Volume-3, Issue-8, January-2017 ISSN No:

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1 THE DETERMINANTS OF INVESTOR VALUATION OF R&D EXPENDITURE: A STUDY OF IT INDUSTRIES IN INDIA Shalendra Kumar Trade Economc Intern, Mnstry of Commerce and Industry, Udyog Bhavan, New Delh110001, Inda. shal.du7@gmal.com Dnesh Kumar Choudhury Assstant Professor, Dept of Economcs, Sr Sathya Sa Insttute of Hgher Learnng Prashant Nlayam, Andhra Pradesh , Inda dneshkumarchoudhury@ssshl.edu.n Abstract Ths paper emprcally nvestgates the mpact of R&D expendture on four key market valuaton varables labor ntensty, market share, age and H ndex n Indan IT frms. However, the results of the regresson analyses partally support that the R&D ntensty s postvely nfluence the frm s market value (RDR), as measure by H ndex. The results extend the understandng of the role of frm sze n the R&D ntensty, and on the frm s fnancal performance. The emprcal tests use an extensve database contanng product level nformaton of software frms between 1997 and 2011, along wth accountng and stock prce data of the same perod. The test results, consstent wth our hypotheses, show that R&D spendng s more valuable for frms wth larger market shares, hgher percentage of Labor ntensty, and those that have dversfed nto dfferent product categores. Keywords: Investor, R&D, Software Industry, Inda I. INTRODUCTION For a busness to experence future growth research and development s very vtal as t helps n developng new products or processes to mprove and expand ther operatons. Innovaton s one of the major engnes of growth and the most mportant way of ganng compettve advantage over compettors n today s new economc envronment. Investor Valuaton s used n fnance to compute the current value of an asset based on statstcal nputs for cash flow expectatons. Its man purpose s to fnd nvestment opportuntes such that the nternal proftablty rate must be above a company's cost of captal n future. Research and Development (R&D) s a key factor of nnovaton and has become an ntegral part of many companes, especally those n the hghtech ndustres. Research s generally defned as the prmary search for scentfc and techncal mprovement. Development s defned as the translaton 54

2 of such mprovements nto product/servce or process nnovaton and technology mports complement or substtute n house R&D efforts. R&Dntensve companes compete on the bass of a new nnovaton that allows them to retan ther exstng customers and capture new markets wth a substantal amount of growth n sales and earnngs. However, gven the strategc sgnfcance of R&D, how does R&D spendng relate to a frm s fnancal performance? Although many studes found that there s a lnk between R&D expendture and frm value, ths relatonshp changes over tme and dffers greatly from ndustry to ndustry and from frm to frm. In most cases, however, fnancal benefts become apparent only when the specfc R&D actvtes lead to patent ssuance. In today s knowledgebased economy, R&D plays a vtal role and acts as strategc weapon to thrve n global market. The frm can reap benefts from the nvestment of R&D f the nnovaton can be marketed on a larger scale. It s found that the level of a frm s R&D spendng postvely affects the frm s fnancal performance. Another factor frms nvest n R&D s the frm sze. Frm sze has a postve mpact on the probablty that a frm wll engage n nnovatve actvtes. R&D expendture n software ndustry has revolutonzed the way busness s beng done. Wth these motvatons we would lke to focus on IT frms n Inda. The major research queston of ths study s to know, whether there s any relatonshp exsts between R&D Structure and to nvestor decson? R&D nvestments should be reflected nto fnancal nvestors valuatons and stock market prces. It s well known that R&D nvestments affect frm performance, expected profts, and cash flows. Snce n effcent fnancal markets nvestors evaluate a frm based on ts expected cash flows (. e., frm s market value should be equal to the present value of all the expected cash flows produced n the future), R&D nvestments should also be reflected n market values. Moreover, stock prces should embed all the nformaton currently avalable on the frm s R&D nvestments and should react to any new nformaton arrval about those nvestments for these reasons, a number of researchers have turned to stock market value as an ndcator of the frm's expected economc results from nvestng n R&D. Indan IT has a large software servces export ndustry wth an exceedngly fast growth rate. R&D collaboratons between R&D unts, network wth IT frms. It s mportant to fnd out the nature and characterstcs of unts that network and the consequences of networkng to the unts and foregn collaboraton. Inda: Software servces reman the domnant output, accountng for more than 90% of the ndustry s sales revenue, rather than packaged software products. Beyond the mpact of R&D expendture on a frm s market value, t has a sgnfcant nfluence on the frm s fnancal performance. We wll revew the mpact of R&D expendture on a frm s revenue and proftablty. Ths paper wll focus on the statstcal evdence of R&D spendng on a frm s fnancal performance. It also examnes the effects of other frm characterstcs. R&D actvtes may also nfluence frm s revenue growth, shortterm proftablty, and longterm economc performance. The rest of the paper s organzed as follows:

