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Innovation Premium Metrics Go Beyond Guesswork

Investors should assess whether a project record supports a company's valuation

11Aug

I'm all about new metrics in business, so long as they're based on solid criteria. I welcome discussions of the "innovation premium" for companies that create great solutions. I must suggest that using NPV based on forecasts of future project cash flows is probably not valid for more than a year or two. The future of any product line is unknowable outside of those few sectors with strong barriers to entry and high switching costs. The unique thing about innovation is that it springs from a pool of intellectual capital that a company has spent time cultivating.

I believe other metrics are more appropriate factors for inclusion in an innovation premium. I'll name a few.

Number of patents filed. The US Patent and Trademark Office has a searchable database of patents filed by year. The search results offer breakdowns by organizations. Find the top patent-generating corporations in America to see who's serious about committing capital to applied research.

Size of IP portfolio. This is related to the number of patents filed, but some companies can build their IP portfolios through acquisitions. IP portfolio management is a cottage industry serving companies who elect to outsource the tracking and fulfillment of things like trademark registration payments. Some companies may wish to keep the size and nature of their portfolios close to the vest.

Size of R&D budget. Good luck getting a company to discuss its hottest research openly. Read a public company's financial statements to get a glimpse of how seriously they take R&D. No way is a privately held company going to reveal their budget. Reverse engineering their budget by reviewing their appearances at conferences may lead to a wild guess.

Number of new innovations launched. This is probably the real bottom line for a company aspiring to the top ranks of innovation. The total number of new products announced in a year is not the only metric. Old products can get new features. Counting this category means separate weights for the number of new products, number of upgrades, and number of new features for existing products. Innovation gets stale if it doesn't get to the market.

There's my criteria rundown for an innovation premium. In each factor, a larger number (more patents, bigger budget) means more innovative power. I do agree that an innovation premium is not necessarily a valuation premium. Railroads rarely innovate but Warren Buffet prefers them to technology stocks. Investors who paid a valuation premium for the most innovative dot-com stocks in the '90s learned the hard way that innovation is not the only requirement for successful execution.

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