1. Introduction
It is well-documented that research and development (R&D) investments play a crucial role in enhancing firm value [
1]. High-growth firms, such as Huawei, Apple, Google, and Samsung Electronics, have continued to increase R&D investments so as to improve the quality and attractiveness of their main products. In this context, one of the main concerns among from academics and practitioners is how R&D investments affect firm value. Prior research has provided mixed evidence on the association between R&D investments and firm value. Some studies find that R&D investments have the potential to generate high future profits and thus increase firm value [
2,
3,
4,
5,
6]. Other studies show that R&D investments have a differential impact on firm value, depending on a firm’s structural characteristics, such as size, the industry firms belong to, and risk [
7,
8,
9]. In particular, recent studies attempt to explore the non-linear relationship between R&D investments and firm market valuation [
10,
11,
12].
In this study, we extend this growing literature by showing that R&D investments are non-linearly related to firm value in the context of China. The reasons we study the relationship in the China setting are as follows. First, R&D investments in Chinese firms have been rapidly growing, which promotes the growth of new industries. China’s total spending on research and development is estimated to have been 1.76 trillion yuan (around
$279 billion) in 2017 [
13]. R&D growth in Chinese firms had led the global market in its scale and scope by capitalizing their advantages in competitive costs to promote innovation and reap the technological capabilities for success in the world market [
14]. Second, in China, both state-owned enterprises (SOEs) and private firms coexist. In particular, SOEs account for a substantial proportion of China’s economy and their political connection with the Chinese government likely facilitate investment financing [
15,
16], enabling them to invest in more R&D. Similarly, Wu [
17] points out that SOEs are likely to engage in more R&D investments.
We test a non-linear relationship between R&D investments and firm value using a sample of 563 Chinese listed firms between 2005 and 2013. In our analyses, we employ three estimation specifications, such as pooled ordinary least squares (OLS) regressions, fixed-effect panel regressions, and dynamic panel generalized method of moments (GMM) estimators. We find that R&D investments have an inverted U-shaped relationship with firm value. As an additional analysis, we also examined the association between R&D investments and firm value in terms of high and low state ownership. We find that there is an inverted U-shaped pattern between R&D investments and firm value in firms with low state ownership. However, we find no evidence of a non-linear relationship in firms with high state ownership. These findings indicate that the extent of state ownership has a distinct impact on the R&D investments–firm value relationship. We further investigate the R&D investments–firm value relationship in the context of firms’ growth opportunities. We find an inverted U-shaped relationship between R&D investments and firm value in firms with high growth opportunities. In contrast, for firms with low growth opportunities, their relationship has a U-shaped pattern. Our empirical results are robust to robust standard errors clustered at the firm level, controlling for industry fixed effects, and omitted variable biases.
Our study contributes to the literature concerning the relationship between R&D investments and firm value by providing evidence that the relationship is non-linear in China. Bae et al. [
8] show, using a sample of U.S. manufacturing firms, that the R&D investments–firm performance relationship is not monotonic. They argue that its relationship changes with the extent of firms’ multinationality. In their recent works, Naik et al. [
10] and Pantagakis et al. [
11] show that R&D investments are non-linearly associated with the market value of the firm. Our study complements these studies by showing an inverted U-shaped pattern between R&D investments and firm value in the Chinese setting.
Our study also contributes to the literature examining the effect of state ownership on the relationship between R&D investments and firm value. In particular, our study extends and complements a recent paper by Ruiqi et al. [
18], which documents the positive impact of state ownership on the association between R&D expenditures and future firm performance. A study by Ruiqi et al. [
18] appears to be similar to ours; however, our study is different in several ways. First, unlike in their study, we identify the existence of a non-linear relationship between R&D investments and firm value by providing evidence of an inverted U-shaped pattern. Second, we find that the extent of state ownership has a different effect on the relationship between R&D investments and firm value in the presence of non-linearity. Thus, our finding provides different insights and perspectives regarding the effect of state ownership on the R&D investments–firm value relationship. Likewise, we expand our understanding of how state ownership has an impact on the relationship. Finally, they use the subsequent three years’ average firm performance, measured as the net income divided by lagged market value of equity, as well as operating income. On the other hand, we use Tobin’s Q and industry-adjusted Tobin’s Q as proxies for firm value. These two proxies used as a measure of long-term firm performance may better explain the relationship between R&D investments and firm value because R&D spending is closely linked to firms’ long-term oriented strategies and objectives.
