Meaning and definition of Price-to-Research Ratio
The Price-to-research ratio can be expressed as a measure of the relationship between a company’s market capitalization and expenses on the research and development. Putting it other way, it can be referred as a comparison between how much is spent by a company on research and development and the value of its current share price. A low price-to-research ratio is considered to be financially sound, indicating that the company is invested heavily in R&D and is, therefore, most likely capable of producing future profitability.
As explained by Investopedia, the price-to-research ratio is of great importance to research based businesses, like pharmaceutical companies. However, a large amount of expenditure on R&D does not essentially indicate definite future profits.
The general formula used for computing the price-to-research ratio is:
Price-to-Research Ratio = Market Capitalization / R&D Expense
Let us presume that Company ABC spent $5,000,000 on R&D the previous year. It has 10,000,000 shares outstanding trading at $5. Using the aforementioned formula, the price-to-research ratio for Company ABC is:
Price-to-Research Ratio = (10,000,000 x $5) / $5,000,000 = 10
Why it matters
The price-to-research ratio is one of the ways of evaluating the ability of a company to generate future profits. After all, research and development is a sign of the commitment made by a firm to innovation. Therefore, a lower price-to-research ratio (i.e. a higher denominator) indicates a greater value of a company as related to its innovative activities.
It should be essentially noted that, although, the research & development expenditure is not a guarantee the materialization of future profits form that research & development expenditure. However, the price-to-research ratio of a company gives the insight to companies competing within the same industry. This is for the reason that research & development intensity can vary widely. Therefore, an interpretation of a “high” or “low” ratio should be made within this context.
Wrapping it up, it can be rightly stated that the price-to-research ratio is used for evaluating the price of stock held by a company as contrasted to its capacity of generating future profits from new products.