The importance of R&D to future financial health

I probably could have titled this article, "Why I am concerned with companies that give dividends" since I feel these subjects are intertwined. When a company gives a dividend but doesn't have a large sum of money going into corporate R&D, I am very concerned about the long-term health of that company. A company dividend is basically saying that the managers of the company cannot think of anything better to do with the money than to give it back to the shareholders. While I have nothing against getting a check from my portfolio companies, I don't want that check to starve future product development that could make the company even more profit in the future.

It isn't difficult to measure R&D but it is sometimes difficult to measure its effectiveness. To measure R&D, you should use one or both of the following techniques.

  • PRR (Price to Research) - This is the market value of the company divided by its research-and-development expenditure over the last twelve months. Look for companies with PRRs between five and 10 and avoid companies with PRRs greater than 15. By looking for low PRRs, investors should be able to spot companies that are redirecting current profits into R&D, thereby better ensuring long-term future returns.
  • Price/Growth Flow Model - Price/growth flow attempts to identify companies that are producing solid current earnings while simultaneously investing a lot of money into R&D. To calculate the growth flow, simply take the R&D of the last 12 months and divide it by the shares outstanding to get R&D per share. Add this to the company's EPS and divide by the share price.

It is far more difficult to look at the effectiveness of R&D. One way, is to calculate the percentage of sales that come from products introduced over the preceding three years. For the calculation, investors need annual sales information for specific new products and this can sometimes be difficult to find. Sometimes, the investor simply has to read the annual report and take note of the CEO or Chairman comments on new product introductions - a lack of conversation often means a lack of products.

Finally, be careful to not overly reward high R&D industries. For example, the pharmaceutical industry spends a huge amount in R&D due to the nature of its market. Just like P/E analysis that I explain in my book, The Confident Investor, R&D spending needs to be compared among its peer group.

If you are amazed at the high dividend given by a company, take a look at their PRR or Price/Growth Flow.  How does that compare to its peer group?  If it is not keeping up then that dividend could actually be starving the long-term potential of the company.

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