3 secton 2 gves lterature revew, secton 3 gves data and methodology; n secton 4 we present the emprcal results wth dscussons and fnally secton 5 provde concludng remarks. II. LITERATURE REVIEW Accordng to the study by Dutta and Rao(1999), the factors lke marketngs, R&D and operaton capabltes are mportant determnants of fnancal performance n hgh technology ndustres. The study of Lau(1998) suggest that the dfference of ROA between hogh and low R&D ntensty frms s margnally sgnfcant, he also conclude that hgh R&D ntensty do not mply hgher ROA. But accordng to the study by Chen et al. (2005), there exst a postve relatonshp among R&D ntensty and both the proftablty measure Return on Assets (ROA) and Return on Equty (ROE) whch mples that for frm s future growth and proft, R&D nvestment s very mportant. Quo et al. (2004) argued that R&D ntensty has a sgnfcant negatve mpact on proftablty and frm sze has a sgnfcant nfluence on R&D expendture and frm s performance. Ho et al. (2005) found sgnfcant negatve relatonshp between frm sze and R&D ntensty and also found postve relatonshp between frm sze and market to book value rato. Ths ndcate bgger frms have hgher market value than smaller frms, but smaller frms are more nnovatve f ther R&D ntensty s hgher compared to bgger frms. Movng on to the studes based on relatonshp between frm s sze and proftablty, the study by Kotabe et al. (2002) suggest a strong postve sgnfcant relatonshp between frm sze and ROA, whch ndcate that bgger frms are more proftable and manages ther assets to ncrease ther proft. In contrast Ln et al. (2006) found sgnfcant negatve relatonshp between frm sze and Tobn s Q ndcatng bgger frms have lower growth potental compared to smaller frms. Quo et al. (2004) found that frm sze has a postve mpact on productvty and no sgnfcant nfluence on proftablty. The reason behnd the postve mpact of frm sze on productvty s due to the economes of scale of large frms. The relatonshp among R&D ntensty, frm sze, proftablty measures remans ambguous as many studes have found both postve and negatve relatonshp among them. III. DATA AND METHODOLOGY The data for the emprcal analyss s derved from the Center for Montorng Indan Economy (CMIE) PROWESS Data base for the 154 software frms n IT ndustry of Indan Economy. We have downloaded data from 1992 to Sample sze and

4 perod are based on the avalablty of data. We wll use pooled data for the emprcal analyss. The lst of varables used n ths study, are as follows: Table No. 1: Defnton of the Varables Sl. No. Varable Varable Defnton of the Varable 1 Stock Excess Return R Annual common stock excess return per share cumulated begnnng nne months before to three months after the fscal year end for frm 2 Earnngs Per Share EPS A fnancal measure that represents a per share assessment of the mnmum value of a company's equty. 3 Research & Development Intensty 4 Change n earnng per share RDI DEPS R&D ntensty s the rato of R&D expendture and net total assets at fscal year end and s denoted here by R&D INT. changes n earnngs per share before R&D for frm 5 Interacton 1 DRDI Interacton between RDI and Change n earnng per share 6 Sze Sze Frm sze s defned as the natural logarthm of a frm s Sales at fscal year end and s denoted here as SIZE. 7 Book to market value BMV A rato used to fnd the value of a company by comparng the book value of a frm to ts market value. 8 H Index H A commonly accepted measure of market concentraton. It s calculated by squarng the market share of each frm competng n a market 9 Age of the frm Age Year of study mnus year of ncorporaton 10 Aggregate Market Share AM Aggregate market share of a frm s the frm s total sales dvded by total ndustry sales. 11 Labour Intensty LI Labor ntensty s the relatve proporton of labor (compared to captal) used n a process. Its nverse s captal ntensty 12 Multnatonal Afflaton MNE MNE are organzatons that own or control producton or servces facltes n one or more countres other than the home country, n ths case a value takes 1 for the MNE afflate and 0 otherwse

