Is R&D Mispriced or Properly Risk-Adjusted?

Research has established that R&D-intensive firms are characterized by substantial future risk-adjusted stock returns. The reasons for this phenomenon and its policy implications, however, are widely debated. Some attribute the excess returns to investors‘ systematic undervaluation of R&D firms and argue for improved disclosure to mitigate the mispricing, while others claim that the excess returns are just compensating for an R&D-specific risk factor and, therefore, no accounting changes are called for. We aim at providing insights into this controversy by examining R&D firms with substantial R&D outlays, i.e., firms with R&D as an important ingredient in their strategy. Among such firms we compare firms with high and low industry-adjusted R&D intensity. The high industry-adjusted R&D intensity firms are more likely to be engaged in basic research activities, while the low industry-adjusted R&D intensity firms are likely to mimic and extend existing technologies. As such, compared to the low industry-adjusted R&D intensity firms, the high industry-adjusted R&D intensity firms are likely to suffer from higher information asymmetry. We find that high industry-adjusted R&D intensity firms exhibit substantially positive risk-adjusted returns during the first four-five future years, after which these excess returns converge to those of low industry-adjusted R&D intensity firms. This evidence is consistent with a significant undervaluation of high industry-adjusted R&D intensity firms. The long-term excess returns are positive for both the high and the low industry-adjusted R&D intensity firms and these excess returns are partly attributable to information risk. We also show that the future excess returns of high industry-adjusted R&D intensity firms are substantially lower for those firms who provide voluntary disclosure (earnings guidance) suggesting that the short-term undervaluation is likely due to mispricing.