Stock forum

Jae Jun said:

Yes you could capitalize R&D but I would not trust a company that capitalizes 100%. It does add to the future, but unless it is a pharma, only a certain amount of R&D will add to company growth. Even then, R&D only goes for about 3 years of the product.

This is why I don't think R&D should be capitalized, because it is a constant expense required to stay competitive.

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Hi Jae-

Well, in theory it is but companies also "wind down" sometimes too. Imation was one of those, lots of R&D then they decided to just ride their remaining technologies into the ground and take the cash out. (I haven't looked at them in a while, so not sure what they're doing now).

Obviously it would need to be a standardized accounting treatment so everybody does it the same IF such a change were ever made.

 -darkgreen

Jae Jun said:

I too don't think you should capitalize expenses. If you get into every single detail for each company you analyze, yes you may be able to do it on a case by case basis, but in general it is safer not to.

Only leads to inflated earnings.

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I think the argument for capitalizing R&D is that R&D is an investment with a long term payoff (and also that people might do more of it if it were capex). As it is right now a project with R&D looks like a deep money pit the first few years and then a cash cow the next few. If you capexed R&D the picture looks a bit more reasonable in that the spending doesn't look as dumb and the earnings have expenses associated with them that represent the costs of getting the project R&D done to launch it.

 

My company has done work with several Fortune-50 level execs who believe that R&D should be capex and the discussions and example annual reports do make a lot of sense.

 

Having said that, I avoid stocks when I find operating expenses hidden in capex. Recent example: Stage Stores (SSI). Looked interesting until I started trying to figure out where all the capex was going. They weren't opening enough stores to explain it and in one of the footnotes to the footnotes I found that they capitalize all expenses, including personnel, relating to warehousing and distribution. So their capex was non-optional and was a way of moving paid salaries into the depreciation column. That's bad.

Xyvern said:

I finally have time to listen Pro. Damodaran's Valuation lectures. So far I am very impressed with his lectures specially what he said we should capitalize real R&D expenses and Operating leases should be treated as financial expenses instead of operating expenses.

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Although I've read some of Damodaran's work I wasn't aware that he believed in capitalizing R&D. Interestingly, I just finished Hewitt Heiserman's book "It's Earnings That Count" a few days ago. Heiserman also believes in capitalizing R&D. Immediately the concept didn't gel with me so I decided to go see what the investors bible (Security Analysis by Benjamin Graham) had to say about the subject. Heiserman believes not only R&D should be capitalized but also advertising. Therefore, the following Ben Graham quote lends merit to the argument.

 

"On comparatively rare occassions, managements resort to padding their income account by including items in earnings that have no real existence. Perhanps the most flagrant instance of this kind that has come to our knowledge occurred in the 1929-1930 reports of Park and Tilford, Inc., an enterprise with shares listed on the New York Stock Exchange. An examination of the balance sheets discloses that during these two years the item of Good-will and Trade-marks was written up successively from $1,000,000 to $1,600,000 and then to $2,000,000, and these increases deducted from the expenses for the period….No statement relating to these amazing entries was vouchsafed to the stockholders in the annual reports or to the New York Stock Exchange in subsequent listing applications. In answer to an individual inquiry, however, the company stated that these additions to Good-will and Trade-marks represented expenditures for advertising and other sales efforts to develop the busienss of Tintex Company, Inc., a subsidiary. The charging of current advertising expense to the good-will account is anadmissible under all canons of sound accounting. To do so without any disclosure to the stockholders is still more discreditable."

 

It seems as though Ben Graham wasn't too fond of the idea either.

 

The argument to depreciatiate R&D over a period of time is a good one because it really is an investment into the company in hopes of producing a return much to the same degree that Cap Ex is. However, there is no certainty that any research and development practices will ever be fruitful. Furthermore, to what degree if any? As an old school investor, I think its important to be on the conservative side of the fence. That is one reason that I completely dismiss all intangibles in my valuations. Unless you have direct knowledge of the value of an intangible item, through experience, I don't believe there is any other investor who can safely value an intangible item. I think it could make sense to depreciate R&D without capitalizing it on the balance sheet. However, again you'd have to have good logical knowledge of what length of time the period of depreciation should be. Unless you know the company & possibly the industry like the back of your hand, you can't answer that question with any degree of certainty. Therefore, for me, the capitalizing and depreciating of R&D and Advertising makes no sense.

http://pages.stern.nyu.edu/~adamodar/

Professor Demodaran teaches two classes at Stern each semeter and all the lectures are available in web cast and free of charge. I recomend everyone interested in stock valuation listen to his lectures because I think the materials are very valuable. Also the web site contains numerous spread sheets that can be helpful in valuation.The only small problem is that you may need access to Bloomberg Professional to do the project for his class.

I recently looked through academic earth and I found Damodarans Valuation course for free and it looks interesting. I was wondering if anyone has looked through this. BTW is Damodaran a value investor? He seems like he is value oriented. The link to the course is http://www.academicearth.org/c…..  What do you all think?