What it means
Some of the most valuable companies spend heavily on research, product design and development rather than on factories. Traditional ratios such as price to earnings can undervalue them, because spending on innovation is deducted from profit today while the benefits arrive later.
Price to innovation is an attempt to put the spending and the valuation side by side. There is no official formula, which is the first thing to know.
A common version divides market capitalisation by the annual spend on innovation, where that spend includes research and development, capitalised development costs and sometimes product design and patent costs. Another divides by the number of patents or new products launched, though that is much harder to compare.
A high ratio suggests investors value the business far above what it spends on innovation, which may mean they expect the output to be very productive or that they are paying a premium for a brand. A low ratio can mean the market doubts that the spending will pay off, or that the company is spending a lot for modest returns.
Neither reading is automatic. The ratio is most useful when comparing similar companies, for example two pharmaceutical groups or two software businesses.
It works poorly across sectors, because some industries need far more research spending than others. It also does not measure quality, so a business can spend a lot and still produce little.
Managers can use it as a prompt for questions rather than as an answer. If the company's ratio is far below its peers, the useful question is whether the innovation budget is too large, too unfocused or too slow to turn into products.
Because the ratio is informal, it works best as a conversation tool inside a company. A board can use it to ask whether the innovation budget is earning the valuation it supports, and an investor can use it to compare how different management teams turn spending into market confidence.
Always write down the definition used so later comparisons stay consistent.
In practice
Real-world examples.
Example
An analyst compares two medical device makers and finds one valued at 14 times its innovation spend and the other at 7 times. She investigates the product pipelines and learns the first has two products awaiting approval.
Example
A venture investor reviewing a listed competitor of one of her start-ups uses the ratio to judge whether the market is paying a premium for new technology. The comparison helps her decide how aggressive to be on valuation.
Example
The finance director of an engineering group notices that his company's ratio is well below its peers. He asks the technical team for a breakdown of how much innovation spending has led to launched products.
Formula
Calculation
Price to innovation = Market capitalisation / Annual innovation spend, where innovation spend is defined consistently, for example research and development plus capitalised development plus product design costs.
A software company has a market capitalisation of $2,400,000,000. Its annual innovation spend is $150,000,000 of research and development, $30,000,000 of capitalised development and $20,000,000 of product design, a total of $200,000,000.
Price to innovation is $2,400,000,000 / $200,000,000 = 12. A rival worth $1,500,000,000 that spends $250,000,000 has a ratio of $1,500,000,000 / $250,000,000 = 6. The market pays twice as much for each dollar of innovation spending at the first company, which may signal higher confidence in its pipeline, or simply a premium that could prove too high.Case study
Seen in the real world.
Solara Diagnostics is a fictional maker of laboratory testing equipment. In an illustrative board meeting, the finance director presented a price to innovation of 5 against a peer average of 11 and asked why investors valued each innovation dollar so low.
The answer, after review, was that the company had three long projects with no launch dates, whereas competitors announced new products every year. Investors could see the spending but not the output.
The fictional company responded by splitting the work into smaller stages with public milestones. Over time the ratio moved toward the peer level, which showed that clear delivery matters as much as the size of the budget.
Watch out
Common mistakes.
- Treating the ratio as an official standard, when each analyst may define innovation spend differently.
- Comparing companies across different sectors, which have very different needs for research spending.
- Assuming that more spending always means better innovation, when results depend on focus and execution.
Questions
People also ask.
Is there a standard formula for price to innovation?
No, so always state what is included in the innovation spend and use the same definition for every company you compare.
How is it different from price to research?
Price to research normally uses reported research and development only, while price to innovation can take a wider view of innovation costs.
Can the ratio be used for private companies?
Only loosely, using a valuation from a funding round or an estimate in place of market capitalisation.
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