Is R&D a cost or an investment? How a value investor should look at R&D

It is inarguable that R&D leads to growth and therefore it becomes important that these expenses are treated properly from an investment analysis perspective.

About $200 billion is spent on research and development every year by the “Big 5” tech companies: Amazon, Alphabet, Meta, Apple, and Microsoft. Based on how accounting works right now, this is an expense.

In comparison, these companies have a totally free cash flow of about $240 billion at the moment. About $7 trillion is the enterprise value, which is the total market value of all debt and equity after cash is taken into account.

From an investment point of view, free cash flow is important because scientific investors (or most value investors) and valuation experts think it is the most important way to measure a company’s value.

Given how much these companies spend on R&D compared to how much free cash flow they have, it is important that R&D costs are treated correctly when analyzing investments.

It’s clear that new products help a company grow and that research and development lead to new products. So, there’s no question that R&D leads to growth.

Since growth leads to a higher market value, it makes sense that spending on research and development (R&D) also leads to a higher market value. Academic research has also shown that this is a good predictor of returns that come from alpha.

But the way accounting is done right now has the opposite effect. With more R&D, total costs go up and free cash flow goes down. From the point of view of a conservative value investor. The more R&D a company does, the lower its value is if it is not adjusted.

Also Read: Before you invest, you should think about these ten things

Conventional estimation

To see what this means, we’ll briefly talk about valuation models and then talk about how R&D spending can be treated in valuation.

Future revenue growth, capital investment intensity, future free cash flow margins, and the discount rate are used to determine a company’s intrinsic value.

The usual way to figure out what a company is worth is to predict its future free cash flows. then use an appropriate discount rate to figure out what those cashflows are worth right now. The discounted cash flow model is another name for this.

This model’s drawback is that negative cashflows often last 10-15 years before turning positive. Future revenue growth, capital investment intensity, future free cash flow margins, and the discount rate are used to determine a company’s intrinsic value. Variations in these variables’ assumptions would greatly affect intrinsic value calculations.

Since this description of intrinsic value is confusing, it’s vital to find a simpler model.

Think that the business is not trying to grow. A company that isn’t growing would need much less R&D to keep making money. It’s likely that 10 percent of R&D costs are enough to keep sales or income at a steady level. In that case, the rest of the R&D costs would be added to the company’s free cash flow, which could then be used to pay dividends to shareholders.

To be on the safe side, we keep 20% of the current R&D spending. The rest can be added back to the amount of free cash flow. This would give the Big 5 Tech companies an extra $170–$180 billion in “hidden” free cash flow, totaling $400 billion.

R&D impact

Multiple by 15, which is common in the US, the market value would be $6 trillion. Multiples of 20 and 10 provide $8 trillion and $4 trillion, respectively. At $7 trillion, the market values these companies as though they will never grow.

Five years after R&D spending, revenue is 11 times greater. These companies would make $2.2 trillion in five years. R&D has added $700 billion to the current $1.5 trillion in revenues.

A value investor estimates a firm worth based on facts.

Based on this, the current valuation of the Big 5 Big Tech businesses in this article would be $6 trillion in hidden steady state value + $1.5 trillion in current R&D. Both total $7.5 trillion. Future growth would increase value. There are ways to estimate them, but they’re more speculative than the steady-state and R&D values.

Mr. Market occasionally values companies conservatively. Value investors can invest in growth and innovation-focused companies then.

We caution against buying these firms or their index ETFs because not all are equally undervalued. The less undervalued or even overvalued ones may have a bigger weighting in some ETFs or funds. Our scientific investing framework favors selective portfolios.

Disclaimer:-Please note that any mention of company names is not a recommendation to buy, sell or hold. Equity investments are subject to market risks. Past performance is no guarantee of future performance. One should invest based on the advice of their financial advisor based on their investment objectives, financial situation, and risk profile. OmniScience Capital, its management and employees, and its clients might be buying, selling, or holding the mentioned companies.

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