Price to research ratio
Published on: Mar 4, 2016
Transcripts - Price to research ratio
MAGIC NUMBER 06
PRICE TO RESEARCH RATIO (PRR)
This ratio compares the company’s market value with the amount it spends on
research and development to try and gauge whether the stock market is putting a high
or low value on this spending.
PRR = Share price / R&D expenditure per share
R&D Expenditure – This term is somewhat ambiguous. Its scope differs from
company to company and industry to industry. It will range from pure research on the
hand through to technology licensing, and the purchase of proprietary technology
from third parties. It may even include test marketing or market research, or the cost
of getting science based products through the regulatory hurdles they may need to
satisfy. There may be differences from company to company in what is and what is
not included. Most companies in the same industry will probably use broadly similar
conventions in the way they define this item.
Issued shares (common stock) outstanding – these are shares that have been issued
and which are publicly traded. This includes shares that are ‘tightly held’ by directors
and their families, even though these may rarely change hands.
Sometimes earnings per share calculations are based on ‘fully diluted’ issued shares
outstanding. This takes in, for example, any extra shares that may be issued in the
future as a result of the exercise of executive share options and other effects. If this
item is significant it is probably also worth applying this fully diluted calculation to
work out research and development spending per share.
Earnings per share calculations also normally use ‘weighted average’ shares in issue.
This is the average number of shares in issue during the period when the profit was
being earned, giving due weight to new shares issued during the period, in accordance
with the time they were issued. New shares issued at the beginning of the year carry
more weight than those issued at the end.
To be strictly accurate, calculations of R&D spending per share should work on the
same basis, since the spending accrues during the course of the year.
Share (stock) price – the current market price of the shares. This is normally the mid-
market price at the close of business on the previous trading day.
Where’s the data?
R&D Expenditure – This is normally either disclosed on the face of the profit and loss
account (income statement) or in the relevant notes to the accounts. It may be part of
the note that itemises the amounts deducted to arrive at operating profit. Most
companies for which it is important will generally disclose it openly, making it easy
to locate the correct figure.
Issued shares outstanding – Weighted average shares in issue during the year can
usually be found in the note to the accounts referring to the earnings per share
Share (stock) price – from any daily newspaper or financial web site. Take care to use
the actual share price and not the prices of any options, warrants, partly paid shares or
other derivatives. Take note also of the units in which the share price is expressed. In
the UK, shares are traditionally quoted in pence, but in $ in the US and in € in
Continental Europe. You need to make sure that the R&D spending per share figure
conforms to the same units as the price so that you are comparing like with like.
Calculating it – the theory
Table 6.1 shows a fictional example of how the highlighted numbers can be used to
calculate the ratios in question
Calculating it for… Microsoft, Glaxo, and Sony
The table shows how the highlighted numbers from the extracts from the accounts of
Microsoft, GlaxoSmithKline and Sony combine to produce the ‘magic numbers’.
This calculation is fairly straightforward. We have taken fully diluted shares in issue
where appropriate to calculate the R&D per share figure. We could, however, perform
the calculation another way. We could work out the company’s stock market
capitalisation and then compare this with the R&D number straight from the accounts.
However, since market capitalisation calculations traditionally use the latest available
shares in issue figure, this would often produce a slightly different result.
What it means
The results of the example point up one reason why this calculation is valuable and
one of its drawbacks.
In theory there is no reason why we can’t compare companies in this way across
borders. It is sometimes suggested that the greater percentage of sales a company
spends on R&D the more highly the market is likely to value that spending. In fact,
though we haven’t calculated it here, Microsoft spends three times as a much as Sony
in terms of R&D as a percentage of sales. Microsoft’s PRR is approximately ten
times that of Sony.
One reason for this is undoubtedly the sharp difference in the general level of stock
market values in the US versus Japan. Despite the sharp fall in Microsoft’s share price
over the past couple of years, we need to bear in mind that Japanese equities have
been in a bear market for the best part of a decade.
But the market may in fact be behaving rationally. Sony’s return on equity and
margins are less than Microsoft’s. The market may simply be making the judgement
that, based on its past record, Microsoft will ultimately generate more sales, profits
and cash from its research and development spending than Sony is likely to. If so, it
makes sense that its spending should be valued more highly as a result.
It is, however, probably more appropriate to use this number when we are companies
in the same industry and the same country. Some observers believe it is a particularly
useful ratio to use when companies are research intensive and are therefore making
losses when measured by conventional accounting.
Analysts would then use a combination of price to sales and price to research ratios to
try and work out which company had most future potential. It would also be relevant
in this context to use the ‘burn rate’ calculation we explored in the original Magic
Number’s book to decide how long the company might be able to survive on its
present cash resources without further fund raising. Software companies and biotech
and other science-based businesses are obvious examples where analysis techniques
like this can be used.