Price-to-Research Ratio (PRR): Meaning, Formula, Limitations

What Is the Price-to-Research Ratio – PRR?

The price-to-research ratio (PRR) measures the relationship between a company's market capitalization and its research and development (R&D) expenditures. The price-to-research ratio is calculated by dividing a company's market value by its last 12 months of expenditures on research and development. A similar concept is return on research capital.

Market value is found by multiplying the total number of shares outstanding by the current stock prices. The definition of research and development expenditures may differ from industry to industry, but companies in the same industry generally follow similar definitions of R&D expense.

R&D expenses may include expenses related to such items as pure research, technology licensing, the purchase of proprietary technology from third parties or the cost of getting innovations through regulatory hurdles. R&D expenses are usually disclosed and explained in the income statement or the relevant footnotes of published accounting statements.

The Formula for PRR Is

 $\begin{aligned} &\text{PRR}=\frac{\text{Market Capitalization}}{\text{Research \& Development Expenditure}}\\ \end{aligned}$​PRR=Research & Development ExpenditureMarket Capitalization​​

What Does PRR Tell You?

Financial expert/writer Kenneth Fisher developed the price-to-research ratio to measure and compare companies' relative R&D expenditure. Fisher suggests buying companies with PRRs between 5 and 10 and avoiding companies with PRRs greater than 15. By looking for low PRRs, investors should be able to spot companies that are redirecting current profits into R&D, thereby better ensuring long-term future returns.

Price-to-research ratio (PRR) is a comparison of how much money a firm spends on research and development in relation to its market capitalization. The ratio is most important in research-based businesses such as pharmaceutical companies, software companies, hardware companies and consumer products companies. In these research-intensive industries, investment in scientific and technical innovation is critical for success and long-term growth and can be an important indicator of the company's ability to generate profits in the future.

In comparison, across peers, a lower price-to-research ratio may be considered appealing, as it may indicate that the company is heavily invested research and development, and is perhaps more likely to succeed in producing future profitability. A relatively higher ratio may indicate the opposite, that the company is not investing enough in future success. However, the devil is in the details, and the lower price-to-research ratio firm may just have a lower market capitalization, and not necessarily a better investment in R&D.

Similarly, a relatively favorable price-to-research ratio does not guarantee the success of future product innovations, nor does a large amount of R&D spending guarantee future profits. What really matters is how effectively the company is employing its R&D dollars. In addition, the appropriate level of R&D spending varies by industry and depends on the company's development stage. As with all ratio analysis, the price-to-research ratio should be viewed as one piece of a large mosaic of data used to inform an investment opinion.

The Difference Between PRR and Price-to-Growth Flow Model

Technology investment guru Michael Murphy offers the price/growth flow model. Price/growth flow attempts to identify companies that are producing solid current earnings while simultaneously investing a lot of money into R&D. To calculate the growth flow, simply take the R&D of the last 12 months and divide it by the shares outstanding to get R&D per share. Add this to the company's EPS and divide by the share price.

The thought is that low earnings can be compensated with greater R&D spending and vice versa. If a company decides to spend on today and neglect the future, current earnings per share may exceed R&D spending. Both cases result in a high reading of the ratio, meaning solid earnings per share or R&D spending. That way investors can evaluate potential earnings growth now and in the future.

Limitations of the Price-to-Research Ratio (PRR)

Unfortunately, while the PRR and Murphy models both do a great job of helping investors identify companies that are committed to R&D, neither indicates whether R&D spending has the desired effect (i.e., the successful creation of profitable products over time).

In other words, PRR does not measure how effectively management allocates capital. A large R&D bill, for instance, does not guarantee new product launches or market implementations will generate profits in future quarters. When evaluating R&D, investors should determine not only how much is invested but how well the R&D investment is working for the company.

Companies often cite patent output as a tangible R&D success measure. The argument goes that the more patents filed, the more productive the R&D department. But in reality, the ratio of patents per R&D dollar tends to represent the activity of a company's lawyers and administrators more than its engineers and product developers. Besides, there is no guarantee that a patent will ever turn into a marketable product.