What it is:
The price-to-research ratio is used to evaluate the price of a company's stock as compared to its ability to generate future profits from new products.
How it works/Example:
The formula for the price-to-research ratio is:
Price-to-Research Ratio = / R&D Expense
For example, let's assume that Company XYZ spent $5,000,000 on R&D last year. It has 10,000,000 shares outstanding trading at $5. Using the formula above, Company XYZ 's price-to-research ratio is:
Price-to-Research Ratio = (10,000,000 x $5) / $5,000,000 = 10
Why it matters:
The price-to-research ratio is one way to evaluate a company's ability to generate future profits. After all, R&D is a manifestation of a firm's commitment to innovation. Thus, the lower the ratio (that is, the higher the denominator) the more a company's "value" is tied to innovative activities.
It is important to note, however, that R&D spending is not a guarantee that future profits from that R&D will ever materialize. Nevertheless, the price-to-research ratio can provide insight into companies that compete within the same industry, because R&D intensity can vary widely. Thus, the definition of a "high" or "low" ratio should be made within this context.