Few fields move as rapidly as technology. Businesses creating outsized profits and returns for shareholders quickly get a bull's-eye painted on their back as they become targets of other companies looking to disrupt their products by selling cheaper alternatives that still prove "good enough." Not only that, but even if a company continues to dominate its particular field, other changes in technology can shift spending away from their products. Think about how Microsoft still dominates PCs but feels pressure from the sales shift toward mobile devices such as smartphones and tablets.

With that in mind, today we're looking at how NVIDIA (Nasdaq: NVDA) innovates.

Technology companies can innovate either through acquisitions or by spending more money on research and development. We'll compare NVIDIA's spending in these areas with that of its closest peers and assess whether the company is investing enough in its future.

Research and development
Over the past five years, NVIDIA has spent an average of 22% of revenues on R&D. The following table summarizes how NVIDIA's R&D expenditures relative to revenues compare with some of the company's closest peers.

Company

2006

2007

2008

2009

2010

LTM

NVIDIA 18.0% 15.9% 25.0% 24.6% 24.0% 24.6%
AMD 21.1% 30.2% 31.8% 31.9% 21.6% 22.2%
Intel 16.6% 15.0% 15.2% 16.1% 15.1% 15.0%

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period.

NVIDIA's R&D spending as a percentage of sales ranks highest amongst its peer group in the past 12 months. However, in terms of actual dollars spent on R&D, the company trails Intel and AMD, both of which have far larger sales.

In 2008, the company ramped up R&D, but sales growth didn't materialize. Some investors took issue with that outcome, but it was partially the result of good foresight from the company. NVIDIA shifted resources away from its core graphics-processor business and into areas such as supercomputing graphics processors and a new mobile processor line named Tegra.

While the market for graphics processors in supercomputing functions looks very promising, mobile processor growth is exploding thanks to tablets and smartphones, and graphics processors are pressured from lackluster PC growth, NVIDIA's shifting of its R&D resources looks increasingly prescient. The main knock on the company, however, might be that it underinvested in graphics processors a little too much during this time. AMD pounced on the opportunity and took large amounts of market share in the graphics segment during 2009 and 2010.

Acquisitions 
In technology, some of the best companies have turned growth through acquisitions into an art. IBM has adeptly spun off capital-heavy businesses such as the hard-drive and PC segments, while it focused on acquiring additional services and software expertise that have transformed its business model.

On the opposite end of the spectrum, Hewlett-Packard is often criticized for underinvesting in R&D, to the point that it has to overpay on acquisitions to catch up with its competitors.

Investors should remember, most of all, that companies are valued by the cash flow they can bring in for their shareholders over time. If companies need to continue making purchases in perpetuity to keep growing, that amounts to a reduction in cash flows, and investors should treat acquisition spending as a continuing outflow against cash flow.

Let's take a look at NVIDIA's free cash flow over the past five years against cash spent on acquisitions.

G

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period. 2010 represents NVIDIA's 2011 fiscal year.

NVIDIA's not an overly acquisitive company, but it did make a recent splash by buying baseband specialist Icera for $367 million. That's the company's largest acquisition ever, even though it's still relatively small next to splashy buys such as Intel's McAfee grab.

There might be more buys coming, too. I recently had the opportunity to speak with Jeff Herbst, vice president of business development at NVIDIA. When asked about future acquisitions in the mobile space, he said that although nothing specifically is in the works, the company would be interested in future wireless opportunities.

Buying Icera gives NVIDIA a baseband component to sell, while key rival Qualcomm incorporates other features such a Wi-Fi, GPS, Bluetooth, FM, and now even near-field communications into its Snapdragon processor designs. It wouldn't surprise me if NVIDIA took a stab at another company selling communications chips in the future.

Final thoughts
NVIDIA's not only making a major push into mobile, but it's also nurturing a growing graphics-processor line targeted at supercomputing applications and launching an ambitious push into PCs and servers thanks to its "Project Denver" initiative. Given all this activity, R&D spending should logically rise in the coming years. In an ironic twist, these forays into new markets that present a threat to rival Intel are also being partially funded by Intel itself. The company reached a $1.5 billion settlement with NVIDIA that has Intel making annual $300 million payments over the next five years.

Given that it's still early in the development of crucial growth areas such as tablets, and with Windows opening up to companies licensing ARM processor technology, long-term investors will need to stomach any bottom-line pain these R&D expenses cause in the short run. The opportunity of diversifying away from consumer spending on graphics processors in PCs is worth the risk.

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Eric Bleeker owns shares of NVIDIA. The Motley Fool owns shares of Microsoft, Qualcomm, and IBM. The Fool owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Intel, NVIDIA, and Microsoft, writing puts in NVIDIA, and creating diagonal call positions in Intel and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.