CHAPTER 3. EMPIRICAL STUDY OF THE RELATIONSHIP BETWEEN THE
3.1. Methodology
The empirical study is based on the following model:
𝑙𝑛𝑉
𝑖𝑡= 𝛽
0+𝛽
1𝑙𝑛𝐵𝑉
𝑖𝑡+ 𝛽
2𝑅𝐼
𝑖𝑡+ (𝛽
3+𝛼
1𝐷𝑉
𝑖𝑡)𝑅𝐷
𝑖𝑡+ 𝛽
4𝑁𝐶
𝑖𝑡+ 𝛽
5𝑁𝑆𝐸𝐶
𝑖𝑡+ 𝑢
𝑖𝑡(3.1)
The dependent variable
𝑉
𝑖𝑡 is a variable of the company market capitalization at company i at time t. The independent variables are variables from a basic model, dummy variables representing firm characteristics and dummy variables representing country and sector of the company i; 𝑢𝑖𝑡 is a random variable. All the variables have the subscript “it”, indicating that this information is measured for each company i at time t. The regression model also includes 𝛽0as an unknown scalar value and
𝛽
1 ,𝛽
2,𝛽
3,𝛽
4,𝛽
5,𝛼
1as vectors of unknown coefficients. Note that this model is linear in terms of its parameters. Natural logarithm of firm value and book value of equity is introduced for normalizing data.Table 1 describes the variables used in regression analysis.
Table 1. Variables’ description
Variable Definition
𝑉 The market capitalization of a company Basic model
𝐵𝑉 The book value of a company
𝑅𝐼 Residual income of a company.
𝑅𝐷 Proxy variable for determining the innovativeness of a company (R&D expenses from the company's income statement).
33 Table 1. Variables’ description (continued)
Variable Definition
The company characteristics (dummy variables)
𝐷𝑆 A binary variable that reflects the size of a company. It takes a value of 1 if the company size is larger than the national industry average, and 0 otherwise. Firm size is measured as the natural logarithm of the replacement value of total assets.
If DS =1, the company size is considered large, and if DS=0, it is considered small.
𝐷𝐺 A binary variable that reflects the company's revenue growth. It takes a value equal to 1 if the company's revenue growth is higher than the average in the country's industry, and 0 otherwise. The firm growth is measured as a rate of sales growth.
At DG =1, the company's growth rate is considered high, and at DG=0, it is considered low.
𝐷𝑀𝑆 A binary variable that reflects the company's market share. It takes a value equal to 1 if the company's market share is higher than the average in the country's industry, and 0 otherwise. The firm market share is measured as a share of industry sales.2
At DMS =1, the company's market share is considered high, and at DMS=0, it is considered low.
Country and sector variables
𝑁𝐶 A binary variable that represent belonging to a particular country. It takes 1 when company is registered in certain country and 0 otherwise.
𝑁𝑆𝐸𝐶 A binary variable that represent belonging to a particular sector. It takes 1 when company is registered as operating mainly in certain sector and 0 otherwise. The Definitive Business Classification (TRBC) was used to classify companies by industry.
The residual value was calculated using the formula:
𝑅𝐼𝑖𝑡= 𝜋𝑖𝑡 − 𝑟𝐵𝑉𝑖,𝑡−1 (3.2) RIit – the residual income of company i at the moment t;
rit –the required return of company’s i equity at the moment t;
BVi,t-1 – the book value of equity of company i at the moment t-1;
𝜋 it – net income of company i at the moment t.
2 For industry sales calculation the sample of 3,603 companies was used.
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The majority of variables were taken from the companies’ financial reports allocated in Datastream. Since the study is international, all variables were converted to the same currency. To do this, the indicators were multiplied by the exchange rate of the US dollar against the national currency at the end of the reporting year. The required yield was calculated according to the CAPM model, where the risk-free yield was taken as the yield of 10-year US bonds, and the market premium was calculated according to country’s Moody's rating for each year, according to the Aswath Damodaran method.