5 3.1 Hypotheses The hypotheses of the study are as follows: 1. The market valuaton of R&D spendng s a postve functon of expected R&D productvty as depcted by labour ntensty. 2. The market valuaton of R&D spendng s postvely related to a frm s product market share. 3. Market valuaton of R&D expendtures s a functon of the frm s average product age. 4. The market valuaton of R&D s hgher for frms that dversfy nto dfferent product categores (wthn the same ndustry) than those who do not dversfy. 3.2 Control varables A szable lterature exsts on the effect of frm sze on market valuaton. In general, large frms have smaller earnngs response coeffcents than small frms. In the R&D context, Holthausen, Larcker and Sloan (1995) argue that centralzaton s necessary for large frms to control employee managers, and that a more centralzed frm tends to nhbt nnovaton due to ts more bureaucratc control mechansms. To the extent that frm sze proxes for centralzaton, frm sze could show a negatve correlaton wth the market valuaton of R&D spendng. However, frm sze s also related to the avalablty of fnancal resources. If the avalablty of fnancal resources can facltate nnovaton effcency, frm sze wll be postvely correlated wth the market valuaton of R&D. Snce the sze effect on the market valuaton of R&D nvestment s ambguous but the effect of sze n frm valuaton s well documented, frm sze only s used as a control varable n the study. In addton to Frm Sze, we adopted multnatonal afflaton of frms as other control varable. 3.3 Methodology To evaluate the four hypotheses presented above, we use the returns model presented by Easton and Harrs (1991), Easton and Zmjewsk (1989), Collns et al. (1994). Ths model depcts returns as a functon of earnngs and the change n earnngs. The basc emprcal model estmated can be presented as follows: R ( RDI ) ( EPSD ) ( DPES ) 5 ( DRDI) ( EPS ) 2 ( SIZE) 6 3 ( BMV ) 7 ( MNE) 7 u (3.1) All varables except the R, and SIZE are scaled by the market value at the begnnng of the year.

6 IV. EMPIRICAL RESULTS Table 2 presents descrptve statstcs of the varables that we use n our analyss. The average of the varable research and development ntensty (RDI) and prce to book value (PBV) s pretty low around 0.07 and 0.05 respectvely. Mean s low for labor ntensty (LI). It s very hgh for total Asset and Net Income. The varablty of research and development ntensty (RDI), prce to book value (PBV) and labor ntensty (LI) varable s low. It s hgh n case of varable RDI and total Asset. Table 2. Summary Statstcs of the sample frms For the Years Varables Mean Standard Devaton Mnmum Maxmum 25% 75 % Net Income Research and Development Expenses Total Asset Prce to Book Value R&D Intensty Labour Intensty Table 3. Sample statstcs of product market structure varables sample perod: Varables Mean Medan Standard Mnmum Maxmum Devaton Age of the sample frm s average product on the market Herfndahl Index Aggregate market share Weghted average market share Market value of common equty

