Thursday, April 12, 2012

Energy Sector: Integrated Oil & Gas - Quality of Earnings, Research & Development

The basic premise of this factor compares R&D expenditures with that of the industry.  Relative decreases may indicate that the company will have trouble competing in the future.

There are differences in how R&D expenditures are treated under U.S. Gaap and under IFRS.  Since Canada has adopted IFRS and there is a lot of cross border investment, I'm going to give a brief overview of both.

Under U.S. Gaap, R&D expenditures are expensed as incurred (there is an exception (of course) but we don't need to worry about it right now).  Under IFRS, Canada expenses research costs and capitalizes development costs.  If we were doing an analysis on securities that report in Canada, we would look at changes in intangibles which is found on the balance sheet and R&D expenses found on the income statement.  Since this analysis deals with securities that report in the States, we only need the Research and Development expenses and we need them for Y and Y-1.

Verdasis, the fundamental analysis software, doesn't at this stage have ready made information on industry averages.  However, you can easily manufacture them yourself with a high degree of confidence.  Higher, perhaps, than numbers that you might find elsewhere because you know how they've been calculated.  That being said, lets get into the calculations needed for this factor.

  1. To get the industry average, use the AVERAGE function for each of R&D Y and R&D Y-1,
  2. Find the growth (or decline) in the industry from Y-1 to Y by doing a simple return calculation: 
    • [(Industry R&D Y) - (Industry R&D Y-1)] / (Industry R&D Y-1)
  3. Do the same return calculation for each security to determine the change in R&D
    •  [(Security i R&D Y) - (Security i R&D Y-1)] / (Security i R&D Y-1)
  4. Subtract the industry figure calculate in 2 from each security figure found in 3.
If the company's R&D expenditures are greater than the industry average, then this is positive and the company gets a "1" rating.  If the expenditures are less than the industry average then the company gets a "-1" rating.

You can see the spreadsheet here:

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