| Do innovations ever pay off? |
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| Written by Adrie van der Luijt | |
| Monday, 23 June 2008 | |
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Two American professors of marketing have devised a new metric for evaluating the total stock market returns to an innovation project.
Management has often been criticised for an earnings-focused short term orientation that reduces or delays investments in risky, long term innovation projects in order to boost the firm’s stock price. Exclusive focus on quarterly results Rarely does a discussion of corporate strategy or entrepreneurial motivation proceed these days without alluding to one significant dynamic — innovation. For example, Clayton Christensen and Scott Anthony write in Business Week, “The notion that managers must above all appease investors drives behaviour that focuses exclusively on quarterly results. Thus, many management teams hesitate to invest in promising innovations that are likely to hurt near-term financial performance.” They have devised a new metric for evaluating the total stock market returns to an innovation project. Tellis explains that they are assessing whether markets respond negatively to investments in innovation and whether they enforce a shorter orientation. “The key questions are: how does the stock market react to announcements about innovation and what is the total return to the innovation project?” Power of innovation They answer these questions in their paper, Do innovations really pay off? Total returns to innovation, which is published in Marketing Science, a marketing journal. Tellis and Sood, who have teamed up before to research areas such as technological evolution and new products adoption across global markets, set out again with this research to help managers better understand and quantify the investments they are making in innovation. In this case, they want them to recognise the power of innovation to do everything from fuelling the growth of new products to promoting the global competitiveness of nations. Tellis suggests that firms may under-invest in innovation 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. “Indeed, accurately assessing the market returns to innovation may be critical to motivating firms to invest in innovation,” he adds. Reaction to an announcement The authors argue that the best approach is for firms to examine the market returns to an entire innovation project. They demonstrate this by using the so-called event study method, also known as the Fama-French-Momentum 4 Factor Model, to analyse 5,481 announcements — everything from the start of a project to joint ventures and key approvals — from 69 firms in five markets and 19 technologies during the period from 1977 to 2006. The event study method, popular for the last 30 years, captures the stock market’s reaction to an announcement and actually predicts the valuation that the stock market puts on that particular announcement. The authors analyse all announcements related to a project and the returns to each announcement. This all-inclusive approach sets their research apart from existing studies. Sood notes that a big limitation of previous research was that they were looking at one event. He says that it is necessary to look at the entire project and all the announcements that the firm makes. That gives a better estimate of the returns to the investments. As a means of organising the announcements, Sood and Tellis separate them into three groups: the activities related to the setup of the innovation project, the activities related to the development of the product and the market activities related to the commercialisation of the product. Underestimation of total returns The authors find that total market returns to an innovation project are $643 million, more than 13 times the $49 million due to an average innovation event. Returns to overall projects are substantially more than returns to individual events. “Focus on only one or two types of events or announcements will lead to underestimation of total returns. Any conclusion based on that lower, wrong estimate might actually make the manager decide that innovation is no good or the markets are not receptive,” Sood says. The research also reveals that, of the three sets of innovation activities, returns to the development activities are consistently the highest across and within categories. “The big surprise was that the markets actually react more to the development phase than the commercialisation phase, which shows that the stock market is not so short-term in its outlook,” adds Sood. He says that because the stock markets reward firms for making announcements in the development phase, it is in the firms’ interest to be open to the market and to update progress on an innovation project. Increase in the number of announcements Tellis warns that it is important to note that quality, not quantity, defines market reactions to announcements. He explains that a firm that decides to simply increase the number of project-related announcements it makes to inspire market reaction will not necessarily yield a greater return on investment. “A mere increase in the number of announcements will not improve your returns,” Tellis adds. Sood and Tellis already have continued down their path of innovation research. They are using existing data to develop a statistical model that will help firms look at the returns in the initial phases of an innovation project and predict how the stock market will react in future phases. After all, the market returns to innovation are among the best assessments of the true rewards of innovation. Related articles
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