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Book-to-market ratio and inflexibility: the effect of unrecorded R&D capital

by Dr Yuan Li, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance

Many sketches and gear shaped objects on white paper representing a business strategy

Yuan Li
Dr Yuan Li

R&D investment has been playing an increasingly important role in the economy. However, accounting standard requires firms to immediately expense R&D as incurred. Therefore, R&D investment is not capitalized on the balance sheet. Could the unrecorded R&D capital affect our assessment of a firm’s risk? The answer is affirmative, according to the findings from a research project conducted by CERF research associate Yuan Li.

Finance theory suggests that a firm’s risk is negatively related to its flexibility to adjust capital investment. The more flexibility a firm has in this regard, the less its cash flows are affected by economic-wide conditions, and the lower its risk. Flexibility is hard to observe directly, but it can be inferred from the book-to-market ratio (BM). High-BM firms are generally burdened with more unproductive capital and hence less flexible to downsize in bad times. Thus, according to the theory, high-BM firms are riskier than low-BM firms, especially in bad times.

However, results from this project suggest that the above theory should not be followed blindly. This is because book-to-market ratio calculated from the balance sheet data increasingly misrepresents inflexibility and risk. This in turn is because book value is understated by the unrecorded R&D capital, which is even less flexible to adjust than physical capital. Results also suggest that considering book-to-market ratio and R&D capital together is a better way to evaluate a firm’s inflexibility and risk.