RIYADH, 4 April 2005 — The stock price of any company depends on future earnings that are generated from current and future products and services. Current products have limited lifespan particularly that they are the main target of competitors. Sooner or later, a competitor develops a new product which is either functionally better, cheaper or both. To protect and grow its revenue, a company has to regularly develop, produce and market new improved products and services. Such products and services are the outcome of its research and development resources, and how effectively they are able to utilize them.
Consumers need new products regularly due to various reasons. Based on basic human instinct people get bored from using the same product for a long time. They are continuously attracted to new products. When people change to new products, they expect them to be more fashionable, to address their needs in a better way, more efficient, and possibly more cost effective than the old product. This change of customer preference transfers the revenue from the old product the new one. The owners of both products can be the same vendor, or two different vendors. To protect their revenue stream, vendors try to introduce new products regularly and in particular ahead of competition. Timing the introduction of a new product is important. It should be early enough to beat any new product from competition, but late enough to fully exploit the revenue potential of its’ current similar product. Although suppliers of new products usually claim that their latest products are superior to the existing ones, but the fact is that this is not always true. From the consumers viewpoint the temptation to shift to new products works well because they usually want to make the change, and accordingly are ready to believe the claims of the vendors.
New consumer requirements whether to serve medical needs, business, entertainment or other needs pop up on a regular basis. Smart companies analyze customer needs and market trends, and try to develop products that address them ahead of competition. An additional reason for pushing new products is the ability of some companies to anticipate future needs, develop products to address them and introduce relevant products at the right time.
Customers who are used to a particular product will easily leave it to a better and more efficient one. It is certainly not a marriage relationship, i.e. for better or worse. Accordingly vendors are regularly under pressure to produce new replacement products, to protect their market share from similar action by competition. In order to come up with new products, companies invest part of their revenue in research and development.
Successful companies need to anticipate their customers’ future requirements continuously, and accordingly develop new products, in a timely fashion to address those needs. This can be achieved by allocating and effectively utilizing research and development budgets. Most companies allocate a substantial amount of their revenue to R&D, in order to remain competitive. Companies R&D budgets are usually measured as a percentage of their revenue. The amount and percentage that companies spend on R&D varies among different industries. The R&D as a percentage of revenue extend from 0.5 percent in old economy and service oriented companies up to 15 percent in high technology and pharmaceutical companies.
A high tech product normally has a short life, and is under continuous replacement pressure. The same applies for pharmaceutical products, which are normally protected by patents or several years. Household consumer products on the other hand have a longer life span.
Companies in the same industry compete with regard to the percentage of their revenue that they spend on R&D, in addition to the effective utilization of such budgets. Among the important indicators that investors look at is the percentage of revenue that a company spends on R&D relative to its’ industry average. Companies that have high R&D budgets and are able to use them efficiently stand a better chance to develop and produce new products quicker than their competitors, thus protecting their revenue flow and profitability.
(Salim J. Ghalayini, [email protected], is the author of “Stocks for the Practical Investor”. He manages several investment accounts.)