How does the financial environment affect the stock market valuation of R&D spending?

This paper investigates the role of the financial environment in the stock market valuation of research and development (R&D) spending by firms. We examine the importance of equity financing relative to bank financing and the importance of both relative to the size of the economy on the stock market valuation of R&D expenditures. Empirical analysis of the Compustat Global Vantage firm-level data indicates that, the more market-based a financial system is, the more R&D expenditures are valued by the stock market. The degree of financial development does not appear to be important. Our results remain materially unchanged after controlling for numerous firm and country differences.     

Innovative intensity and its impact on the performance of firms in Brazil

This article evaluates whether firms that invest in research and development (R&D) have better future performance and if stock market fully value such intangible investment. The results of annual cross-sectional regressions indicate a strong association between the intensity of R&D and future performance, even after controlling for other variables that affect future performance. However, after controlling for firm characteristics and risk factors, the innovative intensity was not significant in predicting future returns. In general, the results suggest that the R&D intensity is not useful for firm valuation in Brazil.     

The effect of management incentives and cross-listing status on the accounting treatment of R&D spending

This paper investigates the effect of management incentives and cross-listing status on the accounting treatment of research and development (R&D) spending for a sample of Canadian hi-tech and biopharmaceutical firms. U.S. GAAP adopts an immediate expensing rule for all R&D spending except for software development costs for which technological feasibility has been established. Contrary to the U.S., Canadian and international standard setters recommend capitalization if development costs meet certain criteria. Because those criteria are largely based on management judgment, capitalization of R&D spending is an accounting choice that can be used for income manipulation or signaling.Using a logit model, we examine how the decision to capitalize R&D spending is influenced by the cross-listing status and several other key firm characteristics that are well documented in the accounting literature. We find that the probability of capitalizing R&D spending increases for cross-listed and non-cross-listed firms in the software industry. The probability of capitalizing R&D spending also increases for firms that are more leveraged, more mature, and have higher level of cash flows from operations. However, the probability of capitalizing R&D spending decreases for larger corporations, firms with more concentrated ownership and highly profitable firms. Overall our results indicate a preference for Canadian firms in the software industry to emulate U.S. accounting practices for R&D spending. They also suggest that firms use the decision to capitalize or expense R&D spending as an earning management tool to either meet debt covenants or to smooth income.     

Stock market reactions to R&D cuts used to manage earnings

Prior research shows that stock returns are positive when firms meet or beat analysts' consensus earnings forecasts but negative when they miss. Past studies also show that managers frequently cut research and development (R&D) expenses in order to meet the consensus forecast. This study shows that the stock market penalizes this behavior and exacts a discount to the market reward if beating the forecast requires cutting R&D. However, it is only a partial discount and firms are still better off managing R&D expenditures in the short run. This study also shows that the reductions in R&D are likely temporary, as firms tend to increase R&D spending in the subsequent periods. Investors appear to recognize these short-term cuts and treat them similarly to accruals.     

The Impact of Corporate Diversification on the Long-Term Stock Return of R&D Increase Announcements

Prior studies have tested the long-term performance of research and development (R&D) spending, but the results are inconclusive. This study extends this line of research and explores the impact of corporate diversification on the long-term stock returns on R&D increase announcements. After controlling for the important variables in explaining the performance of R&D increases, a significantly negative association is found between the degree of corporate diversification and the long-run stock returns on R&D increase announcements. This result suggests that the costs of corporate diversification dominate the benefits regarding corporate diversification, and highlight the important effect a firm's diversification strategy has on the market valuation of R&D innovation.     

Mispricing of Research and Development Investments in a Rapidly Emerging and Electronics-Dominated Market

This paper documents prevailing mispricing of research and development (R&D) investments in the Taiwan stock market, a rapidly emerging and electronics-dominated market. Applying stock return data from July 1988 to June 2005, we observe that R&D-intensive stocks tend to outperform stocks with little or no R&D. The R&D-intensity effect cannot be attributed fully to firm size and seasonal effects. The R&D-associated anomaly not only exists but also persists for up to three years. The market apparently undervalues R&D-intensive firms and overvalues non-R&D-intensive firms. Finally, the R&D anomaly is clearer for firms in the electronics industry after 1996.     

The size,concentration and evolution of corporate R&D spending in U.S. firms from 1976 to 2010: Evidence and implications

The use of research and development (R&D) spending as an empirical proxy for managerial discretion, information asymmetry and growth opportunities, is pervasive in empirical corporate finance research. Underlying this is the implicit assumption that firms choose levels of R&D to maximize value, given firm and industry characteristics. An alternative framework views the level of R&D spending as subject to idiosyncratic behavior as managers myopically manipulate R&D expenditures to meet short-term earnings goals. Using aggregate firm and industry level data, we find evidence consistent with the view that R&D is determined by firm and industry characteristics. Time invariant firm and industry fixed effects explain most of the cross-sectional variation in observed R&D spending, while time-varying factors like size, profitability, or market-to-book explain little of the cross-sectional variation. We find that R&D spending continues to grow faster than advertising and capital expenditures. We also find no evidence of managerial myopia as corporate aggregate R&D expenditures are growing faster than aggregate profitability and the number of firms that undertake R&D has increased over the period from 1976 to 2010.     

