What is the Price-to-Innovation-Adjusted Earnings Ratio?

The price-to-innovation-adjusted earnings ratio is used to evaluate the price of a company's stock as compared to its earnings when adjusted for the amount the company spends on R&D.

How Does the Price-to-Innovation-Adjusted Earnings Ratio Work?

The formula for price-to-innovation-adjusted earnings is:

Price-to-Innovation-Adjusted Earnings = Price per share / (EPS + R&D per share)

For example, let's assume that Company XYZ, a company that designs and manufactures medical devices, earned $10,000,000 in profits last year. One of its big expenses was R&D, on which it spent $8,000,000 last year. Company XYZ's 11,000,000 outstanding shares currently trade at $5 per share.

Using this information, we can calculate that Company XYZ's earnings per share (EPS) equals $10,000,000 / 11,000,000 = $0.91. We can also determine that Company XYZ spent $8,000,000 / 11,000,000 = $0.73 per share on R&D.

Using the formula above, we can therefore calculate that Company XYZ's price-to-innovation-adjusted earnings is:

$5 / ($0.91+$0.73) = 3.05

Why Does the Price-to-Innovation-Adjusted Earnings Ratio Matter?

Unlike the P/E ratio, the price-to-innovation-adjusted earnings ratio gives investors an idea of how well companies perform absent the expense of innovation. By adding back R&D expenses, the ratio removes the pressures and effects (some would even say penalties) of having to expense R&D costs for which a company may have little to show now but might reap huge benefits from later. In turn, the price-to-innovation-adjusted earnings ratio allows investors and analysts to identify more easily companies that are investing in innovation.

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