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Intangibles: Management, Measurement, and Reporting

R&D and the Growth of Business Enterprises

The contribution of R&D to the performance measure (profits ,sales) statistically to R&D expenditures –in the current and previous periods to allow for the delayed effect of R&D on business performance –and by controlling for the effect of other investments (physical assets ) on business performance. This statistical approach to empirically address issues concerning intangibles and their private and social impact was frequently used by economists and researchers in related areas. The empirical worked started with extensive historical case studies and proceeded to large sample (cross-sectional) analyses of R&D on firms’ productivity and growth .The research effort yielded several important findings:

---R&D expenditures contribute significantly to the productivity(value added) and output of firms ,and the estimated rates of return on R&D investment are quite high —as much as—20-35 percent annually – with the estimates varying widely across industries and over time.

--- The contribution of basic research (work aimed at developing new science and technology) to corporate productivity and growth is substantially larger than the contribution of other types of R&D ,such as product development and process R&D(where the latter is aimed at enhancing the efficiency of production processes).The estimated contribution differential of approximately three to one in favor of basic research is particularly intriguing ,given the widespread belief that public companies have been recently curtailing expenditures on basic research, in part as a response to the skepticism of many financial analysts and institutional investors about the commercialization prospects of basic research. Basic research is, of course, more risky than applied R&D (see chapter 2), but it is inconceivable that risk differentials by themselves account for a three-to-one productivity of basic research.

---The contribution of corporate-financed R&D to productivity growth is larger than corporate-based –but government-financed —R&D (granted primarily to government contractors).The fact that most contracts with the government are based

on cost-plus terms may partially explain this findings. This result should not detract from the significant contribution to the industrial and technological infrastructure of publicly funded research conducted by government agencies and in federal laboratories (such as the contribution by the National Institutes of Health to pharmaceutical and biotech companies) as well as the substantial contribution of university research to technology.

It should be noted that much of the research summarized above was based on survey data and industry aggregates, due to severe limitations in corporate published data. In fact, most of the examined variables and attributes—such as basic versus applied research and company versus government-sponsored R&D—cannot be directly estimated from information publicly disclosed to investors. Thus an important implication of these and similar findings is to suggest which kinds of currently unavailable information and data would be useful to managers, investors, and policymakers.

Alternative Output Measures: Market Value and Patent

The research presented above relates R&D inputs (intensity, capital) to firms’ productivity, sales, or profit growth, in an attempt to estimate the return on corporate investment in innovation as well as to examine macro-economic issues, such as the productivity decline in the United States in the 1970s and early 1980s. This methodological approach encounters various problems; in particular the time lag between the investment in R&D and the realization of benefits (such as sales) is often long (particularly for basic research) and generally unknown, increasing the uncertainty about the estimated R&D contribution. Furthermore, biases and distortions in reported profits—arising from firms’ attempts to ―manage‖ investors’ perceptions (see chapter 4)—might cloud the intrinsic relationship between R&D and its subsequent benefits.

These measurement difficulties have prompted a search for alternative and more reliable indicators of R&D output than reported sales and profitability measures. Two output indicators have received considerable in attention: capital market values of corporations and patents. Believers in efficient capital markets argue that stock price

and returns provide reliable signals of enterprise value and performance; hence R&D contribution can be evaluated using market values. Patents, and particularly citations in patent applications, provide an additional of the value of R&D and firms’ technology.

Concerning capital market studies, the research persuasively indicates that investors regard R&D as a significant value-increasing activity. For example, a number of event studies register a significantly positive investor reaction (stock price increases) to corporate announcements of new R&D initiatives, particularly of firms operating in high-technology sectors and using cutting edge technology. When information is available, investors distinguish among different stages of the R&D process—such as program initiation and ultimate commercialization —most significantly rewarding mature R&D projects that are close to commercialization. Furthermore, econometric studies that relate corporate market values or market-to-book ratios to R&D intensities consistently yield positive and statistically significant association estimates. Further probing of the data suggests that investors value an R&D dollar spent by large firms more highly than that spent by small firms, probably a reflection of economies of scale in R&D. For example, large companies may benefit from lessons of failed R&D projects as they pursue the development of other project.

