1. Session 22-23: Readings of Scholar’s Interest
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Course code: 622 Seminar in Finance
Synopsis on: The Stock Market Valuation of Research and
Development Expenditures
By Louis K.C. Chan, Josef Lakonishok, and Theodore Sougiannis, University of Illinois
Presented to: Prof. Dr. Radhe Shyam Pradhan, Tribhuvan University
Presented by: Sudarshan Kadariya, 6th
Batch, M. Phil in Management, TU.
Background: The market value of the stocks ultimately reflects the value of all its net assets and it is relatively
apparent when most of the assets are physical. But, in modern economics, a large part of a firm’s value may
reflect its intangible assets such as brand names, R&D expenditure, advertising and alike. Under generally
accepted accounting principles in United States (US), however, such intangibles are generally not recorded on
financial statements and treated as a current spending. Though the investment on intangible assets is not fully
amortized in a single year and it has multiplicative invisible effect in future. The average return on stocks that
do R&D is comparable to the return on stocks with no R&D. The absence of any differences is consistent to the
notion that the market price on average incorporates fully the benefits of R&D spending.
Motivation: There can be potentially large effects on many firms’ future earnings due to the investment on
R&D and similar types of spending. For instance, high level of spending in R&D suggests that large distortions
can arise from expensing rather than capitalizing R&D costs. If investors fail to adjust standard valuation
measures such as P/E or price-to-book ratios for the long-term benefits of R&D, potentially severe mispricing
can arise. Specifically, the study focused on R&D because the high R&D firms are difficult to value – future
profits are tied to the success of new untested technologies which are highly unpredictable, the benefits of the
current efforts are usually materialized far in the future, and R&D accounting information is of limited
informative. In another way, authors provided the striking example that the amount of R&D spending in some
major technology industries is larger than their earnings. Finally, firms are requested by the authorities to
disclose their R&D expenditures in their financial statements, unlike many other kinds of spending on
intangible assets. With these explanation, it is justified that the scope and the motivation of the study.
Research gap: In an efficient market, there is no problem of valuing the firm where the non-existence of the
association between the R&D investment and future stock returns but, the complications arise when the
possibility that stock prices do not fully incorporate the value of R&D capital. Some authors (Porter (1992),
Hall (1993), and Hall and Hall (1993)) suggested that investors have short time horizons so they fail to
anticipate the rewards from long-term investment such as R&D. On the other hand, many firms’ R&D
investments are not profitable, Jensen (1993) but investors systematically overlook this possibility, results
overvaluation. With these limited previous studies, the study found the considerable research gap concerning
the association between future returns and R&D investments and initiated the effort.
Research question: The study addressed the question of whether stock price appropriately incorporate the
value of the firms’ R&D investments.
Purpose: To examine whether stock prices fully value firm’s intangible assets, specifically investment in
research and development (R&D).
Methodology: The sample is all domestic firms listed on NYSE, AMEX and NASDAQ. All the financial
information was taken from the COMPUSTAT active and research files and market value of common equity
was from the CRSP stock return files for the period 1975 to 1995. The firms’ R&D capital is estimated from its
past history of R&D expenditures. Since no consensus on estimates for the useful life of expenditures and the
Full citation: Chan, L.K.C., Lakonishok, J. and Sougiannis, T. (2001). The stock market valuation of research and
development expenditures. The Journal of Finance, Vol. LVI (6), pp. 2431-2456.

2. Session 22-23: Readings of Scholar’s Interest
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amortization rate, the study adopted the tractable approximation model suggested by Lev and Sougiannis (1996).
These estimated R&D capital measure the proportion of past spending that has productive effect in a given year.
The study effectively assumed that the productivity of each dollar of spending declines by 20 percent a year i.e.
the linear regression model is;
RDCit = RDit + 0.8RDit-1 + 0.6RDit-2 +0.4RDit-3 + 0.2RDit-4
Where, RDCit is R&D capital for firm i in year t based on current and past R&D expenditure, RDit. For the
analysis, R&D spending is expressed relative to total sales, earnings (net income), total dividends, or book value
of equity. Thus the study used altogether five basic variables. Apart from the R&D capital estimates, portfolio
formation and analysis, the study adopted the following regression models.
Rpt – Rft = ap + bp[RMt – Rft] + spSMBt + hpHMLt + wpWMLt + dpUMDt + ept
The model is estimated using monthly returns from each of the first three years following portfolio formation.
Here Rpt – Rft is the monthly return on portfolio p in excess of the Treasury bill rate in month t, RMt – Rft is the
excess return on the value-weighted market index, and SMBt, HMLt are the returns on the Fama and French
(1993)) factor mimicking portfolios for size and book-to-market, respectively. The factors WMLt and UMDt
pick up the effect of long-term and intermediate-term past returns, respectively. Finally, the R&D and return
volatility are measured with the following cross-sectional regression.
