Investors looking to predict future company performance should pay closer attention to the language used in R&D disclosures rather than just the financial figures.
The study, involving Professor Richard Slack, from the Department of Accounting, was conducted in collaboration with Dr Francesco Mazzi (University of Florence), Professor Ioannis Tsalavoutas (University of Glasgow) and Dr Fanis Tsoligkas (University of Bath), found that the narratives and wording within annual reports can be a valuable resource for forecasting future earnings.
Whilst company investment in R&D is a necessary expenditure to facilitate growth and remain competitive, “the related future payoffs of such expenditure are well-recognised as being inherently uncertain,” says Professor Richard Slack.
“Previous explorations have shown that greater R&D expenditure is actually associated with greater volatility in future earnings,” Professor Slack continues. However, their research suggests that investors should pay attention to more than just the numbers.
The study revealed that the language and narratives used by managers in annual reports can provide investors with a wealth of relevant information that can help to better predict the future.
To conduct their study, the researchers built a dictionary of 119 R&D related words and phrases to identify in company annual reports via content analysis. Then, using a sample of nearly 6,500 firm-year observations reporting under IFRS from 15 countries over a 10-year period, the researchers tracked the number of times these phrases were referenced.
From this, the researchers noted that the information about R&D included in the management discussion section of an annual report is the most informative resource for potential investors to pay attention to.
R&D disclosures in the financial statements are of lower levels, reflecting the lack of mandatory disclosure prescribed in accounting standards. The management discussion section of the annual report, whilst voluntary, in comparison is a richer source of information.
By looking at the language and perspectives of managers rather than focusing on the figures, the study finds that investors can better assess what the potential earnings of a company is likely to be, enabling them to make smarter, more successful investment choices.
“By only observing the data on R&D productivity, outsiders are not able to infer the relevant information to make a well-informed prediction on future success,” adds Professor Slack. “However, managers possess information that can help investors to better estimate future payoffs. By examining the R&D disclosures within these discussions, investors stand a better chance of getting a more accurate picture of a company’s future prospects.”
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