R&D an expense or investment? Assessing R&D for the value investor

The Big 5 Big Tech companies – Amazon, Alphabet, Meta, Apple, and Microsoft – spend about $200 billion every year on research and development. As per the current accounting standards, this is being expensed.

Comparatively, the total free cashflow of these companies is currently about $240 billion. The enterprise value, or total market value of debt and equity adjusted for cash, is about $7 trillion.

Free cashflow is important from an investment point of view because scientific investors (or most value investors) and valuation experts consider it the most important metric to value a company.

Given the quantum of R&D expenses in comparison to the free cashflow of these companies, it becomes important that R&D expenses are treated properly from an investment analysis perspective.

It is obvious that new products add to a company’s growth and that R&D leads to new products. Thus, it is inarguable that R&D leads to growth.

Since growth leads to higher market value, it is logically deductible that R&D expenses lead to higher market valuations. This has also been proven by academic research to be a predictor of alpha generating returns.

However, the current accounting treatment leads to the opposite effect. With higher R&D, total expenses increase and free cashflow decreases. Left unadjusted, the more the R&D, the lower the company’s valuation from a conservative value investor’s perspective.

Also read: Want a pie of Apple or Facebook? Here's how you can invest in equities listed overseas

Conventional estimation

To see the impact of this, we will take a slight divergence towards valuation models and then come back to address how R&D expenditure can be treated in valuation.

As a reminder, a scientific investor would estimate the intrinsic value of a company and if it is available at a discount to its intrinsic value, it would be considered for investment as part of a focused, but reasonably diversified, portfolio of 20-50 investments.

The conventional way of estimating the intrinsic value of a company is to forecast its future free cashflows and then use an appropriate discount rate to calculate the present value of those cashflows. This is also known as the discounted cashflow model.

The problem with this model is that many times, negative cashflows would continue for the next 10-15 years, after which the cashflows would turn positive. In this model, the growth rate of future revenue, the intensity of capital investments required in the future to achieve those growth rates, the free cashflow margins in the future and the discount rate to be used become important variables that determine the intrinsic value of a company. Slight variations in the assumptions for these variables would result in huge changes in the estimates of intrinsic values.

Since this explanation of intrinsic value itself would be head-spinning for most, it is important to search for a simpler, more intuitively meaningful, model.

Assume that the company is not trying to grow. A non-growth company would need much lower R&D to maintain its revenue. It is likely that 10 percent of R&D expenses are sufficient to maintain steady state sales or revenue. In that case, the remaining R&D expenditure would get added to free cashflow, which could be given out to shareholders as dividend.

To be conservative, we retain 20 percent of the current R&D expenditure. The remaining can be added back to free cashflow. This would make an additional “hidden” free cashflow of $170-$180 billion available for the Big 5 Big Tech companies, resulting in total free cashflow of $400 billion.

R&D impact

If we apply a multiple of 15, which has been prevalent in the US for decades, it would result in a market value of $6 trillion. A multiple of 20 would result in an $8 trillion value, while a multiple of 10 would result in a $4 trillion value. Given the current market value of $7 trillion, it looks like the market is valuing these companies as if they will never grow.

Data indicates that R&D expenditure results in revenue that is almost 11 times higher five years later. That would result in sales of almost $2.2 trillion in five years for these companies. Subtracting the current revenue of $1.5 trillion, R&D has created additional sales of $700 billion.

Assuming a 25 percent “steady state” free cashflow margin, that would be an additional $175 billion. With a multiple of 15, that would be an additional market value of $2.6 trillion. The present value of this would be $1.3 trillion to $1.5 trillion.

A value investor likes to estimate value based on what is currently known factually about the company.

Based on this, the current value of the Big 5 Big Tech companies taken as the illustration in this article would be $6 trillion in terms of hidden steady state value + the $1.5 trillion, present value of current R&D. Both of these added would result in a value of $7.5 trillion. All future growth beyond this would result in an added value. There are ways to estimate those as well, but they will get more speculative than the valuations for the current steady state value and the current R&D value.

From time to time, Mr. Market values companies such that they are available at conservatively determined valuations. At such times, value investors can enjoy investments in growth and innovation-oriented companies.

We would like to caution against buying these companies or buying the index ETFs of these companies since all companies might not be equally undervalued and the ones less undervalued or even overvalued might have higher weightage in some ETFs or funds. We prefer a more selective portfolio approach using our scientific investing framework.

Disclaimer: Please note that any mention of company names is not a recommendation to buy, sell or hold. Equity investments are subject to market risks. Past performance is no guarantee of future performance. One should invest based on the advice of their financial advisor based on their investment objectives, financial situation and risk profile. OmniScience Capital, its management and employees and its clients might be buying, selling or holding the mentioned companies.