σit = γot + γ1t LNSIZEit + γ2t LNAGEit + γ3t RDSit + ∑ 𝛷𝑗𝑡 𝐼𝑁𝐷𝑖𝑗𝑡𝐿
𝑗=1 + eit
The regression relates each stock’s return volatility σit (the st. dev. of monthly returns based on the subsequent
12 months) to the variables; firm’s stock market capitalization in logarithms, LNSIZEit; firm’s age in logarithms,
LNAGEit; R&D intensity relative to sales, RDSit; and dummy variables for industries, INDijt.
R&D expenditures relative to sales and, R&D expenditures to the market value of equity are used to measure
R&D intensity. This intensity measure is interpreted in the same way as conventional indicators such as
earnings or book-to-price ratios.
Major findings:
The Importance of R&D Spending
A. Measures of R&D Intensity: The time series data shows that R&D spending has grown sharply in importance
and R&D spending is heavily concentrated in technology and science oriented industries (computer
programming, software & service, Drugs and Pharmaceuticals, and computer and office equipments). Thus,
the magnitude of figures suggests that expensing R&D costs may distort conventional valuation yardsticks
i.e. P/E & P/B ratios or mispricing.
B. The impact of expensing R&D costs: The R&D intensive industries highlight the potential distortions from
immediately expending R&D. The amortization adjustment is especially striking for software industry (SIC
737) which indicates that the assumption of five-year life for R&D expenditures may be too long; whereas
for drugs and pharmaceutical industry five-year may not be long enough. Based on the amortization
adjustment effect on P/E and P/B ratios in several industries, it is suggested that in the highly R&D intensive
industry, the practice of immediately expensing R&D outlays can have substantial distortive effect on
accounting information.
R&D Activity and Stock Returns
A. Portfolio results based on R&D relative to sales: Contrary to the common thought that firms doing R&D
provide superior stock price performance. But, the study found that firms that carry out R&D is on average
no different from those of firms without R&D i.e. the market on average correctly values any future benefits
from research spending.

3. Session 22-23: Readings of Scholar’s Interest
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Against, the previous studies’ presumption that these stocks have historically earned comparatively low
returns, the study indicated that their average returns are similar to those of the other stocks. Thus, it is
appeared that glamour stocks, namely highly R&D intensive stocks, do not have the relatively poor returns.
The finding also support that a glamour stock that is highly active in R&D earns a slightly higher return than
other glamour stocks.
The average annual growth rate in earnings is virtually the same for stocks with R&D and without R&D.
Thus, it is concluded that simply doing R&D by itself does not, on average, give rise to differential stock
price performance.
B. Portfolio results based on R&D relative to market value: Stocks with high R&D intensity relative to market
value, there is subsequent recovery of past losers. In another way, even though, high R&D spending directly
depresses earnings, there may be prospects of regaining the profitability in subsequent years.
The nature of investor clientele for R&D intensive technology companies may be an additional factor in
determining stock prices. There may be potentially more severe underpricing when R&D intensive stocks
experience poor performance.
Thus, the results suggested that any mispricing of R&D stocks is more likely to be associated with firms with
poor past performance.
Additional Results
A. Alternative risk adjustment procedures: The regression results shows that, the abnormal performance of
stocks with high R&D to market is not solely driven by return reversals associated with past losers; and the
large returns on the portfolio with high R&D intensity relative to market are not entirely due to risk.
B. Advertising and stock returns: The results for advertising expenditure relative to market essentially agree
with the findings for R&D relative to market i.e. advertising intensive firms with poor past performance
recover in subsequent year.
R&D and Return Volatility
The evidence suggests that there is an association between R&D and return volatility.
Conclusions
Under generally accepted accounting principle in US, intangibles are treated as current expenditures. The
empirical evidences suggested that high level of spending on R&D may lead to mispricing of stock from
expensing rather than capitalizing R&D costs, if investors fail to adjust. The evidence does not support a direct
link between R&D spending and future stock returns or the finding is consistent with the hypothesis that the
stock price incorporates investors’ unbiased beliefs about the value of R&D. Thus, the major conclusion of the
study is that 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, and there is positive association
between R&D intensity and stock return volatility.
Critical appraisal
The study made the simple analysis concerning relatively unexploited area in finance. The industry wise
differences on the effects of intangibles provide the useful insight for the investors, managers, academicians and
researchers. The evidences of return reversal for R&D intensive poor past performers, opined the new scope for
future works.
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