Evaluation of the Impact of R&D on EPS in the Oil and Gas Industry

By Gondhalekar, Vijay; Bhagwat, Yatin et al. | Academy of Accounting and Financial Studies Journal, May 2002 | Go to article overview

Evaluation of the Impact of R&D on EPS in the Oil and Gas Industry


Gondhalekar, Vijay, Bhagwat, Yatin, DeBruine, Marinus, Academy of Accounting and Financial Studies Journal


ABSTRACT

Investment in Research and Development (R&D) creates intangible assets with a high earning potential. Several industries have a continuous R&D program due to the competitive nature of business. Thus R&D outlays may be viewed as fixed costs necessary for firms to achieve growth in size and earnings. The impact of R&D on earnings is measured by degree of R&D leverage, a term analogous to degrees of operating and financial leverage. This paper specifically tests the relationship between changes in R&D outlays and their impact on earnings for a sample of firms within petroleum drilling, refining, and oil and gas field services industry.

The results indicate that non-U.S. firms have higher R&D intensity compared to U.S. firms. Also R&D intensity is higher for firms within the petroleum-related service firms than for petroleum refining companies. Also the firms with lower R&D intensity have demonstrate higher degree of R&D leverage implying diminishing returns at the higher end of the R&D intensity spectrum. On average, every one- percent increase in R&D outlay results in a one-fourth of one-percent increase in earnings per share.

INTRODUCTION

The literature in finance and economics views R&D expenditure as an attractive means of investment in valuable intangible capital that has differing degrees of relevance in different economic sectors. This paper measures the impact of R&D investment on earnings in oil and gas exploration and petroleum refining industry - by estimating the degree of R&D leverage, a measure similar to degrees of operating and financial leverage. The degree of R&D leverage is useful for investors and analysts. If investors are optimistic about prospects for an industry they might favor companies with a high degree of R&D leverage as it may be a predictor of earnings growth. This paper is organized as follows. A brief literature review is provided in Section II. In Section III a theoretical discussion of the degree of R&D leverage is provided. Data, methodology, and results are discussed in Section IV. Finally, Section V summarizes the findings and provides suggestions for further research.

II. LITERATURE REVIEW

Several previous studies have demonstrated that there is merit in investigating the measurement and valuation of intangible capital. Trajtenberg (1990) (investigating optical scanners; Megna and Mueller (1991) (investigating distilled beverages, cosmetics, pharmaceuticals, semiconductors); and Shane and Klock (1997) (investigating semiconductors are some of the examples of industry studies valuing intangible capital. Different industries require different measures of intangible capital. Advertising expenditures are an important source of intangible capital in the consumer products industry. R&D expenditures are considered an important source of intangible capital for the pharmaceuticals industry. Patents are important for optical scanners, semiconductors and other products in the high-tech sector. Patents are the fruition of a successful R&D program.

Chan et. al. (1990), and Doukas and Switzer (1992) find statistically significant R&D announcement day returns, especially in the case of large high-tech industrial firms that devote substantial resources to R&D. Jose, Nichols, and Stevens (1986) and Morck, Schleifer, and Vishny (1988) report positive market value effects of R&D to samples of large firms. Chauvin and Hershey (1993) postulate that R&D spending appear to help investors form appropriate expectations concerning the size and variability of future cash flow. They find R&D investment to possess significant explanatory power in determining the market value of a firm after controlling for cash flows, growth, risk, and market share. Klock and Megna (1999) investigate the measurement and valuation of intangible capital in the wireless telecommunications industry. …

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