What are R & D Tax Credits?

Finding companies taking advantage of the R & D tax credits can add a little safety to your investment portfolio.  I like to use this trick because companies’ spending money on research and development are more likely to find products that are more appealing to the market and more likely to develop new processes that produce products with superior cost structures and quality.

It can be difficult to find companies claiming their R & D tax credits in the open because research is often hidden from the general public.  No company wants their competitors to think they are working on something special.  Since this credit is not always proudly displayed in the annual report I look to look at the ratio of research and development expenses to the total amount paid in taxes.  Here’s where you need to be careful because different industries run on very different ratios.  You want to find two or three of the same competitors and look at a two ratios.  One is the amount of earnings to amount of research and development.  The other ratio is the amount of taxes paid to the amount of research and development.  If both ratios are better for the company you are interested in than the competitors than you’ve found a company that is using research and development wisely.

So why is research so important to a company?  If you are building or doing something that makes a profit than there is another company that wants to do the same thing because it makes money.  If you continue to do the same thing eventually there will be others offering the exact same profit for a little less money or they will find a product or service that meets the same need for less money.  Great companies take a portion of their earnings and plough them back into the company to develop the next better idea.  Companies that do this wisely actually convert these ideas into more profit.  This business model builds a large moat around its services making it very difficult for new companies to come in and compete.  Not only has the well ran company already thought of the new idea, but they’ve developed a product that counters you new product.

The most famous of the R & D companies is 3M.  They are famous for allowing every single employee a portion of their time to work on any project they want to.  If the project shows signs of success it will eventually move onto the project list allowing the inventor to work on a new idea with his creative time.  The famous post it notes was nothing more than a mistake.  The glue formula was bad leaving glue that didn’t hold anything, but was surprising reusable and left little residue.  In a project mode this would have been considered a failure, but because creativity was so sewn into the culture a brilliant use for the glue was thought of.  This is what you’re looking for when you look for R & D tax credits.

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