INTRODUCTION AND LITERATURE REVIEW
As the role and influence of technology impacts firms in the economy and financial markets, so too does the importance of research and development (R&D) spending by corporations. The role of research and development (R&D) on firm productivity and growth are well-documented (Griliches, 1984; 1986) and R&D expenditures across different industries have increased significantly over time (Franzen, Rodgers, & Simin, 2007). As firms and industries continue to evolve, R&D has increasingly become a critical element of firm success and survival (Bremser & Barsky, 2004; Tsai & Wang, 2004).
Table one presents the average R&D intensity (R&D as a percentage of sales) by a large sample of publicly-traded firms drawn from the S&P Compustat Database over the 1976 to 2007 time period. Firms are allocating an increasing portion of their budget outlays to R&D spending. The mean (median) R&D intensity for firms in our sample has grown from 1.75% (0.96%) in 1976 to 7.77% (2.71%) in 2007. Given this increased focus on R&D spending by corporations, it is important to look at the impacts of the spending and how it is perceived by investors.
There is a growing body of research that has studied the influence of R&D on firm behavior as well as the market's reaction to the role of R&D. Chan, Lakonishok, and Sougiannis (2001) found that firms with high R&D to equity market value earned high excess returns. Eberhart, Maxwell, and Siddique, (2004) found that while R&D expenditures were beneficial and firms with high R&D expenditures experienced positive long-term returns, markets were slow to recognize the returns. Chan, Martin, and Kensinger (1990) found increased R&D announcements by high-technology firms resulted in positive abnormal returns on average, whereas announcements by low-technology firms were associated with negative abnormal returns.
Studies by Chan, Martin, and Kensinger (1990) and Szewczyk, Tsetsekos, and Zantout (1996) looked at market response to R&D announcements. Both studies found a positive response to increases in R&D spending. Szewczyk, Tsetsekos, and Zantout (1996) found a positive response to increases in R&D spending, primarily for firms with higher values of Tobin's q (the ratio of the market value of the firm relative to the replacement value). Thus, firms that are perceived to be more productive see a greater response than those that are perceived to be less productive. Hsieh, Mishra, and Gobeli (2003) examined the pharmaceutical industry and found that R&D is a significant factor in improving firm performance across a variety of measures.
Connolly and Hirschey (2005) examined the impact of R&D intensity on Tobin's q and found a positive, linear relationship after controlling for growth, risk, profit margin, and advertising intensity. Huang and Liu (2005) examined R&D intensity in Taiwanese firms and found a curvilinear relationship with respect to R&D spending and profitability. Another interesting approach was that of Gleason and Klock (2006) who attempted to look at R&D as a stock variable instead of a flow variable. They found that the value of R&D expenditures accumulated over the previous five years had a significant, positive impact on Tobin's q. Dutta, Om, and Rajiv (2005) took a different perspective and analyzed a firm's R&D capability instead of intensity. They found that firms with a higher level of capability with respect to R&D tended to have higher levels of Tobin's q.
The consensus of the above research is that R&D intensity is associated with higher levels of firm performance and greater valuation in the financial markets. Our paper contributes to this research in three ways. First, we introduce the curvilinear model to US firms using Tobin's q. Tobin's q is a widely used measure of performance (Lee & Tompkins, 1999). A curvilinear relationship found by Huang and Liu (2005) focused on profitability instead of Tobin's q and was based on Taiwanese firms. Second, we consider a variety of classifications to examine how investors respond to R&D spending for firms with different characteristics. Third, in addition to examining how investors value R&D spending ACROSS firms, we investigate how investors respond to changing R&D intensity WITHIN firms. By extending the literature in modeling the response of investors to R&D spending by corporations, we hope to gain a better understanding of the role of R&D.
DATA AND METHODOLOGY
The data is generated using the S & P Compustat database from 1975-2007. While Compustat has a line item entry (Compustat Data Item xrd) for R&D, this item is left blank for many firms (52% of the firms in the original data set). Our first step in collecting the data was to eliminate all firms that did not report R&D expenditures. We identified a total of 51,223 observations (Table 4). Of these, 40,249 (79%) have non-zero values for R&D Intensity and 10,974 (21%) have values of 0. Next, after examining two market indexes (Russell 3000 and the S&P 600) we eliminated all firms with a market capitalization of less than $25 million as these were well below the normal range for even these small capitalization indices. Since our data set includes several observations that are extreme outliers, resulting in significantly skewed variables, we reduced the impact of outliers by requiring firms to exhibit a return on sales between negative 100% and 100%, R&D intensity of less than 100% and annual sales growth of less than 200%. Tobin's q was calculated as demonstrated by Connolly and Hirschey (2005) who based their method upon Chung and Pruitt (1994). Table Two provides a description of the primary variables used in our analysis.
As mentioned above, Tobin's q represents the market value of the firm divided by the replacement value of the firm's assets. As we calculate the replacement value of the firm's assets based on book value, high values of Tobin's q have a couple of related interpretations. Either the balance sheet fails to capture all of the assets employed by the firm or the firm's management is capable of using these assets more productively than their current and potential competitors. One reason why the balance sheet may understate the market value of the firm's assets is if it does not fully capture intangible assets. For instance, R&D may be perceived as an asset in the financial markets in that it can generate future profits; however, it is expensed in the current period. The value of a firm's brand developed through advertising may also fit this description. Based on this, we might expect firms with higher levels of R&D and advertising to have higher levels of Tobin's q.
It is also reasonable to think that there is a point where both R&D and advertising expenses reach diminishing (or even negative) marginal returns. Huang and Liu (2005) found a curvilinear relationship between R&D intensity and profitability in the current year (as measured by return on sales and return on assets) for a sample of 297 Taiwanese firms. This is an interesting finding that represents a starting point for further analysis. We extend their analysis...