What Is Research and Development (R&D)?

What is research and development?

Research and development is exactly what it sounds like: the researching and developing of new products and services for a business. Although you may not hear about it as much from companies like real estate investment trusts (REITs), it's important for every kind of business to engage in some amount of research and development to be able to offer products and services that the public wants.

Companies that are heavily dependent on research and development would include anything in the tech or pharmaceutical industry, but most companies have these expenses. They're generally included in the operating budget, found on the balance sheet.

Research and development models

Although we generally think of scientists employed by a company slaving over a hot beaker full of colorful and potentially dangerous liquid when we think of research and development, that's not always how it works. There are three common ways that companies handle their R&D.

Corporate departments

Many large corporations have internal research and development departments that do nothing but work on potential new products and services. They often employ experts like industrial scientists and engineers, but any number of professionals may be involved in research and development, depending on what kind of product the company offers.

Mergers and acquisitions

Some companies focus less on internal R&D and instead look for very small companies in their industry that make outstanding products. These large corporations may invest in these smaller companies, but they're more likely to acquire them instead, so they have full control over what happens with the product from there.

Start-ups and incubators

Start-ups and incubators can be a special situation when it comes to R&D. Unlike corporations, which dedicate a small percentage of their time and resources to developing new products and services, many start-ups are nothing but research and development. They may be aided by incubators, which help start-ups develop their product or service fully and create the product. For very small start-ups, incubators add the special sauce that it takes to get off the ground.

Research and development metrics

For investors, there are a couple of research and development metrics to pay attention to. These are return on research capital (RORC) and price-to-research ratio (PRR).

RORC is used to gauge the effectiveness of research and development spending by measuring and tracking the ROI of R&D over time. Although you can look at RORC once, it won't mean a lot unless you compare it to the same company across multiple periods to see how they're doing across time, as well as to competitors to see how they stack up. A company with consistently high RORC for its industry is one that's using its research dollars well.

The PRR is a ratio that compares the company's market capitalization to its R&D spending. You want to see that companies are putting enough money into R&D to continue to grow. Anywhere between five and 10 is a pretty solid number, but again, this must be compared to other companies in the industry to really be useful. You can calculate the PRR by dividing the market capitalization by the company's R&D spending for the previous 12 months.