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 (Nasdaq: MSFT) 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 Microsoft innovates. Technology companies can innovate either through acquisitions or by spending more money on research and development. We'll compare Microsoft'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, Microsoft has spent an average of 14% of revenues on R&D. The following table summarizes how Microsoft's R&D expenditure relative to revenues compares with some of the company's closest peers.

Company

2006

2007

2008

2009

2010

LTM

Microsoft

15%

14%

14%

15%

14%

13%

Apple

4%

3%

3%

3%

3%

2%

Google

12%

13%

13%

12%

13%

13%

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.

As you can see, Microsoft significantly outspends its rivals on R&D. But the comparison with Apple isn't completely, well, apples-to-apples. Microsoft makes the vast majority of its revenues on high-margin software, but Apple has significantly more hardware exposure. Differences in the companies' business models should mean Microsoft would have a higher R&D spend as a percentage of sales.

Still, the fact that Apple's R&D spend is only 18% the size of Microsoft's is telling. Although Microsoft has a large R&D wing, projects are often unfocused or difficult to bring to the market, and there are dozens of large-scale research initiatives constantly in progress at the company. That approach hasn't been working. Despite realizing the power of tablets earlier in the decade, the company was never able to introduce its own concept that consumers gravitated toward. The one tablet project that looked to have consumer appeal, the Courier, was squashed before it even saw retail shelves. In contrast, Apple's R&D process has a more laser-like focus on improving existing platforms to address user demands. Any way you slice it, Apple's tighter focus on a few product lines in its research spend has given it the best return on investment in its peer group.

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 look at Microsoft's free cash flow over the past five years against cash spent on acquisitions.

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

Although the company is highly acquisitive, Microsoft's cash flows are still robust, even after accounting for acquisitions. More importantly, organic growth is probably very similar to overall growth, since most acquisitions seem to be for companies that sport high price-to-sales multiples and that Microsoft believes will plug technology holes.

Final thoughts
It wouldn't surprise me if the company became significantly more acquisitive moving forward. Although acquisitions that the company managed to close have largely been for companies with technology Microsoft lacked, remember that the company also made an enormous offer for Yahoo! a mere three years ago. Meanwhile, after Microsoft and Nokia tightened their relationship recently, it wouldn't shock me to see industry dynamics shake out in a way that Microsoft could even be interested in Nokia in coming years. If anything, Microsoft's recent $8.5 billion Skype acquisition shows that the company will be willing to spend heavily to catch up in growth markets in the coming years.

That approach might give Microsoft the best shot at staying relevant as computing becomes more mobile, but it could also be a scary thought for value investors looking to cash in on Microsoft's rock-bottom valuation.

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Eric Bleeker owns shares of no companies listed above. The Motley Fool owns shares of Microsoft, Apple, IBM, Yahoo!, and Google. Motley Fool newsletter services have recommended buying shares of Google, Yahoo!, Apple, and Microsoft and have also recommended creating a diagonal call position in Microsoft and a bull call spread position in Apple. 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.