THE JOURNAL OF FINANCE • VOL. LVI, NO. 6 • DEC. 2001

The Stock Market Valuation of Research and Development Expenditures
LOUIS K. C. CHAN, JOSEF LAKONISHOK, and THEODORE SOUGIANNIS* ABSTRACT
We examine whether stock prices fully value firms’ intangible assets, specifically research and development ~R&D!. Under current U.S. accounting standards, financial statements do not report intangible assets and R&D spending is expensed. Nonetheless, the average historical stock returns of firms doing R&D matches the returns of firms without R&D. However, the market is apparently too pessimistic about beaten-down R&D-intensive technology stocks’ prospects. Companies with high R&D to equity market value ~which tend to have poor past returns! earn large excess returns. A similar relation exists between advertising and stock returns. R&D intensity is positively associated with return volatility.

THE MARKET VALUE OF A F IRM’S SHARES ultimately ref lects the value of all its net assets. When most of the assets are physical, such as plant and equipment, the link between asset values and stock prices is relatively apparent. In modern economies, however, a large part of a firm’s value may ref lect its intangible assets, such as brand names. Under generally accepted U.S. accounting principles, many types of intangible assets are not reported in firms’ financial statements. When a firm has large amounts of such intangibles, the lack of accounting information generally complicates the task of equity valuation. One type of intangible asset, business research and development ~R&D! activity, has lately been the subject of much attention. In part, the interest ref lects recent widespread technological change, together with the dazzling growth of science- and knowledge-based industries, which are especially active in R&D. For example, at year-end 1999, the technology sector and the