7 Table 3 presents descrptve statstcs of the varables that we use n our analyss. The average of the varable Herfndahl Index (HI) and Weghted average market share (WAMS) s low around 0.53 and negatve respectvely. Mean s very hgh for Age of the sample frm s average product on the market, Aggregate market Share (AMS) and Market value (MV). The varablty of HI varable s very low. It s hgh n varable Age, AMS and WAMS and very hgh n case of varable MV. Table4 Correlatons among the varables of nterest A. Spearman correlaton of product market structure varables of the man sample Varables Average Product Age Herfnda hl Index Average Product 1 Age Herfndahl Index Weghted Average Market Share Weghted Average Market Share Frm Sze Frm Sze Labour Intensty Labour Intensty B. Spearman correlaton of percentage of labor ntensty wth cost structure varables Varables R&D to Cost to PI Cost Excludng R&D to Revenue Revenue Revenue Labour Intensty From table 4 we can observe that Herfndahl Index (H) s negatvely correlated to Average Product Age. Weghted Average Market Share (WAMS) s negatve correlated to both Average Product Age and Herfndahl Index (HI). Frm Sze s weakly correlated to Average Product Age or WAMS and negatvely correlated to HI. Labour Intensty (LI) s 27% correlated to Frm Sze. LI varable has postvely correlated to all varable.e AGE, SIZE, HI, WAMS, and LI. Labour Intensty s 28% correlated to Cost to Revenue and PI. Labour ntensty s low correlated to R&D to Revenue and Cost Excludng R&D to Revenue Test of Hypothess H1 PanelA of Table 5 presents the results of evaluatng Hypothess H1 n the sample. Hypothess H1 predcts that R&D spendng s more valuable for frms whch exhbt hgher future R&D productvty as measured by the labour ntensty. In PanelA; RDI s the varable whch s turnng out to be sgnfcant at 1% level of sgnfcant. DEPS s sgnfcant at 10% level of sgnfcant. R Square s 0.50 by usng OLS model. One unt ncrease n DEPS wll lead to 0.1% ncrease n RDR. The regresson analyses support Hypothess 1.

8 4.2. Test of Hypothess H2 Because the market structure nformaton used n ths study s compled based on CMIE data, the regresson results reported here are weghted by percentage of sales derved from net sales. However, to ensure a mnmum representaton, a ten percent weght s mposed on frms that derve less than that proporton of sales from retal markets. The results reported here are not affected when the regressons are weghted by mposng a mnmum of one percent weght, when three dfferent weghts are assgned to three levels of net sales, or when nonweghted regressons are run. Regardng market competton, Hypothess H2 predcts that the market valuaton of R&D s postvely related to market share. Panel B of Table 4 shows the results on the market competton hypothess. In PanelB; RDI, DRDI, SIZE and BMV s the varable whch s turnng out to be sgnfcant at 10% level of sgnfcant. R Square s 0.75 by usng OLS model. One unt ncrease n SIZE wll lead to 1% decrease n RDR and same as 1 unt ncrease n BMV wll lead to 11% decrease n RDR. An ncrease n R&D spendng s apparently vewed by nvestors as benefcal to a frm only f the frm has a large market share. Wthout factorng n the market competton envronment, a study may mstakenly conclude that ncremental R&D s always prced postvely by the market. The analyss usng weghted average market share, although not reported, produces smlar results Test of Hypothess H3 Panel C of Table 4 reports the regresson results of the Lfe Cycle Hypothess. The purpose of the regresson s to examne the extent to whch beng n the mddle part of product lfe cycle stage (relatve to the other stages) adds to the market value of software development cost. In PanelC; SIZE s the varable whch s turnng out to be sgnfcant at 1% level of sgnfcant. RDI, EPS and DEPS are sgnfcant at 5% level of sgnfcant. DRDI and DRDID are sgnfcant at 10% level of sgnfcant. R Square s 0.75 by usng OLS model. One unt ncrease n SIZE wll lead to 55% decrease n RDR and same as 1 unt ncrease n EPS and DEPS wll lead to 0.2% and 0.1% ncrease n RDR Test of Hypothess H4 Panel D of Table 4 reports the results for the dversfcaton hypothess. The hypothess predcts that R&D spendng s more valuable for a dversfed frm than not dversfed frm. In PanelD; RDI s the varable whch s turnng out to be sgnfcant at 1% level of sgnfcant. EPS and DEPS are sgnfcant at 10% level of sgnfcant. R Square s 0.34 by usng OLS model. One unt ncrease n EPS wll lead to 0.3% decrease n RDR and same as 1 unt ncrease n DEPS wll lead to 0.3% ncrease n RDR. Changes n R&D tself s sgnfcant n three of the regressons but the nteracton term of change n R&D and the factors s, ndcatng some degree of

