R&D AND CAPITAL MARKETS

The substantial growth of R&D expenditures over the last two decades, together with the continuous substitution of knowledge (intangible) capital for physical (tangible) capital in corporate production functions, has elevated the importance of R&D in the performance of business enterprises. At the same time, however, the evaluation of corporate R&D activities by investors is seriously hampered by antiquated accounting rules and insufficient disclosure by corporations. Despite the fact that the expected benefits of R&D stretch over extended periods of time, corporate investments in R&D are immediately written off in financial reports, leaving no trace of R&D capital on balance sheets and causing material distortions of reported profitability. After a brief review of statistics documenting the growth and economic importance of corporate R&D in the U.S., the article presents a comparison of R&D disclosure regulations among industrialized nations that shows U.S. rules to be the least flexible in allowing management discretion in how they measure and report R&D. Next the author surveys the large and growing body of empirical research on R&D, which provides strong testimony to the substantial contribution of R&D to corporate productivity and shareholder value. Moreover, despite widespread allegations of stock market “short termism” throughout the 1980s and early '90s, the research indicates “unequivocally” that capital markets consider investments in R&D as a significant value-increasing activity. But if investors clearly demonstrate a willingness to take the long view of R&D, there is also evidence of undervaluation of some R&D-intensive companies—particularly those with low profitability—as well as other potential costs to corporations and investors stemming from inadequate public information about R&D. To help correct the reporting biases and distortions of R&D, the author offers some suggestions for investors and analysts that follow R&D-intensive companies. In particular, he proposes (1) adjustment of reported data to reflect the capitalization and amortization of (instead of expensing) corporate R&D and (2) the use of various quantitative measures for gauging research capabilities and output, including citations of the firm's patents and measures indicating the share of current revenues coming from products developed within recent years.