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.
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
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.
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.
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.