Innovation Does Pay Off–If You Measure Correctly

Abstract

Innovation is probably one of the most important forces fueling the growth of new products, sustaining incumbents, creating new markets, transforming industries, and promoting the global competitiveness of nations. However, some critics assert that an earnings-focused, short-term orientation on boosting stock price may undercut investments in innovation that typically have a long payoff. These critics assume that stock markets respond positively to announcements of immediate earnings but negatively to announcements of investment in innovation that have an uncertain long-term payoff. As a consequence, many firms may not be investing enough in innovation, and some analysts fear that the U.S. may be losing its competitive edge as a result. Firms may under-invest in R&D because of the high costs, the long delay in reaping market returns, if any, the uncertainty of those returns, and the difficulty of adequately measuring them. Therefore, accurately assessing the market returns to innovation may be critical to understanding how markets respond to innovation and motivating firms to invest in innovation. Assessing Innovation Returns The event study method is one of the best means of assessing the true returns to an innovation project ( 1,2 ). The basic assumption underlying the method is the effi- cient market hypothesis, which states that a stock price at a particular point in time fully reflects all available information up to that point. Thus, any change in price of a stock due to arrival of new information reflects the present value of all expected current and future profits from that new information. The method has been widely used in the finance, accounting, economics, management, and marketing literatures to assess the market response to new information. However, past research has focused on isolated events of an innovation project (e.g., alliances, patents or new product launch) to estimate the returns to innovation, instead of the entire project. This approach may lead to a substantial underestimation of the total returns. If the returns to the entire innovation project could be estimated from a single, target event during the project, then returns for other events would not be significantly different from zero. That target event would be critical, with important implications for firms and investors. On the other hand, if firms continue to experience incremental returns to various events over the innovation project, ignoring certain events would result in underestimating the total returns to innovation. Considering All Events We propose that the total returns to innovation can only be estimated if all events of the innovation project are included in the analysis. We include eight important events spanning the entire innovation project: alliances, funding, expansion, prototypes, patents, pre-announcements, launch, and awards. The total returns to innovation are the sum of returns to all events in an innovation project. In addition to completeness, the benefit of considering all events in an innovation project is that it compensates for sub-optimal or strategic announcements of the firm. For example, if the firm under-promises in early stages of an innovation project and over-delivers in later stages, the possibly low market returns in early stages will be compensated by high returns in later stages. Conversely, if a firm over-promises and then under-delivers, taking all events into consideration will compensate for possibly too-high returns in earlier stages. Methodology For this study, we defined an innovation project as the total of a firm's activities in researching, developing and introducing any new product based on a new technology, from the initiation of the technology to about a year after introduction of the new product. We defined a technology as a distinct principle or platform for producing products to serve a consumer need ( 3 ). For example, neon lamps are based on fluorescence technology, which produces light by the distinct scientific principle of fluorescence. …