Sure, we all like to see robust growth in earnings per share (EPS). Psychologically, at least, it just seems very intuitive as an investor to look at the earnings per share number and think, "Hey, that's mine." As an investor in Amgen (Nasdaq: AMGN), for example, I can just look at Amgen's quarterly report, see its $1.02 per share earnings, multiply it by the number of shares I own, and calculate how much of the company's profits belong to me.
For a company like Amgen, however, and for most technology-oriented companies, that fiscal 1999 EPS number is just a marker on a road sign; it only indicates the general direction the company is headed. For companies competing in industries where intellectual and technological assets such as drug patents, smarter network routers, or faster circuits are crucial advantages, continued research and development (R&D) spending is the only sure way for our Rule Makers to keep ahead in their industries. With the intense scrutiny with which the quarterly earnings numbers are subjected, it must be tremendously tempting for a high-tech company to pump up current earnings in any way possible. Often, the easiest way to enhance current earnings is to sacrifice a little of their current R&D spending.
Because investing is about the future and not the past, Fools hate to see R&D skimped upon and will avoid companies that appear to be juicing current earnings by limiting R&D spending. Especially for drug manufacturers, biotechnology companies, and medical technology firms, accounting conventions certainly seem to penalize R&D spending. Let's review three ways that companies tend to invest in their future, and how they are handled on the income statement.
First, there is the purchase of plants, equipment, and other large capital expenditures (sometimes dubbed "cap-x"). These are large costs, and because these types of expenditures have a predictable usable life, the expenses are amortized on the income statement over a number of years. Such substantial investments are not expensed all at once, as it wouldn't make sense to charge the entire cost of a new plant or piece of machinery in one quarter or fiscal year, because the company will continue to recognize benefits from that investment over a long time period.
The second way companies invest in their future is through acquisitions. Companies like Cisco (Nasdaq: CSCO) often find that it is more economical for them to purchase entire companies in order to obtain new technology, expertise, or other knowledge-based assets to incorporate into their own business and fuel future growth. (In fact, Cisco is legendary for its ability to rapidly acquire and successfully integrate numerous small companies each year.)
Acquisitions can be accounted for by one of two methods: purchase or pooling. If acquired by the purchase method, the company amortizes goodwill (the amount by which the purchase price exceeds book value) over a long period of time, which results in slightly reduced earnings over the amortized period. If acquired by the pooling method, the companies combine financial statements. For some additional explanation of purchase versus pooling, our in-house accounting expert, Phil Weiss, recently offered his thoughts on the matter in the context of JDS Uniphase's (Nasdaq: JDSU) acquisition track record.
The third and final way a company grows its business is through in-house R&D. In an industry like drug discovery and development, revenues and profits don't come until the Food and Drug Administration (FDA) approves the products. And approval doesn't come until the company has spent millions upon millions of dollars for research, development, and clinical testing. Companies can create a sustainable advantage in their industry by outresearching and outspending their competitors in the search for new drug candidates. Unfortunately, every dollar that goes into R&D comes directly out of net earnings in the quarter that it is spent. For companies that do a lot of research, this can really understate the current profitability of the current operations.
Back in October of last year, our own Bill Mann described a couple of ratios one can use to evaluate the efficacy of a company's R&D spending. One of those methods was to calculate a company's net income over a period of years and divide that into the R&D expenditure over the same period. To use Bill's example, from 1996 to 1998, Pfizer (NYSE: PFE) invested $5.6 billion in R&D and produced $7.5 billion in net income. Using this method, Pfizer has produced $1.32 in profits for every dollar in R&D. The problem with this formula is, of course, that if you have a company that has spent NO MONEY whatsoever in the past couple of years in R&D and is just living off of current sales of a soon-to-be outdated product, the net income-to-R&D ratio is going to seem very good. Of course, this company is NOT investing in its future, and will likely be overtaken by more R&D-intensive competitors.
I do agree with Bill that one of Philip Fisher's (author of Common Stocks & Uncommon Profits) greatest contributions to investing literature was his emphasis on finding companies with sustainable R&D advantages. Fisher considers R&D something of a commodity, and because there is really no way of directly measuring returns on a company's R&D investment, it is generally easiest to assume that one unit of R&D will universally equal X units of return on that R&D across all companies.