The evidence thus indicates unequivocally that investors view R&D expenditures as on average enhancing the value of firms and that that also demonstrate some ability to differentiate the contribution of R&D across industries, firm sizes, and stages of R&D maturity. Investors’ ability to fine-tune R&D valuations is obviously hampered by the absence of detailed information on these attributes in corporate financial reports.

Data on R&D expenditures available in financial statements are crude indicators of R&D contribution and value creation: there is productive R&D and wasteful R&D (Motorola and partners’$5 billion investment in the Iridium satellite communications project, currently in bankruptcy, is an example of the latter). The R&D productivity estimates discussed above obviously averaged the good and the bad, missing

considerable information in the process. In an attempt to improve the estimation of R&D contribution, researchers experimented with patents, which can be considered an intermediate output measure of R&D (the final output measure is, of course, the benefit—sales, cost savings—generated by the R&D expenditure). Patents are only partial indicators of R&D output, since not every R&D project id patented. Yet patent research provides interesting insights.

The Findings of Patent Research

Various attributes of patents, such as the number of patents registered by a company (patent counts), patent renewal and fee data, and citations of and to patents were examined by researchers. Both patent counts and the number of innovations emerging from a company’s R&D program were found to be associated with the level of corporate investment in R&D (the higher the R&D expenditures, the larger, on average, the number of consequent patents and innovations) as well as with firms’ market values (the larger the number of patents and innovations, the higher the market value, on average). Patents are thus related to both inputs (R&D) and outputs (market values) of the innovation process and, therefore, are meaningful intermediate value measures.

It is clear, however, that patent and innovations are noisy measures of R&D contribution, due to the skewness of their value distributions—that is, the tendency of a few patents or innovations to generate substantial returns (blockbusters), while the majority turn out to be virtually worthless. Citations (references) to a firm’s patents included in subsequent patent applications (forward citations) offer a more reliable measure of R&D value, since such citations are an objective indicator of the firm’s research capabilities and the impact of its innovation activities on the subsequent development of science and technology.

Various studies show that patent citations capture important aspects of R&D value. For example, Manuel Trajtenberg reports a positive association between citation counts and consumer welfare measures for CAT scanners; Hilary Shane finds that patent counts weighted by citations (the firm’s number of registered patents divided by the number of citations by others to these patents) contribute to the

explanation of differences in Tobin’s q measures (market value over replacement cost of assets) across semiconductor companies; and Bronwyn Hall and colleagues report that citation-weighted patent counts are positively associated with firms’ market values (after controlling for R&D capital). Patents and their attributes thus reflect technological elements used by investors to value companies.

In a direct test of the usefulness of patent citation measures as indicators of value, studies have been conducted to examine the ability of various citation-based measures to predict subsequent stock returns and market-to-book values possess such predictive ability: the number of patents granted to the firm in a given year, the intensity of citations to a firm’s patent portfolio by subsequent patents, and a measure based on the number of citation in a firm’s patents (backward citations) to scientific papers (in contrast with citations to previous patents).

The third measure reflects the scientific intensity of a patent and may provide a proxy for the extent of basic research conducted by the company. The fact that patent indicators are associated with subsequent stock prices and returns suggests that investors are not fully aware of the ability of these measures to convey useful information about firms’ innovation processes and capabilities. This is of course not surprising, given the novelty of patent-related measures as indicators of enterprise value.

Patents are the intangible assets actively traded in markets (see chapter 2), in the form of licensing and sale of patents. An examination of firms’ royalties from the licensing of patents indicates that the volume of royalty income is swiftly increasing and that investors value a dollar of patent royalties (the implicit, market multiplier of royalty income) two to three times higher than a dollar of regular income. The reason for the high valuation of patent royalties probably lies in the stability of this income source (patents are usually licensed for several years) relative to other more transitory components of income. Patent royalties also impact investors’ valuation of R&D, namely the market value they assign to a dollar of R&D expenditures. The valuation of the R&D of firms with royalty income is higher than the valuation of the R&D of firms that do not license patents, probably due to investors’ belief that the quality and