1. COURSE TITLE: SEMINAR IN FINANCE COURSE CODE: MPH 622
Presentation on
The Stock Market Valuation of Research and
Development Expenditures
By
K.C. Chan, Josef Lakonishok, and Theodore Sougiannis
University of Illinois
Published in: The Journal of Finance, 2001, Vol. LVI (6), pp. 2431-2456.
June 1, 2011

2. Plan
 Background & motivation
 Research gap, research question & purpose
 Research Methodology
 Major Findings
 Conclusions
 Critical appraisal

3. Background & motivation
 In perfect capital market, stock price ultimately
reflects the value of all its net assets and it is relatively
apparent when most of the assets are physical. When a
firm has large amount of intangibles, the lack of
accounting information generally complicates the task of
equity valuation.
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 is the one
reason for stock volatility.
(context: globalization, rapid change in IT, shift of market demand – social
networking, production to service industries, knowledge-based industries, etc)

4.  The study is tried to explore the facts based on US
data where intangibles are generally treated as current
spending. But it may not be fully amortized in a single
year.
Why R&D has been the subject of much attention?
Greater proportion (40% of S&P) of R&D based
industries in the stock market (R&D intensive = few
intangible assets)
R&D expenses in technology industry is larger than their
earnings, and
US government policy to disclose R&D spending in
financial statements.
 Benchmark: Diff. in return = (Rwith R&D – Rwithout R&D)
If 0, market price fully incorporate the benefits of R&D
spending.

5. The future returns can be potentially influenced by the
investment on R&D and similar types of spending so that
the distortion in stock price appears.
The study focused on R&D investments because the
R&D intensive firms are difficult to value.
 Future profits are tied to the success of new untested
technologies which are highly unpredictable. (Medicine for
AIDS, Cancer, .. New software, etc)
 The benefits of the current efforts are usually
materialized in future, and
 R&D accounting information is of limited informative.
 For instance, R&D spending in some major
technology industries is larger than their earnings.

6. Research gap, research question &
purpose
Some evidences including 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. (e.g. R&D, advertising,…)
On the other hand, many firms’ R&D investments are
not profitable,Jensen (1993). But, investors systematically
overlook/passion for technology stocks reflect the belief
that R&D intensive technology stocks are undervalued.
These limited earlier studies concerning the association
between future returns and R&D investments provides
basis for the study.

7. Research Questions:
Does the stock price appropriately incorporates the
value of the firms’ R&D investments?
Is there R&D intensity related to future stock return?
Is there volatility of stock returns is related to R&D?
Objective:
To examine whether stock prices fully value firm’s
intangible assets, specifically investment in research and
development (R&D).

8. Population: US firms
Sample: All domestic firms listed on listed on
NYSE, AMEX and NASDAQ
Data collection: Secondary sources
(Financial information from COMPUSTAT and
market value of common equity from the CRSP)
Study period: From 1975 to 1995
R&D expenditures relative to sales and, R&D expenditures
to the market value of equity are used to measure R&D
intensity.
Methodology

9. Firms’ R&D capital is estimated from the past record
as per model suggested by Lev and Sougiannis (1996)
RDCit = RDit + 0.8RDit-1 + 0.6RDit-2 +0.4RDit-3 + 0.2RDit-4……….. (1)
Regression models: (Return reversal & Volatility)
Rpt – Rft = ap + bp[RMt – Rft] + spSMBt + hpHMLt + wpWMLt + dpUMDt + ept ….. (2)
Where,
(Rpt – Rft ) = Monthly return on portfolio p in excess,
(RMt – Rft ) = Excess return on the value-weighted market index,
SMBt, and HMLt are the returns on the Fama and French (1993) factor mimicking portfolios
for size and book-to-market, respectively, WMLt and UMDt are the effect of long-term and
intermediate-term past returns, respectively.
σit = γot + γ1t LNSIZEit + γ2t LNAGEit + γ3t RDSit + + eit ……………(3)
Where, σit = Stock’s return volatility, LNSIZEit = Firm’s stock market capitalization in
logarithms, LNAGEit = Firm’s age in logarithms, RDSit = R&D intensity relative to sales, and
INDijt = Dummy variables for industries.