The model used to study the relationship between R&D and firm value is based on the capital market arbitrage condition. According to this condition, the net profit after tax for the shareholders of company i during period t is formed in two ways: from current dividends and capital gains. Thus, the shareholders retain their shares as long as the resulting profit is equal to their required after-tax return. This equilibrium can be expressed by the following equation:
ritVit=(𝐸𝑡𝑉𝑖,𝑡+1− 𝑉𝑖𝑡) + 𝐸𝑡𝐷𝑖,𝑡+1 (3.3) or
Vit=𝐸𝑡∑ 𝐷𝑖.𝑡+𝑗
(1+𝑟𝑖𝑡)𝑗
∞𝑗=1 (3.4)
Vit – the equity value of company i at the moment t;
rit – required after-tax return of company i at the moment t;
Di,t+1,t+j –the dividends of company i at the moment t+1,t+j.
The amount of the dividend can be calculated using the following net surplus ratio (CSR) from the accounting rules:
Dit= 𝐵𝑉𝑖,𝑡−1+𝜋𝑖𝑡 − 𝐵𝑉𝑖𝑡 (3.5) Dit – the dividends of company i at the moment t;
BVit, t-1 –the book value of company i equity at the moment t, t-1;
𝜋 it – net income of company i at the moment t.
Thus, we get the following equation:
𝑉𝑖𝑡 = 𝐸𝑡∑𝐵𝑉𝑖,𝑡+𝑗−1+ 𝜋𝑖𝑡 − 𝐵𝑉𝑖,𝑡+𝑗 (1 + 𝑟𝑖𝑡)𝑗
∞
𝑗=1
(3.6)
or
35 𝑉𝑖𝑡 = 𝐵𝑉𝑖𝑡+ 𝐸𝑡∑(𝜋𝑖𝑡− 𝑟𝐵𝑉𝑖,𝑡+𝑗−1)
(1 + 𝑟)𝑗
∞
𝑗=1
− 𝐸𝑡(𝐵𝑉𝑖,𝑡+∞)
(1 + 𝑟)∞ (3.7)
Following (Dechow, Hutton, Sloan, 1999; Myers, 1999), we can assume that the last term in equation (3.7) is zero.
Since the residual income is expressed as (3.2) the equation could be expressed as:
𝑉𝑖𝑡 = 𝐵𝑉𝑖𝑡+ 𝐸𝑡∑ (𝑅𝐼𝑖,𝑡+𝑗−1)
(1+𝑟)𝑗
∞𝑗=1 (3.8)
(Sougiannis 1994) argues that the impact of R&D on market value can be indirectly reflected through profit. This is because the impact of past R&D expenditures on current market value can be reflected in investments that generate profits and, as a result, have an impact on current residual income. Therefore, past R&D expenditures probably play a role in explaining the residual income that depends on the information currently available.
According to (Sougiannis, 1994), the values of past R&D expenditures rarely convey additional information when explaining market value if the current residual income was included in the valuation model as an explanatory variable, that’s why only the company's current R&D investments were included in the econometric model.
Considering the two factors mentioned above, the model can be written as:
𝑉
𝑖𝑡= 𝐵𝑉
𝑖𝑡+ 𝛽
1𝑅𝐼
𝑖𝑡+ 𝛽
2𝑅𝐷
𝑖𝑡+ 𝑢
𝑖𝑡(3.9)
Vit – the equity value of company i at the moment t;
BVit – the book value of company i equity at the moment t;
RIit –the residual income of company i at the moment t;
RDit –the research and development investments of company i at the moment t;
The study sample was formed based on the following requirements:
1. Companies that are registered in China, South Korea, Japan, Singapore;
2. Public companies and ordinary shares only;
3. Companies that give information in their reports about innovation through R&D;
4. Only companies that regularly invested in R&D for at least 5 consecutive years and disclosed the amount of their investments in 2012-2017 were selected.
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A total of 3,603 companies were found in Datastream.