The Innovation Premium

Firms that engage in innovative product development, as measured by the fraction of their investment that goes to Research and Development (R&D) activities, earn higher risk-adjusted equity returns. A portfolio that goes long the most innovative and shorts the least innovative firms earns a risk-adjusted return in excess of 7% per annum. R&D-intensive firms also tend to charge higher price markups. Combining insights from industrial organization with a production-based asset pricing framework, I propose a model in which heterogeneous firms produce vertically differentiated goods and market them to heterogeneous consumers. Firms are subject to aggregate demand and supply shocks, which are both priced by investors, and thus the return premium of innovative firms is explained by their differential exposures to these shocks. In addition to explaining this return spread, the model makes predictions on firm investments, future profit markups, and firm size that are consistent with the data.