Why do firms with high R&D intensity offer their investors higher stock returns? Although R&D typically has long-term implications for future earnings, its costs must be expensed as they occur and could therefore negatively impact reported earnings. Certain studies suggest that R&D expensing can lead to earnings distortion and mispricing, whereas other investigations argue that uncertainty about R&D outcomes may generate additional risk, leading investors to require higher returns. Our study offers a new perspective on the R&D premium. We hypothesize that a firm’s probability of becoming a takeover target increases with its R&D intensity and that takeover probability affects the pricing of its common stock.
Prior papers have shown that firms invest in R&D to increase their appeal as takeover targets since takeovers generate huge premiums for target shareholders. Moreover, Chan, Lakonishok, and Sougiannis (2001) demonstrate that firms with high R&D intensity typically have beaten-down stocks. Therefore, for potential acquirers in need of R&D capacity to generate growth, high R&D capacity relative to firm valuation makes R&D-intensive firms attractive takeover targets. Therefore, we hypothesize that R&D-intensive firms are more sensitive to shifts in takeover waves and face higher takeover risk, a systematic risk proposed by Cremers, Nair, and John (2009). They suggest that the values of firms that are more likely to become takeover targets will increase more when economic fundamentals are good and acquirers are flush with cash to pursue takeovers. Conversely, as a takeover wave recedes, the values of firms with higher takeover probabilities will exhibit greater declines. Thus, the values of firms facing higher takeover probabilities will fluctuate with the crests and troughs of takeover waves. Cremers et al. (2009) construct a takeover factor to capture takeover waves and use the sensitivity of a firm’s stock returns to the takeover factor to measure the firm’s takeover risk.
We find robust evidence that a firm’s R&D intensity is a significant determinant of its likelihood of becoming a takeover target, with higher R&D intensity associated with higher takeover probability. Moreover, Fama-MacBeth regressions reveal a positive relationship between the R&D premium and takeover probability even after controlling for many R&D-related factors. Furthermore, we confirm the well-known fact that the R&D premium is large, approximately 2.81 percent per month, during months when the takeover factor is positive, as indicated in Figure 1. However, the R&D premium is significantly negative, approximately -1.37 percent per month, during months when the takeover factor is negative. Our findings suggest strong co-movement of the R&D premium and the takeover factor and illustrate a major risk of holding highly R&D-intensive firms’ stocks when the takeover factor falters, which typically occurs as takeover waves recede.
Two other anomalies related to R&D have also been noted in the literature: (i) the premium associated with large R&D increases documented by Eberhart, Maxwell, and Siddique (2004) and (ii) the innovation efficiency premium documented by Hirshleifer, Hsu, and Li (2013). Can takeover risk also help explain these two R&D-related anomalies? Interestingly, we find that similarly to R&D-intensive firms, firms with large R&D increases have an increased likelihood of becoming takeover targets. However, we find that a firm’s innovation efficiency, as measured by its patent citations divided by its R&D investments, is not related to its likelihood of becoming a takeover target. This result is unsurprising given Bena and Li’s (2013) finding that firms with large patent portfolios and low R&D expenses tend to be acquirers rather than takeover targets. Consequently, we expect and find that takeover risk is not responsible for abnormal returns associated with innovation efficiency.
Figure 1. Premiums Sorted by the Sign of Takeover Factor Returns
References
1. K. J. Martijn Cremers, Vinay B. Nair, and Kose John (2009). Takeovers and the cross-section of returns. Review of Financial Studies, 22(4), 1409–1445. DOI:10.1093/rfs/hhn032.
2. Louis Chan, Josef Lakonishok, and Theodore Sougiannis (2001). The stock market valuation of research and development expenditures. Journal of Finance, 56(6), 2431–2456. DOI:10.1111/0022-1082.00411.
3. Jan Bena, and Kai Li (2014). Corporate innovations and mergers and acquisitions. Journal of Finance, 69(5), 1923-1960. DOI:10.1111/jofi.12059
4. Allan Eberhart, William Maxwell, and Akhtar Siddique (2004). An examination of long-term abnormal stock returns and operating performance following R&D increases. Journal of Finance, 59(2), 623–650. DOI:10.1111/j.1540-6261.2004.00644.x.
5. David Hirshleifer, Po-Hsuan Hsu, and Dongmei Li (2013). Innovation efficiency and stock returns. Journal of Financial Economics, 107(3), 632–654. DOI:10.1016/j.jfineco.2012.09.011.
Professor Yanzhi Wang
Department of Finance
yzwang@ntu.edu.tw