October 30, 2015

Failing to capitalize R&D creates havoc in accurately measuring profitability across time, across companies, and across many different industries.

Under Generally Accepted Accounting Principles (GAAP), expensing R&D in the year spent is required. For many firms, this leads to extensive volatility in profit and return calculations, and to an inadequate measure of assets or invested capital. This doubly impacts return on asset calculations, and not consistently so, thereby creating wildly different calculations of economic profit.

R&D is very often not stable from year to year, and this creates material and directionally different changes in profit measures. Many companies in the technology and healthcare sectors succumb to this problem. In the Consumer Discretionary space, R&D expense has been growing at +8% a year over the past 10 years, but with a 25% standard deviation in growth rates. While Technology firms have seen R&D grow at 10% a year the past decade, we measure a 7% standard deviation among growth rates. This issue is material in many other industries such as in the Healthcare, Industrials, Consumer Discretionary, and Energy sectors.

Specific examples of firms with material and materially inconsistent levels of R&D include Boeing, Pfizer, United Technologies, Danaher, Yahoo!, and Qualcomm.