Using real options theory to explain patterns in the valuation of research and development expenditures

Real options theory posits that the value of the firm is a combination of the value generated by the assets in place and the value of the option to invest in the future. It is based on the idea that many decisions are difficult to reverse, and valuing the outcome of these decisions is more complicated than estimating the present value of future cash flows. R&D activities often generate real options due to the nature of these activities, and examining the valuation of R&D expenditures through the lens of real options theory can help explain differing results documented in both the R&D and value relevance of earnings and book value literatures. Numerous studies have documented that the stock market positively values R&D expenditures; however, recent work has raised questions about whether this positive relation occurs across firms reporting both profits and losses. Consistent with real options theory, I find that the negative coefficient on the R&D expenditures of profitable firms documented by prior studies only exists for low growth firms. In addition, for all R&D firms experiencing high sales growth, the market places a lower value on assets in place and a higher value on R&D expenditures.     

Conservatism, Growth and the Role of Accounting Numbers in the Fundamental Analysis Process

I evaluate the effects of conservative accounting for research and development (R&D) and past growth in R&D on: (1) the relation between aggregate earnings (deflated by price) and contemporaneous stock return, and (2) the association between estimates of value derived from the residual income valuation model (i.e., RIV estimates) and equity market value. I show that the conservative treatment of R&D affects the earnings/return relation only for firms that experience high growth in R&D during the return interval of interest. I also demonstrate that the effect of conservative accounting for R&D on the association between RIV estimates and equity market values is increasing in past growth in R&D.This revised version was published online in August 2005 with a corrected cover date.     

The valuation relevance of R&D expenditures: Time series evidence

The literature on the valuation relevance of R&D investments is based primarily on cross-sectional regressions or panel data regressions with time and firm (or industry) fixed effects such that the parameters relating R&D to market value are cross-sectionally constant. In an alternative approach, this paper investigates the value relevance of R&D investment using an earnings-based time series valuation model. Model parameters are estimated for each firm separately. In contradistinction to the results obtained from cross-sectional and fixed effects panel models, this study finds weak empirical support at best for the value relevance of R&D expenditures at the firm level.     

The effect of capital market pressures on the association between R&;D spending and CEO option compensation

We examine the effect of capital market pressures for meeting earnings benchmarks on the relationship between R&D spending and CEO option compensation. We consider a particular scenario when firms face small earnings declines but could opportunistically reduce R&D spending to increase reported earnings. We find that firms with income reporting concerns punish their CEOs with lower option compensation when R&D spending increases but reported earnings decreases. Further, for firms with income reporting concerns, we find that the penalty for increasing R&D is greater when the firms frequently miss quarterly earnings benchmarks in the year. Overall, our findings suggest that the adverse consequence on CEO options encourages short-run compensation-motivated actions to eliminate or postpone R&D projects with positive net present values.     

Industry expertise on corporate boards

Recent surveys indicate that industry expertise is the most sought-after director qualification. Yet evidence on the value of such expertise is limited. This paper shows that firms that are difficult for non-experts to monitor and advise are more likely to appoint industry expert directors. Such appointments also depend on the supply of industry-experienced candidates in the local director labor market. Board industry expertise reduces R&D-based real earnings management and increases R&D investments. The increase in R&D spending is value-enhancing: firms with industry expert directors receive more patents for the same level of R&D, their R&D spending is associated with lower volatility of future earnings, and their value is higher. Finally, industry expertise is associated with CEO termination and pay incentives that encourage R&D investments.     

Measuring R&D curtailment among short-horizon CEOs

I review evidence produced by prior literature on CEO horizon problems and show that prior empirical findings are correlated with the research design employed. I find that evidence of R&D curtailment by CEOs as they approach retirement stems predominantly from cross-sectional correlations between CEO age or tenure and R&D spending. Using a broad sample of CEOs of S&P 1500 firms, I identify two factors that confound the cross-sectional relationship of firm R&D spending on CEO age or tenure which can lead to spurious inferences regarding the CEO horizon problem. I find that tracking R&D spending by the same CEOs over time produces no evidence of R&D curtailment. These results have research design implications for future researchers investigating the impact of shortened CEO career horizons on investment myopia.     

The information content of R&D reductions

An extensive literature shows that R&D intensities and increases are positively related to firm performance, but little research examines the valuation of R&D reductions. This paper fills the void by studying long-term performance following R&D reductions. We find that, contrary to conventional wisdom, large R&D cuts are associated with positive future stock returns. This return drift cannot be explained by asset pricing factors, including R&D intensities and R&D increases. We explore two potential economic motives behind R&D reductions: R&D spillover and firm life cycle. We show that operating performance deteriorates immediately before R&D reductions but exhibits no abnormal pattern afterward. While firm growth falls substantially and variability in profitability reduces, firms with low or declining investment opportunities and mature firms outperform. These findings are inconsistent with the spillover hypothesis, but support the life cycle story that firms attempt to resolve overinvestment in R&D that arises over the course of firm life cycle.     

