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Abstract:
Research has established that R&D-intensive firms are characterized by substantial future risk-adjusted stock returns. The reasons for this phenomenon and its policy implications, however, are widely debated. Some attribute the excess returns to investors' systematic undervaluation of R&D firms and argue for improved disclosure to mitigate the mispricing, while others claim that the excess returns are just compensating for an R&D-specific risk factor and, therefore, no accounting changes are called for.

We aim at resolving this controversy by distinguishing between "R&D leaders" who focus mainly on basic research, and their activities are obscured from investors and therefore susceptible to mispricing, and "R&D followers" who largely modify current technologies and are therefore more transparent. We show that R&D leaders enjoy substantial risk-adjusted returns during the first four-five future years, after which these excess returns converge to those of R&D followers. This evidence is consistent with a significant undervaluation of the shares of R&D leaders. We also show that both R&D leaders and followers enjoy long-term excess returns which are attributable to both business and information risks. Regarding policy implications, we show that the excess returns of R&D leaders (reflecting undervaluation) are cut in half by voluntary information disclosure (earnings guidance). Improved information is an obvious remedy for share mispricings.

R&D Valuation, Innovation Strategy, R&D mispricing, R&D risk

Abstract:
We examine future excess returns, earnings variability and stock volatility of R&D Leaders and Followers. Drawing on the business strategy literature, which makes a clear distinction between R&D Leaders and Followers, we show that R&D Leaders do earn significant future excess returns, while R&D Followers just earn average returns. We further document that R&D Leaders generate higher future sales growth, and return-on-assets than Followers. We also tackle the perennial question of whether the excess returns subsequent to R&D are due to mispricing or risk, and show that only a small part of the returns can be attributed to risk compensation. Finally, it has been documented that R&D expenditures are strongly associated with future earnings volatility, suggesting that R&D is less reliable (verifiable) an asset than physical capital. We show that the association between R&D intensity and future earnings volatility of R&D Leaders is not lower than that of R&D Followers. Thus, penetrating the population of R&D firms to distinguish between R&D Leaders and Followers, we bridge the chasm between the major findings of the economics/finance strand and the accounting body of R&D research.

Abstract:
Prior studies document that firms with an increase in research and development (R&D) expenditures experience positive abnormal returns for up to five years. The reason for this association is unclear, however. This result may reflect an unidentified R&D correlated risk factor and/or it may reflect a systematic underestimation by market participants of future benefits from current R&D increases. We document that future abnormal returns to R&D increases are concentrated around subsequent earnings announcements. We further show that that the market underestimates the association between R&D increases and future earnings. Finally, we document that in their forecasts of future earnings security analysts also underestimate the effect of R&D increases. These results suggest that future abnormal returns following R&D increases are at least in part due to the market's underestimation of the earnings benefits of R&D increases.