Research and Development Costs on an Income Statement
Investing Lesson 4 - Analyzing an Income Statement
I want to spend some time talking about a particular type of expense called Research and Development Expenses, or R&D expenses, that appear on the income statement of certain businesses, particularly those engaged in scientific undertakings. Research and Development costs are one of the most important expenses on the income statement for certain types of enterprises because they represent future growth, innovation, and, if well-managed and executed, profits.
Whether it is a pharmaceutical company spending hundreds of millions of dollars trying to discover a breakthrough drug to fight cancer or a technology company developing a new line of hardware, research and development is the lifeblood of not only a flourishing economy, but a thriving business.
Generally speaking, a company that's involved in making things will spend more money on R&D than other companies.
For shareholders, R&D expenditures can be a mixed bag. On one hand, shareholders should be excited to see a company using cash to invest in itself, as this often helps the company grow and boost its share value. But this also means that a company is less likely to pay out dividends to shareholders.
How Much Money Should a Company Spend on Research and Development?
Like so many questions in life, the answer to this question: It depends. Generally, a good place to begin is by comparing the firm you are studying to competitors in its industry. If everyone in a specific niche sector of the economy is putting 10% to 20% of sales back into R&D, and a firm you are trying to value is spending only 5%, that may or may not be a red flag.
Let's take a look at some major companies and what they have spent on research and development.
Apple - The maker of the iPhone, iMac, and MacBook spends about $3.7 billion quarterly on research and development. That's about 4% of its quarterly revenue.
Johnson & Johnson - J&J spent $3.2 billion on R&D in the last quarter of 2018, one of its highest totals ever. (It spent more than 4 billion in the same quarter of 2017.) The company's R&D costs comprised more than 18% of its revenue in the 4th quarter.
Alphabet - Google's parent company spent a whopping $5.3 billion on R&D in the third quarter of 2018.
That's about 15% of its quarterly revenue.
Amazon - The major online behemoth reported $7.16 billion in R&D costs in the quarter ending in September, 2018. That's about 13 percent of the company's quarterly revenues.
Another useful exercise in attempting to determine an appropriate level of research and development expense is to compare a company's own historical R&D spending to its past. This includes measuring it as a percentage of revenue and as a percentage of gross profit. This is because some firms are simply more efficient at converting a dollar of research and development costs into a dollar of revenue. Perhaps they have better scientists. Maybe their internal processes are more conducive to entrepreneurial experimentation.
The important thing is to revenue that it is not always true that more spending is better. There have been cases in the past where management teams allowed R&D to get out of control as divisions squandered precious shareholder capital on their pet projects that never showed any meaningful results.
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.