Of course, the ratio is likely to be different across industries, which is why it's best to compare R&D of companies within the same general industry sector. Fisher's favorite tool was the Price-to-Research ratio. Simply take the market cap of a company (share price times number of shares outstanding) and divide into the trailing 12 months of R&D spending. By using the Price-to-Research ratio, one should be able to identify opportunities to purchase companies that are heavily investing money in R&D at the expense of current profits. Let's try this ratio on Amgen:
Amgen's market cap (as of January 26) was $65.5 billion, and the company has spent $822 million on R&D in the past 12 months. That gives us a Price-to-Research ratio of 79.6, meaning an investor is paying $79.60 for each dollar in R&D. Fisher typically looks for companies with a Price-to-Research ratio under 10, which indicates that a company is dirt cheap relative to the amount of money they have spent on research. These would typically be companies that Wall Street has pounded due to lack of current earnings, but that should have valuable knowledge assets. With a ratio of 79.6, Amgen is no bargain here.
Many other ratios have been developed by longtime high-tech guru Michael Murphy, who now brings you the California Technology Stock Letter. Murphy's biggest contribution is what he calls the Price-to-Growth Flow ratio (no relation to our Foolish Flow Ratio). Growth Flow attempts to identify companies that are producing good current earnings and are simultaneously investing a lot of money in R&D. To calculate the Growth Flow, simply take the last 12 months R&D divided by shares outstanding (I use diluted shares) to get R&D per share. Add this to EPS and divide by the share price. Again, let's use Amgen as an example.
In fiscal 1999, Amgen spent $822 million on R&D, and has 1,078 million diluted shares outstanding. This equates to $0.76 in R&D per share. Add this to the EPS of 1.02, and you have 1.78 of combined earnings and R&D. Divide this into the current share price of $62.87, and you get a Price-to-Growth Flow (PGF) ratio of 36, significantly lower than the P/E of 61.6. Especially for smaller biotech, software, and other high technology firms, the PGF can sometimes get down to 8 or 10 for even good companies.
Another Murphy favorite is the P/E-to-R&D/Sales ratio -- a beast to look at, but it's really not too complex. First, calculate R&D as a percentage of sales. In 1999, Amgen's revenues were $3,340 million and R&D was $822 million. Divide 822 by 3340, and you come up with 24.6%, which is Amgen's R&D investment relative to sales. Amgen's P/E ratio is 62.7, or 2.5 times the R&D/Sales metric. Murphy looks for companies with a P/E lower than the R&D/Sales ratio as a quick way to tell if a company's stock may be cheap compared to it's R&D spending.
So, how can you use this information as Rule Maker investors? Well, keep tabs on your company's R&D/Sales ratios, and make sure that the ratio stays relatively constant or at least that the absolute R&D spending doesn't drop. Also, if you are on the fence about a given company due to it's high P/E ratio, you can run the PGF ratio as well. For a research-intensive company like Amgen, it will give you a better feeling for the value you are getting than the standard P/E ratio.
In the chart below, I've run some comparisons for various pharmaceutical and biotech companies. If you have any questions or comments, why not speak up on the Rule Maker message boards? Click on one of the links below.
Until next time, y'all be Foolish!
AMGN BGEN PFE AHP LLY Share Price (1/26) 64.13 97.00 34.94 44.00 62.75 Market Cap** 65.5 14.6 135.3 57.5 68.4 Sales* 3340 794 14,133 13,555 10,003 R&D* 823 221 2,776 1,739 1,784 Net Income* 1,096 220 3,179 (1,227) 2,721 EPS (Diluted) 1.02 1.40 0.82 (0.94) 2.46 Diluted Shares* 1,078 157.8 3,877 1,309 1,106 P/E 62.9 69.3 42.6 N/A 27.8 Price-to-R&D 79.6 65.9 48.7 33.0 38.3 R&D/Sales 24.6% 28.0% 19.6% 12.8% 17.8% R&D/Share 0.76 1.39 0.72 1.33 1.61 EPS + RDS 1.78 2.79 1.54 0.39 4.07 Price-to-GF 36.0 34.8 22.7 88.6 15.4 P/E-to-R&D/Sales 2.72 2.48 2.17 N/A 1.5 *Dollars in millions **Dollars in billions