R&D investment decisions of IPO firms and long-term future performance

Abstract

Purpose

The purpose of this paper is to link valuation of different accounting items to research and development (R&D) investment decisions and investigate how suboptimal R&D choices during initial public offering (IPO) are linked to future operating and market underperformance.

Design/methodology/approach

For firms with substantial growth opportunities, accounting net income is a poor measure of the firm’s performance (Smith and Watts, 1992). Therefore, other metrics such as R&D intensity are used by investors to evaluate firms’ performance. This leads to a coexistence of two strategies: if earnings are the main value driver, firms tend to underinvest in R&D; and if R&D expenditures are the main value driver, firms tend to overinvest in R&D.

Findings

The authors show that the R&D investment decision varies systematically with cross-sectional characteristics: firms that are at the growth stage, unprofitable or belong to science-driven industries are more likely to overinvest, while firms that are able to avoid losses by decreasing R&D expenditure are more likely to underinvest. Finally, they find that R&D overinvestment leads to future underperformance as evidenced by poor operating return on assets, lower product market share, higher frequency of delisting due to poor performance and negative abnormal stock returns.

Originality/value

While prior literature concentrates on R&D underinvestment as a tool of reporting higher net income, the authors demonstrate the existence of an alternative strategy used by many IPO firms – R&D overinvestment.

Citation

Fedyk, T. and Khimich, N. (2018), "R&D investment decisions of IPO firms and long-term future performance", Review of Accounting and Finance, Vol. 17 No. 1, pp. 78-108. https://doi.org/10.1108/RAF-09-2016-0147