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
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
On the other hand, if you thought Sun Microsystems'
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
However, patents don't necessarily translate into money-making products. Think of Xerox
Then there's pharmaceuticals giant Merck
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
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
Still, not all companies are the same. Dell
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
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.
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Fool contributor Ben McClure hails from the Great White North. He owns shares in Dell. The Motley Fool is investors writing for investors .
