R&D Intensity, Future Performance, and Operational Distress

• In Event: Determinants of Future Earnings Performance

Abstract

Prior studies suggest that the positive relation between R&D, future earnings, and future stock returns arises because investors predictably misjudge the benefits of R&D (the ‘earnings-based’ mispricing hypothesis) or because the future payoffs of R&D are more uncertain (the ‘uncertainty-based’ risk hypothesis). I examine a third explanation based on real-options theory. The average high R&D firm has recently realized a negative demand shock, pushing down growth expectations. In response high R&D firms restructure, however, because R&D is a quasi-fixed cost, drops in R&D are slower than drops in firm scale leading to higher operating leverage. The restructuring of cost and capital structures in response to the negative shock explains the profit and investment patterns of R&D firms while the fixed-cost qualities of R&D seem to explain expected returns. The collective empirical evidence strongly supports the risk-based explanation proposed in the real-option literature while strongly challenging the two extant hypotheses as explanations for the performance, investment and stock return patterns of R&D firms.

Author

• Robert J Resutek, The University of Georgia