Is R&D Mispriced or Properly Risk-Adjusted?
40 Pages Posted: 3 May 2006 Last revised: 29 Sep 2008
Date Written: August 31, 2008
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.
Keywords: R&D Valuation, Innovation Strategy, R&D mispricing, R&D risk
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