By James Bell
We use Price-to-Research Ratio to compare the R&D spending to the company’s market value. In this way we can compare companies that are different sizes. The idea is that the more they spend on R&D in relation to their market value, it signals a greater effort towards innovation and will hopefully continue to create long term value. In 2018, Amazon and Alphabet spent the most on R&D at 22.6B and 16.2B respectively (source).
This ratio was developed by the investing guru Kenneth Fisher in his book, “Super Stocks”.
The idea is that you want a low ratio. Below is the suggested grading scale.
>15 = Avoid
>10 or ≤ 15 = Barely Pass
≥5 or ≤10 = Pass
<5 = Best
Their is no guarantee that greater R&D spending will lead to more value or profit down the road. Also, these expenses may even look like they are hurting the company in the short term if they are not able to realize profits stemming from such expenditures. This becomes somewhat of a subjective conversation at this point so while PRR may be a great ratio, it is never going to be the sole deciding factor in making an investment decision.
Research and Development costs
This is the market value, not book value, of the company. You can find the Market Cap on yahoo, google, or other financial sites. You can calculate this manually by multiplying the total number of shares by the share value.
We are looking at the total R&D expense for the last 12 months. It’s common to use 1 year of expenses and this is what we use to determine the Price-to-Research Ratio.
R&D expenses can be found in different places depending on if the company falls under GAAP or IFRS accounting standards. For US GAAP, we have to look at ASC 730 to know that these costs are expensed as they are incurred. There are special rules for motion picture films, websites, cloud computing, and software. For IFRS, we have to look at IAS 38 and it’s a little more complicated. This is because the company may capitalize some costs under IFRS. Depending on what regulatory body the company falls under, you may need to look at the balance sheet in addition to the income statement. This article by KPMG does a pretty good job of explaining the differences.
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