Research and Development

Research and Development are activities that lead to the discovery and development of new products or improvements to existing products.

A company without Research and Development costs is a good thing. It means the company may have a business model that can withstand the ever-changing times. However, there are many great companies that have Research and Development costs.

Companies that have Research and Development costs are usually Technology, Biotechnology, and Drug Companies. Before investing in a company that has these cost, check their Research and Development to Gross Profit ratio.

 

Equations

 

For a company with a Durable Competitive Advantage:

 

If the company has Research and Development cost, that is if:

 

Use this ratio as a guide:

 

Examples of Companies without Research and Development Cost:

  • Coca-Cola
  • Wal-Mart
  • H&R Block

Examples of Companies with Research and Development Cost:

  • Apple
  • IBM
  • Google
  • Johnson and Johnson
  • Merck

Below is a comparison of these companies' Research and Development to Gross Profit Ratio for the year 2012.

 

Comparison of Research and Development to Gross Profit Ratio

Company Research and Development for the Year 2012 (Millions) Gross Profit for the Year 2012 (Millions) Research and Development to Gross Profit Ratio
Apple $3,381 $68,662 4.9%
IBM $6,302 $50,298 12.5%
Google $6,593 $29,670 22.2%
Johnson and Johnson $7,665 $45,566 16.8%
Merck $7,911 $30,821 25.7%

 

For technology companies, Apple and IBM have very low Research and Development to Gross Profit Ratio, they are at 4.9% and 12.5% respectively. Even though Apple's ratio is very low, their profits mostly comes from the sale of electronics. Electronics become outdated in just a few years. What will happen if Apple fails to create the next big thing? On the other hand, IBM comes in at 12.5%, they are in the business of providing services. In other words, IBM's profits mostly come from providing computer services. Warren Buffet loves companies that provide unique services.

Google is at 22.2% which is close to the threshold of 20%. At this time Google is in the business of innovation. They have to spend much of their profit on Research and Development to keep their technology up to date. Without innovation, Google's technology could become obsolete.

As for biotech companies, Johnson and Johnson is at 16.8% while Merck is at 25.7%. Johnson and Johnson has a diversified consumer products business. They make shampoo, soap, mouthwash, etc., - things people buy every month - along with creating new medication. Merck is in the business of solely creating new medication. Patents expire, so Merck has to invent new blockbuster drugs to stay in business.

 

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