Our study further provides important implications for stakeholders, such as investors, policy makers, standard-setters, state owners, and regulators. Specifically, our findings can be useful to policy makers who pursue long-term performance objectives. Evidence from this study can also help state owners and regulators better understand R&D investments and firm value in light of state ownership.
The remainder of this paper is organized as follows:
Section 2 provides a review of the prior literature and hypothesis development;
Section 3 presents the data and empirical model;
Section 4 presents the empirical results;
Section 5 provides the additional analysis;
Section 6 discusses robustness checks; and
Section 7 concludes the study.
2. Literature Review and Hypothesis Development
Since Schumpeter [
19] argues that an innovation in technology is crucial for firm growth, a number of prior studies have explored whether R&D investments serve as a vehicle for influencing firm value. Previous research provides mixed evidence regarding the link between R&D investments and firm value. For example, several studies find that R&D investments are positively associated with firm value [
1,
2,
3,
4,
6,
20,
21,
22,
23]. Lev and Sougiannis [
4] show that R&D investments increase future firm profitability and thus positively affect firm value. Bae and Kim [
20] examine the effect of R&D investments on the market value of firms in the U.S., Germany, and Japan. They document that the market places a higher value on the R&D investments of firms in the U.S. than those in Germany and Japan. Eberhart et al. [
21] find that the U.S. firms have experienced significantly positive abnormal operating performance following an increase in R&D expenditures. Ehie and Olibe [
24] show that R&D investments in the manufacturing sector are linked to higher market value than those in the service sector during the pre-9/11 period. More recently, using a sample of Chinese firms, Rao et al. [
23] investigate whether an investment in R&D is associated with firm value from the perspective of long-term persistence. They find that R&D investments positively affect firm performance; however, its effect becomes weaker and even disappears as time goes on.
On the other hand, prior literature shows that R&D investments have a non-linear relationship with firm performance [
8,
10,
11,
12]. Using a sample of the U.S. manufacturing firms, Bae et al. [
8] document that the relationship between R&D investments and firm performance in multinational firms is not monotonic, but the relationship varies with the phase of firms’ multinationality. Specifically, they show that the relationship is negative at the initial stage, followed by a positive relationship, which then again reverts to a negative one when they use both accounting- and market-based measures as proxies for firm performance. Naik et al. [
10] examine the association between R&D intensity and firm market valuation using Indian manufacturing firms. They find that the R&D intensity–firm value relationship is inverted U-shaped. Pantagakis et al. [
11] investigate the link between R&D investments and firm performance based on 39 European firms. They show that R&D intensity is non-linearly associated with market value of the firm. Booltink and Saka-Helmhout [
12] examine the relationship between R&D intensity and firm performance using a sample of non-high-tech small and medium-sized enterprises (SMEs). They find that there is an inverted U-shaped relationship between R&D intensity and firm performance. In the context of Chinese firms, prior studies further suggest that R&D investments have either a positive or negative impact on firm performance [
25,
26,
27]. Choi and Williams [
25] find that innovation intensity is positively related to sales growth. Specifically, they show that while the depth of innovation has a U-shaped relationship with sales growth, the diversity of innovation has an inverted U-shaped relationship. In another study, Xu and Jin [
26] find no evidence that R&D investments affect current firm performance, but the cumulative effect of R&D investments are negatively associated with firm performance in China’s Internet of Things (IoT) industry. In a more recent study, Xu and Sim [
27] show that R&D intensity positively affect firm performance based on emerging market countries such as China and South Korea. However, these recent studies using Chinese data suggest that the relationship between R&D investments and firm value is far from simple, and it is significant to note that existing studies reveal mixed results in terms of R&D investments [
23,
25]. Based on the above mixed evidence regarding the relationship between R&D investments and firm value, we conjecture that their relationship in Chinese firms may be non-linear.