10. All
firms:
Year
Selected
Industry:
SIC Code
R&D expenditure as percentage of R&D capital as
percent of
book valueSales Earnings Dividends Book value
All firms Sel. Ind. All firms Sel. Ind. All firms Sel. Ind. All firms Sel. Ind. All firms Sel. Ind.
1975 SIC 737 1.70 16.60 36.10 207.10 84.10 2833.00 4.13 27.50 10.55 54.90
1980 SIC 283 1.78 11.90 34.40 92.20 87.60 192.00 5.08 21.10 12.55 53.30
1985 SIC 357 3.01 7.10 83.70 159.30 145.80 1242.40 8.11 21.00 21.25 55.90
1990 SIC 38 3.40 5.60 79.40 89.80 148.90 276.90 9.59 13.00 25.76 36.60
1995 SIC 36 3.75 4.90 65.30 58.20 165.20 242.20 10.88 10.30 28.73 25.60
SIC 48 3.70 98.10 80.20 13.70 36.40
SIC 37 3.60 125.50 297.50 16.60 46.10
SIC 737: Computer programming, software, & services, SIC 283: Drugs & Pharmaceuticals, SIC 357: Computers & office
equipment, SIC 38: Measuring instruments, SIC 36: Electrical equipment excluding computers, SIC 48: Communications & SIC 37:
Transportation equipment.
Yellow = Low
Red = High
Findings:
The magnitude of figures suggests that expensing in R&D outlays has
grown sharply.
R&D spending is heavily concentrated in technology and science
oriented industries.
Table I
Intensity of R&D activity for all firms doing R&D and for selected industries
Major findings1975-
1995

11. Table II
The impact of expensing R&D spending on earnings and BV for selected industries
Selected Industry: SIC Code
Panel A: Earnings Panel B: Book value of equity
Earnings
as % of MV
Adj. Earnings
as % of MV BV as % of MV
Adj. BV as %
of MV
SIC 737 1.93 4.28 14.54 22.52
SIC 283 3.67 4.79 16.05 24.6
SIC 357 4.46 5.73 33.65 52.46
SIC 38 4.11 4.53 28.4 38.81
SIC 36 5.44 6.43 30.76 38.64
SIC 48 2.49 2.98 17.84 24.33
SIC 37 5.99 7.21 45.22 66.05
SIC 737: Computer programming, software, & services, SIC 283: Drugs & Pharmaceuticals, SIC 357:
Computers & office equipment, SIC 38: Measuring instruments, SIC 36: Electrical equipment
excluding computers, SIC 48: Communications & SIC 37: Transportation equipment.
Finding:
In the highly R&D intensive industry, the practice of immediately expensing R&D
outlays can have substantial distortive effect on accounting information.
P/E 51.8% 23.4%
P/E 27.2% 20.9%
P/E 6.9% 4.4%
P/E 6.2% 4.1%
Note: Adjustment are made as per the amortization equation. (estimated R&D)
1995

12. Table III
Returns and Characteristics of portfolios classified by R&D Expenditure Relative to Sales
Portfolio ranked by R&D intensity (R&D/Sales) 5 (High) Average R&D (1-5) Non- R&D
Average annual return before formation 0.2254 0.2049 0.2025
1 yr after portfolio formation 0.1815 0.2015 0.1987
2 yr after portfolio formation 0.1971 0.1926 0.1916
3 yr after portfolio formation 0.2071 0.1955 0.1947
Aver. annual return over 3 yrs after port. 0.1952 0.1965 0.1950
Annual earnings growth over 5 post-formation yrs 0.1424 0.1018 0.1015
Findings:
Firms that carry out
R&D is on average no
difference in returns
from those of firms
without R&D.
Glamour stocks with
low B/M ratio earn on
an average lower than
average
The average annual growth rate
in earnings is virtually the same
for stocks with R&D and
without R&D.

13. Table IV
Returns and Characteristics of Portfolios Classified by R&D Expenditure Relative to Equity
Market Value
Portfolio ranked by R&D intensity (R&D/Sales) 5 (High) Average R&D (1-5) Non- R&D
Average annual return before formation 0.0989 0.2031 0.2025
1 yr after portfolio formation 0.2647 0.2015 0.1987
2 yr after portfolio formation 0.2534 0.1932 0.1916
3 yr after portfolio formation 0.2677 0.1961 0.1947
Aver. annual return over 3 yrs after port. 0.2619 0.1969 0.1950
Annual earnings growth over 5 postformaion yrs 0.1713 0.0943 0.1015
Findings:
Portfolio results based on
R&D relative to market value
indicated that even though,
high R&D spending directly
depresses earnings, there may
be prospects of regaining the
profitability in subsequent
years.
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.
same
Return reversal
Excess return after
portfolio formation is
high (6.12%) when
adjusting the size and
B-M.