9 nvestor sophstcaton. That s, nvestors do not smply regard more R&D spendng as valuencreasng actvty unless the frm s ether more productve (hgher proporton of techncal employees), has larger market share, provdes dversfed product offerngs, or s n the mddle stage of product lfe cycle consstent wth the predctons of our hypotheses. Overall, the emprcal analyses offer support to the hypothess that the market valuaton of R&D s not crosssectonal constant and that market share, product dversfcaton, product lfe cycle, and the frequency of product nnovaton together have some ncremental ablty to explan the crosssectonal varaton n the market valuaton of R&D expendtures. Table 5. Results of the regressons to evaluate the effect of R&D varables on valuaton of software frms (wth robust standard errors) Varable Intercept RDI DRDI MNE DRDID EPS DEPS SIZE BMV R 2 Panel A: The effect of percentage of labour ntensty on the market valuaton of R&D spendng t Statstcs Coeffcent VIF Panel B: The effect of market share on the market valuaton of R&D spendng Parameter t Statstcs Coeffcent VIF Panel C: The effect of Age on the market valuaton of R&D spendng Returns regresson results t Statstcs Coeffcent VIF Panel D: The effect of Hndex on the market valuaton of R&D spendng t Statstcs Coeffcent VIF

10 V. CONCLUSION Ths paper emprcally nvestgates the mpact of R&D expendture on four key market valuaton varables labor ntensty, market share, age and H ndex n Indan IT frms. We found that compared to large frms, smaller frms nvest more on R&D and n turn are more productve n nnovaton. From the results we can also see that research and development ntensty, dfference n research and development ntensty, earnng per share, dfference n earnng per share are sgnfcantly related to the return from R&D. We conclude that the market valuaton of R&D spendng s a postve functon of expected R&D productvty and related to labour ntensty, the market valuaton of R&D spendng s postvely related to a frm s product market share, market valuaton of R&D expendtures s related to frm s average product lfe cycle stage and; the market valuaton of R&D s hgher for frms that dversfy nto dfferent product categores (wthn the same ndustry) than those who do not dversfy. An extenson of ths study could be to nvestgate the nvestor s valuaton of R&D expendture for the larger and the smaller frms n the Indan ndustres. REFERENCES [1] Dutta, S., Narashmhan, O., and Rajv, S. (1999). Success n hghtechnology markets: s marketng capablty crtcal? Journal of Marketng Scence, 18(4), [2] Das A., Halder R., Kumar V and Kumar U. (2009). Impact of R&D Expendture on Fnancal Performance: A study of Canadan IT frms, Admnstratve Scences Assocaton of Canada. Vol 30, No.25. [3] Lau, R.S.M. (1998). How does research and development ntensty affect busness performance? South Dakota Busness Revew, 57(1), 18. [4] Ln, B., Lee, Y., and Hung, S. (2006). R&D ntensty and commercalzaton orentaton effects on fnancal performance. Journal of Busness Research, 59(6), [5] Quo, B., Wang, Q.Z. and Shou, Y.Y. (2004). Frm sze, R&D, and performance: an emprcal analyss on software ndustry n Chna. Proceedngs of IEEE Internatonal Engneerng Management Conference, 1821, October, 2, [6] Lantz, J.S., and Sahut, J.M. (2005). R&D Investment and the Fnancal Performance of Technologcal Frms. Internatonal Journal of Busness, 10(3), [7] Lau, R.S.M. (1998). How does research and development ntensty affect busness performance? South Dakota Busness Revew, 57(1), 18. [8] Ln, B., Lee, Y., and Hung, S. (2006). R&D ntensty and commercalzaton orentaton effects on fnancal performance. Journal of Busness Research, 59(6), [9] Chan, S., Martn, J., and Kensnger, J. (1990). Corporate research and development expendtures and share value. Journal of Fnancal Economcs, 26(2), [10] Agrawal, A., and Knoeber, C.R. (1996). Frm performance and mechansms to control agency problems between managers and shareholders. Journal of Fnancal and Quanttatve Analyss, 31(3),

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