: PFE). For those of you who follow the Pfizer message board, you are not having a case of soup du jour; I have covered this very topic, using these same statistics there. Feel free to skip ahead.

The "one dollar premise" gauges how much a company yields in market value for each dollar of retained earnings.

Retained Earnings = Net Income - Dividends

A rule of thumb is that a company should be able to return at least one dollar of market value for each reinvested dollar. Consistent failure to provide sufficient return for reinvested capital is a red flag for a management that is unable to add value to the company and its shareholders.

For Pfizer I found the following:
Year     Retained Earnings
1994        $   699M
1995            902M
1996          1,158M
1997          1,332M
1998          2,375M

Total       $ 6,466M
For this period, Pfizer's total retained earnings were $6,466 million. At the same time, Pfizer's market capitalization increased from $24.9 billion to $161.7 billion, an appreciation of $136.8 billion.

For each dollar Pfizer spent, $21.16 has been returned to its shareholders. This is an astoundingly high number, and speaks to the incredible efficacy of management's use of capital. To compare, Coca Cola's (NYSE: KO) capital efficacy comes in at a robust $10.22, while Union Carbide (NYSE: UK), a company that has been beaten down in the last several years, has returned a relatively anemic $1.24.

Another gauge is more specifically related to the efficacy of R&D expenditures. To calculate this, divide the total net earnings by the total R&D expenditures for a time period. For Pfizer, the total net income for 1996-98 was $7.5 billion, with an R&D expenditure during the same of $5.6 billion, for a return of $1.32 -- a very solid return. Our other pharmaceutical Rule Maker, Schering-Plough (NYSE: SGP) bests Pfizer with $1.71 of net income for each dollar of R&D over the same time period.

By way of comparison, Intel (Nasdaq: INTC) had net income of $18 billion for the combined years of 1996-98 and R&D expenses of $7.8 billion for a ratio of $2.30. For Microsoft (Nasdaq: MSFT), the net earnings were $10.1 billion, the R&D expenses $5.7 billion, for a ratio of $1.77. Caterpillar (NYSE: CAT), one of the Foolish 4 Rule Makers, surprisingly fared even better with a ratio of $3.19.

I'll point out in closing that this type of analysis, particularly the "one dollar premise," is an excellent way to compare companies in different industries from one another.

So go out, tear apart some financials and run some R&D numbers. If you have questions, we are always trawling the Rule Maker boards and would be more than happy to try to help.

Fool On!

- Bill Mann, October 18, 1999

Related Links:
- One Dollar Premise for Microsoft
- Foolish review of Common Stocks, Uncommon Profits
- Phil Weiss' Philip Fisher review (Parts 1, 2, 3, 4)