Tuesday, September 10, 2013

Ideas Matter – Gross Profits and Research & Development Expenses Correlate in the Chemistry Industry

2010 and 2011 revenues, gross profits, and research & development (R&D) expenses were found for 25 chemical companies from data on submitted 10Ks to the US Securities & Exchange Commission.   These data was obtained because of an interest in examining the concept that a company's R&D expenses can represent how well a company’s “good” ideas (with R&D expenses reflecting such ideas) correlate with how well a company generates value.  The assumption is made that if there is such a correlation, than the R&D expenses as a percentage of revenues would show a correlation with gross profit margin percentages (GPM%) for a series of chemical companies.

The following two graphs show the GPM% for 25 chemical companies plotted against the corresponding R&D expenses as a percentage of revenues for the 25 companies.   These two graphs show what appears to me to be a good visual correlation between the two sets of data.  That is, as R&D expenses represent a higher percentage of the revenues for a company, the GPM% goes up.  Regression analysis (using Excel) was done to determine R-Square values for the two sets of data.  For the 2010 data, R-Square results were 63% and for the 2011 data, 65%.  Both R-Square values generally are considered to show good correlations between sets of data.

A basic finance principle is that it is primarily “ideas” (good projects) that matter in creating a company's financial value.  If the assumption is that a company that puts more emphasis on R&D could be expected to generate more good ideas, then one might expect a correlation between such companies’ emphasis and the value it creates.  Another assumption is that GPM% relate to values creation, with higher GPM% creating more value.

The chemical industry is a good sector to use R&D expenses as a surrogate for idea generations since,  antidotally, R&D has long been recognized as critical for chemical companies in creating new products (in having good ideas).   Two to five companies were selected from the US Census Bureau’s seven sub-categories (basic; plastics; agriculture; pharmaceuticals; paints; soaps; and other).  (The companies identify their business sub-categories as in the 10K filings.) 

The 2010 average GPM% and the percentage of R&D expenses of revenues for the 25 chemical companies are 41.7% and 5.5%, respectively.   In 2011, the respective averages are 42.6% and 5.2% for the 25 companies

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