Source: Kristina Blokhin
The P/E of Facebook Inc. (FB) is a hotly debated subject, no doubt. Currently standing at 50x (in 2013 at some point it was an unconceivable 133x), the P/E has been widely cited by pundits as being too high. Facebook is a classic growth company. Given its risk and growth profile, it may well deserve its high earnings multiple. However, there is one thing that Facebook is not given credit for, and it is a large amount of research and development (R&D) that the company spends on. Because U.S. GAAP prohibits capitalizing R&D expenses with some caveats, Facebook's P/E ratio is higher than what it could be under an alternative treatment of these costs for valuation purposes.
GAAP Treatment of R&D Expenses
Statement of Financial Accounting Standards No. 2 written in 1974 says that research and development costs must be expenses as incurred. GAAP is guided by the conservatisms, and it hates uncertainty. Paragraph 39 sums it all up:
There is normally a high degree of uncertainty about the future benefits of individual research and development projects, although the element of uncertainty may diminish as a project progresses. Estimates of the rate of success of research and development projects vary markedly-depending in part on how narrowly one defines a "project" and how one defines "success"-but all such estimates indicate a high failure rate. For example, one study of a number of industries found that an average of less than 2 percent of new product ideas and less than 15 percent of product development projects were commercially successful.
Obviously, the failure numbers should be updated, but it gives the big picture view of why GAAP still sticks to its guns on this issue. If R&D costs were allowed to be capitalized, how does one draw a line between what is deemed a commercially viable product vs. a sure failure down the road? Permitting capitalization would give incentive to management to massage earnings and produce a huge headache for auditors.
FASB issued Standard 86 in 1985, and Position 98-1 in 1998 to update its rules regarding capitalization of certain costs spent on computer software development. These standards differentiate between software for resale and software for internal use. Each type of software has its own set of capitalization rules. However, the basic premise remains the same: companies must still expense a bulk of their R&D costs, even if products under development come to fruition.
Facebook primarily relies on software developed for public use, which it then monetizes through ads. The company can capitalize its software development costs only after it establishes technological feasibility, which is a point when Facebook has completed all planning, designing, coding, and testing activities for the software to be produced. Most companies, with Facebook likely included, reckon that technological feasibility is established when the software can be used by the public, resulting in most development costs being expensed. This is a conservative position taken by firms, which makes them less likely to face tough questions from auditors.
What Happens When Facebook's R&D Costs Are Capitalized?
Facebook's R&D expenses account for a significant share of its revenue and are large relative to its net income. The company's R&D is also often not stable from year to year, creating volatility in profitability metrics.
Source: Morningstar
There is a line of thought that R&D expenses should not be treated as operating expenses, but rather as capital ones to be amortized over time. The argument goes that R&D on products such as drugs or Facebook's newsfeed create value for companies beyond a one-year period. The argument can be also extended to failed projects as well, because a company still learned something in the process that it can later reuse. For instance, Facebook's efforts on Slingshot failed at the end, but the knowledge the company gained was later reused in the development of its other products, such as Instagram. Therefore, if Facebook earns revenue from monetizing its newsfeed that it largely developed several years ago, the cost of that R&D investment should be matched with revenues in subsequent years.
To capitalize Facebook's R&D, it is necessary to make assumptions about an amortization method and how long it takes on average for the company to convert this cost into commercial products. Because Facebook's products emerge from R&D rather quickly, the appropriate amortization period should be between one and five years. Professor Damodaran of NYU Stern School of Business developed an easy-to-use Excel spreadsheet that allows capitalizing and amortizing R&D using the straight-line method. To amortize Facebook's R&D expenses, I chose a three-year period.
Source: company's filings, author's calculations. In millions of USD. R&D data is for the trailing twelve-month periods ending on September 30 of each year.
The unamortized portion of $9.4 billion is the additional equity created as a result of capitalizing R&D. The adjustment to net income would be $3 billion, which is equal to TTM R&D of $5.7 billion less the amortization of $2.6 billion. This produces the following values for adjusted book value, net income, ROE and P/E ratio:
Source: company's filings, author's calculations. In millions of USD. Data as of 9/30/2016.
As you can see, the effect on ROE, net income and P/E ratio for Facebook is quite positive. The P/E ratio dropped substantially and does not look as high as before. If the same analysis was performed in 2015, the impact of capitalizing R&D is even more dramatic with net income almost doubling and the P/E ratio decreasing by about 50%. If one would have looked only at GAAP earnings, he would not have captured significant investments from Facebook's R&D in 2015 that would bring large benefits the following year.
Investor Takeaway
Is it that simple just to capitalize R&D and move on? I don't know. But I know that GAAP are there for a reason, although they are a bit slow at times to adapt to changing circumstances. For example, I wrote an article about how GAAP only recently caught up with an idea of capitalizing operating leases, something that the investment community has been doing for years. Most likely, the truth lies somewhere in the middle. This dilemma also applies not only to Facebook, but to other R&D heavy industries, such as electronics, chemicals, biotechnology, and pharmaceuticals.
Consistency is the key here, but be aware of bias and shortcomings that will be introduced with each approach. Full capitalization of R&D will likely give too much credit to firms with poor track records of success. Even the most successful companies such as Facebook may have a losing streak in commercializing products under development. As these efforts go to waste, capitalizing R&D will paint a rosier picture than what is really happening. At the same time, not capitalizing R&D potentially ignores large future benefits that can be derived from these efforts.
In my work, I do valuations with and without capitalizing R&D and do qualitative work by reading how successful a company is with commercializing its products. This is relatively easy to do for pharmaceutical companies since they disclose their drug successes and failures. But it is a much harder endeavor for secretive tech firms like Facebook that have hundreds of R&D projects. If I were pressed with which side to take, my bet would be on the non-GAAP approach. Capitalizing all R&D provides a better match of revenues and expenses for valuation purposes, creates a more consistent profitability measurement that factors out fluctuations in R&D and GAAP profits, and considers R&D failures and successes of a company. But the biggest fun in dealing with this issue is that there are no clear-cut answers in how to approach R&D in valuation. This is why investing is more of an art than a science.
