Capitalizing R&D

Industrial companies reinvest in plant, property, and equipment to grow revenues. Technology companies grow by investing in research and development. However, on an income statement, these R&D investments are treated as an operating expense (instead of a capital investment).

One can reorganize financial statements of such companies by capitalizing R&D expenditures. You can check out this video, and this spreadsheet (look for R&DConv.xls) from Aswath Damodaran to understand the logic and mechanics of this reclassification.

The R&D asset you create goes to the asset side of the balance sheet.

Since assets = equity + liabilities, this increase in assets leads to an increase in the book value of equity, and hence the invested capital.

Similarly, we adjust the operating earnings by adding back the R&D expense and subtracting the depreciation of this asset in the current year.

When we capitalize R&D, we get a more authentic view of the earnings, reinvestment, and returns on capital. This alters the fundamental inputs that go into a discounted cash flow valuation, including earnings, growth and reinvestment rates (sales to capital ratio), and operating margins.

Process

To begin the process of capitalizing, we need the following inputs

  • An amortization period, N years, over which R&D is expected to deliver results (software ~ 2 years, hardware ~ 3-5 years, pharma ~ 10 years; Damodaran’s spreadsheet has some numbers for guidance)
  • Collect R&D expenses for the prior N (or N+1) years from the income statement. You can get these from company filings or a data service like Morningstar.
  • Create a table (see spreadsheet) to determine (i) the net value of the R&D asset on the balance sheet, and (ii) the current year amortization number.
  • Recompute operating earnings, net income, invested capital, and reinvestment rate.
  • Use these numbers to inform inputs in the DCF analysis

Example

I took Damodaran’s spreadsheet, and modified it slightly to account for partial year data. I did this to understand the spreadsheet better; not necessarily because I think such an adjustment is important. Of course, it uses the latest numbers, so it has that thing going for it.

For prior years, I assumed that R&D expenditures were distributed evenly throughout the year. Thus, if $100M were spent over an year, I assume $25M were spent each quarter. This spares me the burden of having to deal with quarterly filings.

I used this modified spreadsheet to analyze CSCO after two quarters of fiscal 2017.

1

Cells in yellow are inputs, while those in green are computed. This yields the following calculation for the value of the R&D asset and the amortization.

2

It also yields some summary statistics. In CSCO’s case, capitalizing R&D did not have a big effect on (i) operating income/margin and (ii) net income/margin. It had a modest effect on the reinvestment rate, which increased. The amount of capex, invested capital, and depreciation increased dramatically, while the return on capital went down modestly.

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