The rationale for the existence of non-linear relationship is also summarized as follows. First, according to the real option theory, R&D investments may be considered as a firm’s growth option value [
28,
29]. Specifically, firms’ R&D investments positively contribute to growth option value [
30]. This is due to the fact that the higher volatility (uncertainty) of the expected return on R&D investments is related to higher market value [
31]. Moreover, from the resource-based view, firms’ competitive advantages in their markets are derived from their unique resources [
32]. Based on this argument, R&D investments may have a positive relationship with firm value. Second, the degree of information asymmetry associated with R&D investments is larger than that of tangible assets because the investments have higher firm-specific risk. R&D investments can contribute to information asymmetry between managers and investors. Cui and Mak [
33] and Honore et al. [
34] argue that asymmetric information between investors and managers is severe in firms with high R&D intensity. Consequently, it is likely that a higher level of R&D investments aggravates information asymmetry, thereby adversely affecting firm value. Third, from the technological standpoint, the S-curve theory and technological limits can be applied to explain the association between R&D and the firm value. The S-curve theory suggests that the diffusion trend in innovations changes as an S-curve shape over time [
35,
36,
37]. According to the theory, the value of R&D investments may be subject to the diminishing of marginal returns given the limits of technology. Prior studies show that the link between R&D investments and firm value depends on diminishing marginal returns [
38,
39,
40]. Thus, the diminishing marginal return to R&D investments suggests that as R&D investments increase, firm value increases until a certain level and, beyond the certain level, it decreases.
Given the above empirical evidence and reasoning, it is expected that the relationship between R&D investments and firm value is non-monotonic, that is, a non-linear pattern of the relationship. Thus, we predict that the positive and negative effect of R&D investments on firm value coexist; that is, the dominance of the positive or negative effect on firm value depends on the extent of R&D investments.
We therefore propose the first hypothesis:
Hypothesis 1. There is a non-linear relationship between R&D investments and firm value.
5. Additional Analysis
5.1. The Non-Linear Relationship between R&D Investments and Firm Value in High and Low State Ownership Firms
Ownership structure has an important implication in understanding the relationship between R&D investments and firm value. This is important because ownership structure is one of the determinants of corporate resource allocation [
18,
50]. In the context of Chinese firms, Zhang et al. [
51] document that the state sector has lower R&D and productive efficiency than the non-state sector, suggesting that a high level of state ownership can decrease the overall productivity of firms in transition economies. Financial performance in state-owned enterprises (SOEs) may be given low profit incentives since SOEs contribute to promoting social stability and continuing social welfare due to public nature [
52].
We test whether there is a non-linear relationship between R&D investments and firm value by splitting our sample into two subsamples, i.e., high and low state ownership firms. High (low) state ownership firms are defined as those with above (below) the average values of state ownership.
Table 7 presents the regressions of Tobin’s Q on R&D intensity, its square, and control variables. Regarding firms with high state ownership, we find no relationship between R&D intensity and Tobin’s Q in columns (1) through (3). Similarly, the coefficients on the square of R&D intensity are insignificant in the columns. In contrast, with respect to firms with low state ownership, we find a positive and significant coefficient R&D intensity in columns (4) through (6). These findings indicate that R&D investments are positively related to firm value. Moreover, the coefficients on the square of R&D intensity are negative and significant in the columns, indicating the inverted U-shaped relationship between R&D investments and firm value.
Furthermore, we repeat the analysis using the industry-adjusted Tobin’s Q (IndAdjTobin’s Q) as an additional dependent variable. The results, not reported for the sake of brevity, are qualitatively similar to our findings based on Tobin’s Q.
Taken together, we find no evidence of a non-linear relationship between R&D investments and firm value in the subsample of high state ownership firms. In contrast, we find that R&D investments have an inverted U-shaped relationship with firm value in the subsample of low state ownership firms. These findings suggest that the inverted U-shaped relationship is more pronounced for firms with low state ownership than for firms with high state ownership.
5.2. The Non-Linear Relationship between R&D Investments and Firm Value in High and Low Growth-Opportunities Firms
We further test the non-linear relationship between R&D intensity and firm value in the context of firms with high and low growth opportunities. To do this, we divide sample firms into two subsamples, high and low growth-opportunities firms. We define firms with high (low) growth opportunities as those with above (below) the mean value of Tobin’s Q.
Table 8 presents the results of the regression with several estimation specifications. Regarding the regression of Tobin’s Q using high growth-opportunities firms, we find a positive and significant coefficient on R&D intensity is positive and significant in columns (1) through (3). We further find a negative and significant coefficient on the square of R&D intensity in the columns. These findings suggest an inverted U-shaped relationship between R&D investments and firm value in firms with high growth opportunities. In contrast, for firms with low growth opportunities, the coefficients on R&D intensity are negative and significant in columns (4) and (6). We also find a positive and significant coefficient on the square of R&D intensity in the columns, likely indicating the existence of a U-shaped pattern.
