Sector Views

Research & Development Spend – is all that glitters really gold?


This is the second article in our series on research & development (R&D) data. My previous article – R&D benchmarking – proceed with caution – looked at the dangers of extracting R&D data for benchmarking purposes. So how should investors use R&D data to assess suitable levels of investment?

Revenue spend ratio is the total reported spend on R&D as a percentage of reported revenue. In the software and technology universe, especially in North America, it is common to see ratios of 15% to 20% reported by the majors – a ‘gold standard’ that separates innovative companies from the laggards.

Careful spend

With a steady capital inflow from trading or equity, it is easy to spend cash on R&D and land in the 15% to 20% range, or even outperform and spend 40%. Many investors will know, to their cost, this spending doesn’t always generate the desired result. A company may achieve a ‘gold standard’ spend ratio of 20% because R&D is over budget and sales are under!

I think a company should evaluate each R&D project on its merits by considering the planned cash return to shareholders. This may mean reviewing discounted cash flows to evaluate whether to proceed with an R&D project, modify the approach, or do something entirely different.

Importantly, a board should approve and then robustly monitor expected cash flows to actual cash flows. It’s acceptable to spend speculatively, but acknowledge you have done so. Project pre-approval promotes control and accountability. Monitoring creates a healthy and challenging environment, preventing scope drift and focusing on investor return. How often have investors been promised that R&D investment will grow sales, only to be delivered a bill for R&D spending that merely sustains current sales?

Lessons learned

Rather than comparing R&D investment ratios, it’s more relevant to compare the company’s R&D process with successful peer companies around the world and learn from this. How do successful peers manage capital allocation? How much are others prepared to write-off each year from creative but failed R&D? How do they understand markets and competition? How do they launch successfully?  How do they manage indicators of failure or underperformance? Can we do better?

Hitting the gold standard R&D investment ratios might be a sign of innovation health but it won’t by itself pay the dividends that investors expect. Cash flow considerations and good R&D project governance are where the real gold is to be found.

Written by Chris Errington, Head of Research – Kestrel Partners LLP

Kestrel’s Sector Views should neither be construed as investment research, nor the provision of investment advice, nor a recommendation. This article should be viewed as short term commentary only based on the latest economic statistics, company results or information on upcoming releases or events. It is only a brief unsubstantiated summary of Kestrel’s opinion on such information as at the date of publication and no reliance may be placed upon any contents of this article by the recipient.


Back to News