Stock market valuation of R&D spending of firms acquiring targets from technologically abundant countries

In this paper, we aim to extend the internalization theory by Buckley and Casson [Buckley, P.J., Casson, M., 1976. The Future of Multinational Enterprise. Holmes & Meier, New York] and Caves [Caves, R.E., 1971. International corporations: the industrial economics of foreign investment. Economica 38, 1–27] in two respects. First, we hypothesize that synergies arising from a technology-oriented cross-border M&A increase the stock market value of an acquirer’s R&D spending. Second, we hypothesize that an acquirer’s access to a country with more favorable R&D environment through the target firm is the main source of synergy arising from intangibles in these M&As. Our empirical results of analyzing data from 10 most R&D active countries in Europe are consistent with these hypotheses and support our extension of the internalization theory. Specifically, we find that multinationality of a firm with intangible assets as such does not add value to R&D, but the combination of its own R&D with that of a firm located in a country with highly favorable R&D environment.     

Market Valuation of Research and Development Spending under Canadian GAAP*

Section 3450 of the Canadian Institute of Chartered Accountants (CICA) Handbook requires Canadian firms to capitalize development costs that meet certain criteria and to expense those that relate to research. International Accounting Standard (IAS) No. 38 favours a similar approach. In the United States, Statement of Financial Accounting Standard (SFAS) No. 2 recommends the immediate expensing of all research and development (R&D) spending. The only exception is SFAS No. 86, which requires software development costs to be capitalized when a product successfully passes a technological feasibility test. Consequently, the Canadian financial disclosure regime provides a rich setting for testing the market valuation of capitalized R&D. Our primary research question asks whether capitalized R&D provides useful information to market participants investing in Canadian firms. We use price‐level and return models to assess the value relevance of capitalized R&D disclosed in the financial statements under Canadian GAAP. In line with expectations, using a price‐level model, we find that capitalized R&D and R&D expense as disclosed in the financial statements provide information that is value relevant to market participants. However, we find that R&D capitalized during the year helps explain returns while R&D expense does not. Thus we conclude that the application of section 3450 of the CICA Handbook produces value‐relevant information.     

The Stock Market Valuation of Research and Development Expenditures

We examine whether stock prices fully value firms' intangible assets, specifically research and development (R&D). Under current U.S. accounting standards, financial statements do not report intangible assets and R&D spending is expensed. Nonetheless, the average historical stock returns of firms doing R&D matches the returns of firms without R&D. However, the market is apparently too pessimistic about beaten-down R&D-intensive technology stocks' prospects. Companies with high R&D to equity market value (which tend to have poor past returns) earn large excess returns. A similar relation exists between advertising and stock returns. R&D intensity is positively associated with return volatility.     

The sharpest tool in the shed: IPO financial statement management of STEM vs. non-STEM firms

The valuation of STEM (science, technology, engineering, and math) firms has recently gained attention in the literature. Research has shown that, for valuation of STEM firms, accounting items such as sales growth and R&D expenditures matter more than bottom-line earnings. We examine whether, around the time of the IPO, STEM managers apply discretion over the accounting items most weighted by investors for their valuation. We find that investors tend to weigh sales growth and R&D more heavily than earnings in valuing STEM firms and that managers respond by managing those items rather than bottom-line earnings as in prior research. We find that future stock returns of STEM firms are negatively associated with sales management and not with abnormal accruals as for non-STEM firms. Our results illuminate the differential behavior of STEM managers and highlight the importance of a departure from the traditional IPO earnings management paradigm, which assumes that firms mainly manage their earnings.     

R&D tax incentives: a reappraisal

This paper examines R&D tax incentives in oligopolistic markets. We characterize the conditions under which tax incentives reach the socially desirable level of firm-financed R&D spending. The outcome of the market depends not only on the level of technological spillover in the industry but also on the degree of strategic interaction between the firms. One major result emerges from the model: The socially desirable level of R&D investment is not necessarily reached by subsidizing R&D. When the technological spillover is sufficiently low, the government might want to tax R&D investments, and this result does not necessarily arise because firms are overinvesting in R&D. There are also cases in which an R&D tax is desirable even though firms are underinvesting in R&D compared with the first-best optimum. In practice, this theoretical finding calls for a lower sales tax combined with an R&D subsidy in oligopolistic industries with high technological spillovers, and a lower sales tax combined with an R&D tax in oligopolistic industries with low technological spillovers.     

Corporate Governance,Product Market Competition,and the Wealth Effect of R&D Spending Changes

This article examines whether corporate governance and product market competition interact to affect the profitability of corporate research and development (R&D) investments. Firms announcing R&D spending changes experience positive and significant wealth effects, and these effects are mainly driven by good‐governance firms. Investors appear to view announcements of R&D spending changes undertaken by firms with stronger shareholder rights as evidence of value creation. Moreover, the favorable wealth effects are stronger for good‐governance firms in noncompetitive industries than in competitive industries, supporting the argument that good governance substitutes for product market competition.