In addition, we repeat the analysis using the industry-adjusted Tobin’s Q (IndAdjTobin’s Q) as the dependent variable. The untabulated results are qualitatively similar to our findings using Tobin’s Q.
Taken together, our results imply that the R&D investments-firm value nexus in firms with high growth opportunities is affected by the degree of information asymmetry, which is consistent with Cui and Mak [
33].
7. Conclusions
In this paper, we examine whether there is a non-linear relationship between R&D investments and firm value. Using a sample of Chinese listed firms between 2005 and 2013, we provide empirical evidence that the R&D investments–firm value relationship has an inverted U-shaped pattern, which is consistent with our central hypothesis. We also find an inverted U-shaped relationship between R&D investments and firm value in firms with low state ownership. However, we find no evidence that there is a non-linear pattern of the relationship in firms with high state ownership. These findings suggest that the existence of a non-linear relationship between R&D investments and firm value can be determined by the degree of state ownership. In addition, we find the presence of an inverted U-shaped relationship between R&D investments and firm value in firms with high growth opportunities. We further find a U-shaped pattern of the relationship in firms with low growth opportunities. These findings imply that there is a different non-linear pattern between R&D investments and firm value with respect to the extent of firms’ growth opportunities.
This study extends and complements the R&D investments–firm value literature in two ways. First, we provide new evidence on the presence of a non-linearity in the relationship between R&D investments and firm value in the context of China. Second, this study sheds light on the role of state ownership in the relationship between R&D investments and firm value. This study provides meaningful implications for academics and practitioners. In particular, our findings can be useful to policy makers who implement R&D investment policies.
This study also provides theoretical and managerial implications by providing evidence of a non-linearity in the R&D investments–firm value relationship. First, our findings confirm the theoretical prediction. According to the real option theory, the future volatility of the return on R&D investments affects market value. The real option theory suggests that a higher risk leads to a higher return. Our evidence from Chinese firms suggest that increased market uncertainty augments the market value of R&D investments until a certain level; then, beyond a certain level, it reduces the market value. Second, our findings confirm the prediction of information asymmetry hypothesis. Firms with more R&D investments may face higher information asymmetry and thus greater adverse selection costs, which negatively affects firm value. Third, our findings confirm the prediction of the S-curve theory by showing the diminishing marginal return to R&D investments. Our evidence based on Chinese firms suggests that an increase in R&D investments augments the marginal rate of return until a certain point; then, it appears to diminish the marginal rate of return beyond a certain point. From a managerial perspective, as Oriani and Sobrero [
31] point out, R&D investments are closely linked to uncertainty. Thus, managers need to recognize market and technological uncertainty when they decide to invest in R&D. From the perspective of stakeholders (e.g., investors and creditors), Chinese capital markets are less efficient compared to developed countries, such as the U.S. Thus, for their easy access to financing for R&D investments, firms need to mitigate information asymmetry between firms and stakeholders. This implies that Chinses firms should enhance market transparency and manage risk efficiently.
This study has the following limitations. First, we empirically test the non-linear relationship between R&D investments and firm value based on Chinese firms. In our analysis, we consider the possibility of omitted variable problems. We repeat the analysis by controlling for firm age, export intensity, and profit margin that can affect firm value. However, we are not able to control for potential variables such as advertising intensity and technological intensity of imports due to the difficulty of obtaining data from Chinese firms. Thus, further research should consider these variables in examining the R&D investments–firm value relationship. Second, based on the leapfrogging theory, which is constructed around Schumpeter’s concept of creative destruction [
54,
55,
56], it is crucial to discuss the type of innovations firms pursue, e.g., incremental or radical innovations. Thus, further research should explore the relationship between R&D investments and firm value in the framework of types of innovations. Furthermore, regarding state ownership, it is more interesting to consider competition and knowledge spillovers in this framework. Third, even though we investigate the role of state ownership in the R&D investments–firm value relationship, we do not pay attention to state-initiated channels associated with the generation of knowledge and the support of technological innovations in more detail. Thus further research should consider these channels in the relationship. Fourth, several studies provide policy implications for China, one of the efficiency-driven economies [
27,
57,
58]. In particular, Xu and Sim [
27] focus on the comparative study between China and Korea in the framework of competitive market conditions. Thus, further research should consider the link between R&D investments and firm value in the context of competitive advantages from the cross-country comparative perspective. Sixth, our sample period is restricted from 2005 to 2013; thus, further research should extend the sample period in examining the R&D investments–firm value relationship.