Cutting back on R&D is not a smart idea, even in tough economic times, despite the temptation to report higher short-term earnings. That is because stock markets tend to react positively to innovation and R&D announcements and reward companies long before the innovation projects actually reap in the rewards.
Show me the money you say! I can with the help of Gerry Tellis and his co-author Ashish Sood. Their article - Do Innovations Really Pay Off? Total Stock Market Returns to Innovation - is due to be published in Marketing Science, a leading peer-reviewed journal.
However, since not too many of us are going to be devouring Marketing Science any time soon, I thought it would be nice to have Gerry share his thoughts with us in plain English, rather than in simultaneous equations.
Gerry, do companies truly appreciate the value of innovation?
I don't think so. Emotionally, I think they understand how important Innovation is in driving growth and in creating new markets, but I don't think they have an effective framework for computing the true value of innovation and its payoff in the long run. So, in a nutshell, they understand its importance, but underestimate its value and payoff.
What are some of the roadblocks that prevent companies from appreciating the full value of innovation?
The payoff to innovation is highly uncertain and occurs over the long term. Firms find it very difficult to measure this payoff. They tend to believe that stock markets react positively only to announcements of immediate earnings, so they eschew spending on risky, long-term projects such as innovation, to boost their firm's stock price.
You of course disagree?
Absolutely. That's what our paper is all about. Our assertion is that stock markets value announcements on innovation projects and reward companies with disproportionately higher stock returns. Our results clearly show that the total market returns to an innovation project are $643 million, more than 13 times the return of $49 million from an average innovation event. Additionally, returns to initiation of innovation projects occur 4.7 years ahead of launch.
Gerry, could you please explain briefly, three key terms which are central to your research, but which the reader may be puzzling over - innovation project, innovation event, and announcement?
Sure:
- An innovation project is the sum total of all of a firms activities (such as researching, developing, and commercializing) involved in introducing a new product based on a new technology; from initiation to say about 12 months after launch
- An innovation event is some tangible event indicating that the project is progressing, such as patents, launch, and new rounds of funding.
- An announcement is release of information about the innovation event, either directly from the firm, or from other sources
The market is reacting to the announcement, as it's a strong signal of intent. But it does so in an efficient, intelligent manner. We found that a company can't game the system by merely varying the sheer number of announcements; quantity of announcements are not related to returns. So, no evidence that a company can influence returns by adopting different announcement strategies.
What about negative announcements - as when a firm slips up, fails to carry through its intentions, has to abort what it announced earlier, how do they influence returns?
In a big way! We found, that on average, returns to negative announcements are higher in absolute value than returns to positive announcements. Which is why companies should think twice before resorting to vaporware or exaggerating progress in their innovation projects.
You also claim that your paper is unique in the way you approach an innovation project - as three distinct phases, rather than as a single homogenous activity. Help us understand that?
You are right; our paper does make a unique contribution. Managers may want to know which set of activities attract the highest returns. And to the best of my knowledge, no previous study has answered this question. By examining the innovation project as a set of three distinct activities, we are able to do just that.
And the three sets of activities being - - -?
Initiation, development, and commercialization -
- initiation - start of a project, comprising events like alliance, joint ventures, and funding
- development - progress in research, comprising events like patents, prototypes, and preannouncements
- commercialization - marketing an innovation, comprising events like product launch, shipments, and awards
We find that development activities generate the highest return, followed by initiation and commercialization activities.
I find this a little counter-intuitive, given the importance placed on execution and implementation.
To be honest, we were a little surprised too. There is no strong theory to support this result. However, we think that development won out because development activities represent a greater reduction in uncertainty than commercialization and they don't require as much upfront investment as initiation.
Its time for some free consulting Gerry - what advice would you give to companies to actively manage payoffs on their innovation projects?
- First, managers should adopt a new metric to gauge whether and to what extent their R&D efforts are paying off in the long run; market returns capture the discounted future value of all current events.
- Second, they should learn that markets respond to and reward all stages of an innovation project; by limiting the value of innovation to a few select events, companies actually undervalue the total returns to innovation.
- Third, communication of progress on innovation projects, without resorting to exaggeration or vaporware, is absolutely critical. If companies don't manage this proactively, they lose the opportunity to increase their market capitalization from positive announcements.
Thank you Gerry. Good to have you share your insights with us. And while we wait for Gerry to generate some more blockbuster insights, let's update our thinking and knowledge on measuring the true payoff to innovation, so we don't kill innovation projects prematurely, or delay initiating them.
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