14. Finding:
Provide further evidence that past losers who spend heavily in R&D tend to be undervalued.
The abnormal performance is concentrated in stocks with relatively low past returns.
Table V
Excess returns of portfolios classified by R&D intensity, and by past 3-year return
Classified by Excess return in year after portfolio formation
Average excess
return over 3
post-formation
years
R&D relative
to sales
Past 3-year
return First year Second year Third year
1 (Low) 1 (Low) 0.0085 -0.0120 -0.0172 -0.0069
2 (High) -0.0164 -0.0180 -0.0081 -0.0142
2 1 0.0282 0.0178 0.0028 -0.0069
2 -0.0004 -0.0065 0.0029 -0.0014
3 1 0.0477 0.0173 0.0094 0.0248
2 -0.0071 0.0172 0.0176 0.0092
4 1 0.0492 0.0357 0.0253 0.0368
2 0.0177 0.0085 0.0106 0.0122
5 (High) 1 (Low) 0.0219 0.0482 0.0618 0.0440
2 (High) -0.0150 0.0120 0.0062 0.0010
Abnormal performance of the past
losers. Notable result in average column

15. Table VI
Excess returns of portfolio classified by R&D intensity, and by past 3-year return
Finding:
The large returns on the portfolio with high R&D intensity relative to market is not entirely due
to risk and, return reversals associated with past losers.
Rpt – Rft = ap + bp[RMt – Rft] + spSMBt + hpHMLt + wpWMLt + dpUMDt + ept
Portfolio a b s h w d R2
First year after
portfolio formation
1 (Low) -0.14 0.98* 0.68* -0.09* -0.03 -0.02 0.96
2 0.05 0.96* 0.74* -0.10* -0.07* -0.06 * 0.96
3 0.16 1.01* 0.76* -0.10* -0.08* -0.09 * 0.95
4 0.26* 1.02* 0.81* -0.11* -0.18* -0.08 * 0.95
5 (High) 0.55* 1.04* 0.96* -0.10 -0.32* -0.10 * 0.92
Second year after
portfolio formation
1 (Low) -0.10 0.96* 0.61* -0.07* -0.07* -0.07 * 0.97
2 0.04 0.95* 0.75* -0.06 -0.04 -0.09 * 0.96
3 0.21* 1.00* 0.71* -0.09* -0.11* -0.09 * 0.95
4 0.39* 1.00* 0.79* -0.16* -0.15* -0.10 * 0.94
5 (High) 0.52* 1.02* 0.93* -0.16* -0.30* -0.05 0.93
Third year after
portfolio formation
1 (Low) -0.04 0.93* 0.62* -0.05 -0.07* -0.07 * 0.96
2 0.04 0.95* 0.66* -0.01 -0.06 -0.07 * 0.95
3 0.26* 0.97* 0.63* -0.14* -0.15* -0.10 * 0.95
4 0.19* 1.02* 0.79* -0.10* -0.14* -0.18 * 0.95
5 (High) 0.53* 1.01* 0.89* -0.23* -0.29* 0.00 0.93
Annual spread 8.28%
Annual spread 7.44%
Annual spread 6.84%
* Indicates t-statistics is greater than 2.00 or 5% level of significance

16. Finding:
Advertising intensive firms with poor past performance recover in subsequent year, and no
difference on average between advertising and non-advertising firms..
The evidence also suggests that there is an association between
R&D and return volatility.
Table VII
Returns and Characteristics of Portfolios Classified by Advertising Expenditure Relative to
Equity Market Value
Portfolio ranked by R&D intensity
(R&D/Sales)
1
(Low) 2 3 4 5 (High) Non-Adv..
Average annual return before formation 0.3146 0.2286 0.1978 0.1769 0.1402 0.1981
1 yr after portfolio formation 0.1651 0.1958 0.2179 0.2246 0.2276 0.1946
2 yr after portfolio formation 0.1491 0.1945 0.2113 0.2045 0.2321 0.1886
3 yr after portfolio formation 0.1648 0.1972 0.2189 0.2196 0.2491 0.1854
Aver. annual return over 3 yrs after port. 0.1597 0.1958 0.2160 0.2162 0.2363 0.1895
(0.16+0.20+0.22+0.22+0.24)/5 = 20.48% is almost equal to 18.95%

17. 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 make
adjustment. The evidence does not support a direct link
between R&D spending and future stock returns.
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.
Conclusions

18. The study follow the simple analysis concerning the
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.
Critical appraisal

19. Thank you.
I am very much thankful to Respected Prof. Dr. Radhe
Shyam Pradhan, Prof. Dr. Manohar Kr Shrestha, Prof.
Dr. Kamal Das Manandhar, Prof. Dr. Rajan B. Paudel
and my dear colleagues from the bottom of my heart,
for their proper guidance, generous support and
useful comments.
Sudarshan Kadariya, M. Phil in Management