How R&D creates value for the firm and, ultimately, the investor

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Published: November 14, 2018 12:55:04 AM

Companies invest every year significant amount on research and development (R&D) activities because they want to grow by developing new products and services.

In sectors such as pharmaceutical, telecom, electrical, engineering, bio-technology, information technology, automobile, etc. R&D is a crucial component of innovation and a key factor in developing new competitive advantages.

Companies invest every year significant amount on research and development (R&D) activities because they want to grow by developing new products and services. It is difficult for companies to remain competitive if they do not stay ahead of the technology curve. While investing in a company’s stocks, we should focus on the R&D spending of that company. In sectors such as pharmaceutical, telecom, electrical, engineering, bio-technology, information technology, automobile, etc. R&D is a crucial component of innovation and a key factor in developing new competitive advantages.

Encouragement by government
The government encourages research in business. Under the Income Tax Act additional deductions for R&D expenses are provided. Scientific research and R&D expenses are covered. One hundred percentage deduction is available on expenses incurred on specified scientific research as per I-T Act. This 100% deduction is available in the year in which capital expenditure is incurred. But depreciation is not allowed on this capital expenditure. Further, expenses incurred in earlier three years before the commencement of the business is also allowed for deduction.

R&D creates value for the firm
In fact, R&D projects evolve over stages and generally the stages in an R&D projects such as start-up, failure, breakthrough, and new product introduction are often linked to each other in sequences, rather than standing alone as isolated events. Even failures and dead ends often provide valuable scientific and future product information.
The most important question is whether R&D investments create value for the firm. Investment science literature concludes that stock markets across the globe value firms’ R&D investments positively. The market value of traded firms is positively affected by R&D investments and stock prices react positively to announcements of new R&D investments.
At the same time, the outcome of R&D investments are subject to a very high degree of uncertainty. Short-term investors often view R&D expenses as a drag on profits because it is hard to measure the
long-term impact of individual R&D
investments.

Measuring outcome of R&D
Firms may be continuously spending R&D but there is no guarantee that the company will come out with innovative products / services. This is especially true for companies in the pharmaceutical, telecom, and technology sectors. One globally agreed way through which we can measure the outcome of R&D is patent volume. Under this method, investors can identify the overall patent volume and patent grant success rates. It measures the global reach of a company’s portfolio of intellectual property entries and gauges the impact of a patent on the basis of citations linked to it.
Companies across the globe spend money on R&D to ensure that their products and services sport the latest innovations and avoid being technologically
obsolete or suffer from market displacement effects and the like. Investors should check out the R&D spending before investing in a company.

P Saravanan is a professor of finance and accounting, IIM Tiruchirappalli. S Aghila is a doctoral research scholar from IIT Madras, currently doing her internship in IIM Tiruchirappalli

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