New research shows that investors can get a more accurate picture of a company’s future prospects by focusing on the language within R&D disclosures, rather than simply honing in on the figures
By disclosing information about their research and development (R&D) activities in annual reports, companies pursuing innovation can provide investors with a reliable means of predicting their future performance, new research from Durham University Business School reveals.
Whilst company investment in R&D is a necessary expenditure to facilitate growth and remain competitive, “the related future payoffs of such expenditure are well-recognised as being inherently uncertain,” says Professor Richard Slack, who co-authored the study alongside colleagues Dr Francesco Mazzi of the University of Florence, Professor Ioannis Tsalavoutas at the University of Glasgow and Dr Fanis Tsoligkas of the University of Bath.
“Previous explorations have shown that greater R&D expenditure is actually associated with greater volatility in future earnings,” Professor Slack continues. However, their research suggests that investors should pay attention to more than just the numbers.
The study revealed that the language and narratives used by managers in annual reports can provide investors with a wealth of relevant information that can help to better predict the future.
Management discussions are richer sources of information
To conduct their study, the researchers built a dictionary of 119 R&D related words and phrases to identify in company annual reports via content analysis. Then, using a sample of nearly 6,500 firm-year observations reporting under International Financial Reporting Standards (IFRS) from 15 countries over a 10-year period, the researchers tracked the number of times these phrases were referenced.
From this, the researchers noted that the information about R&D included in the management discussion section of an annual report is the most informative resource for potential investors to pay attention to. R&D disclosures in the financial statements are of lower levels, reflecting the lack of mandatory disclosure prescribed in accounting standards. The management discussion section of the annual report, whilst voluntary, in comparison is a richer source of information.
By looking at the language and perspectives of managers rather than focusing on the figures, the study finds that investors can better assess what the potential earnings of a company is likely to be, enabling them to make smarter, more successful investment choices.
Professor Slack continues: “By only observing the data on R&D productivity, outsiders are not able to infer the relevant information to make a well-informed prediction on future success. However, managers possess information that can help investors to better estimate future payoffs. By examining the R&D disclosures within these discussions, investors stand a better chance of getting a more accurate picture of a company’s future prospects.”
Further information
The full paper ‘R&D Disclosures And The Informativeness Of Future Earnings’ is available to read in Abacus: A Journal of Accounting, Finance and Business Studies, published by Wiley.