What it means
Research and development, usually shortened to R&D, is money spent on discovering and building new products. Accounting rules often require much of it to be treated as an expense in the year it is incurred, which lowers reported profit.
The price to research ratio helps investors look past that and judge what they are paying for the research effort. The ratio is calculated by dividing the share price by R&D spending per share, or by dividing the whole market value by total R&D expense.
The two routes give the same answer. A higher figure means investors pay a larger premium for each dollar of research spend, perhaps because they expect strong results.
It is most helpful for companies that lose money or make little profit, where price-earnings ratios are meaningless. A young biotechnology company may have no profit at all but a large research budget, and the ratio gives a way to compare it with similar firms.
It also helps when profit is temporarily depressed by heavy investment. The ratio has limits.
It says nothing about the success rate of the research, and a company can spend a great deal for little result. It also ignores timing, since research spending may take years to pay off.
Different accounting treatments also matter, because some firms capitalise part of their development costs while others expense everything. Make sure you compare like with like, and treat the ratio as one input alongside revenue growth, patents and the product pipeline.
Boards also use the ratio when deciding how much to spend. If the company's research budget grows and the share price does not, the ratio falls, and that tells management investors are not yet convinced by the spending.
It is a prompt to improve communication about progress, such as clinical milestones or prototype tests.
In practice
Real-world examples.
Example
An investor in a biotechnology fund compares three loss-making drug developers. Their ratios are 8, 12 and 25, and she asks why the third commands a premium, learning that it has a late-stage trial under way.
Example
A semiconductor company reports flat profits but raises its research budget by 20%. Its share price does not move, so the price to research ratio falls, and analysts debate whether the market is doubting the payoff.
Example
An industrial group considers acquiring a smaller engineering company. The buyer uses the ratio to check whether the asking price is reasonable compared with other quoted firms that spend similar amounts on research.
Formula
Calculation
Price to research ratio = Share price / Research and development expense per share, which equals Market capitalisation / Total research and development expense.
A drug developer has a share price of $48 and 30,000,000 shares in issue, so its market capitalisation is $48 x 30,000,000 = $1,440,000,000. Its annual research and development expense is $90,000,000, which is $90,000,000 / 30,000,000 = $3.00 per share.
The price to research ratio is $48 / $3.00 = 16. Checking the other route gives $1,440,000,000 / $90,000,000 = 16, the same answer. If a peer trades at 9 times its research spending, the first company carries a much higher premium for each research dollar. If the first company raised its research budget to $120,000,000 and the share price stayed at $48, the ratio would fall to $1,440,000,000 / $120,000,000 = 12, because the same market value now sits on a larger research base.Case study
Seen in the real world.
Zenith Genomics is a fictional company developing gene-based diagnostic tests. In an illustrative year, it reported a loss, so its price-earnings ratio could not be used, and an investor turned to the price to research ratio instead.
The ratio stood at 22 against a sector figure of 12. Reading further, the investor found that most of Zenith's research spending was on one platform with a single late-stage test, so the premium reflected concentrated hopes.
The fictional company's test was approved the following year and the ratio fell back as revenue arrived. The case shows how the ratio can point to where expectations are concentrated, although it cannot say whether those expectations will be met.
Watch out
Common mistakes.
- Treating a high ratio as proof of a good company, when it may just reflect hype.
- Ignoring accounting differences, since some firms capitalise development costs and others expense them all.
- Using the ratio for businesses with little research spending, where it becomes meaningless.
Questions
People also ask.
Is the price to research ratio the same as price to R&D?
Yes, the two names describe the same measure.
Why use it instead of price-earnings?
It works for companies with little or no profit, where price-earnings cannot be calculated.
Which industries use it most?
Pharmaceuticals, biotechnology, software and other businesses with large research budgets. It is rarely used for retailers or utilities, where research spending is small relative to the rest of the business.
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