Consumers want cars with excellent fuel economy because of the rising cost of gas. This reality dominates strategy in the auto industry, so for manufacturers, better MPG demands serious technology from serious research and development (R&D) efforts. Given this tech-centric competitive environment, a successful R&D program may amount to a real advantage. So, let’s use some leading auto manufacturers as an example, and take this moment to ask the question: how can investors evaluate a particular company’s R&D department?
The return on research capital (RORC) metric is useful to this end because it reveals whether the R&D investment has paid off – or if company engineers and scientists have really just researched and developed for themselves a better “get rich quick” scheme. Specifically, RORC describes how many dollars of gross profit the business earns for every dollar put into R&D. The metric uses gross profit in its formula because operating profit and net profit account for other expenses totally unrelated to the R&D process. For those interested in adding RORC to your stock analysis toolkit, RORC = gross profit divided by last year’s R&D expense.
Booz and Company ran a study on the top 1,000 innovative companies and published a great list of the top 20 R&D spenders.
I’ll give you the short of Booz’s study: Toyota Motor Corporation (ADR) (NYSE:TM) invests heavily in R&D, and has been the number one spender for four of the last eight years, and in or near the top five for the other four years. Ford Motor Company (NYSE:F) was a top five spender for many years until it tapered off the investment in 2008, then suddenly dropped out of the top 20 in 2010 – clearly a strategic decision. Honda Motor Co Ltd (ADR) (NYSE:HMC) has maintained a relatively constant R&D investment presence just inside the top 20 for the last eight years.
Toyota Motor Corporation (ADR) (NYSE:TM), Ford Motor Company (NYSE:F), and Honda Motor Co Ltd (ADR) (NYSE:HMC) are definitely committed to the R&D track, but differ significantly in individual strategy: Toyota Motor Corporation (ADR) (NYSE:TM) wants to be the leader, Ford Motor Company (NYSE:F) has cut back recently, and Honda Motor Co Ltd (ADR) (NYSE:HMC) maintains a steady stream of solid investment. In case you were wondering, I left out General Motors Company (NYSE:GM) on purpose – the bankruptcy event a few years ago left lots of holes in the financial statements, and I don’t want to rely on spotty data when trying to explain how to calculate and interpret RORC.