A capital markets approach to IP valuation

The application of capital market principles to the valuation of IP will lead to a more realistic assessment of how much specific properties are worth.

By Jeff Maddox, CEO of CPA Global North America LLC

White Paper Contents

• A Capital Market Perspective
• A Closer Look at Risk and Return
• Discounting for Riskier Projects
• Merck and Fosamax
• Valuing IP
• Product and IP
• Understand Value

On 28th January 2005 the US Court of Appeals invalidated Merck & Co's patent for a once-a-week version of its osteoporosis drug, Fosamax, opening the door to generic competition beginning in 2008, not 2018 as Merck had originally planned. The news about the company's second biggest drug dropped Merck's share price 10% on the day of the announcement, costing shareholders nearly US$7 billion in market value.

The capital market reaction to the court's decision provides a strong reminder of the importance of IP to a company's value. Instead of being an afterthought in M&A and business strategy, IP has emerged in recent years as an asset whose value requires careful assessment and proactive management. This transition has coincided with changes to accounting rules that require management to allocate the portion of an acquisition's purchase price attributable to IP meeting specific recognition criteria (FAS 141) and provide yearly assessments of value impairment to that IP (FAS 142).

The growing awareness of IP's importance has stimulated debate on the most appropriate method for valuing intellectual assets. Opinions vary, sometimes widely, on even the most fundamental requirements. For example, at a recent conference on IP valuation, expert panelists' estimates of a discount rate for one patent ranged from 10%to 30%. Such divergent views can lead to uncomfortably large differences in valuations. In the case of Fosamax, the difference between a 10% and 30% discount rate is nearly US$5 billion.

Fortunately, answers exist. While people may disagree on the inputs to a valuation model, everyone should at least be using the same model. The economic model used by the capital markets to value financial assets provides the framework management should use to value IP.

A Capital Market Perspective

Companies compete in product markets by investing in many types of assets. Some of these assets are tangible, including plant and equipment, inventory and accounts receivable. Others are intangible, consisting of work processes, knowledge and various forms of intellectual property. Management's overriding financial goal is to develop and invest in product market strategies that create value. Value creation occurs when the worth of the tangible and intangible assets comprising the firm's product market strategy exceeds their initial cost.

Companies fund their tangible and intangible assets by raising capital in the form of debt and common stock. In countries with well-developed capital markets, the market price of a company's debt (bonds, notes, etc) and common stock accurately reflects the value of its assets. Consequently, understanding how valuation works in the capital markets provides the economic framework that can be used to set prices for tangible and intangible assets.

Investors in bonds and stocks require the same information to determine a rational market price:

• Cash flows expected to be received in the future
• A time horizon over which the cash flow will be received
• A discount rate which investors use to discount the expected cash flow to a present value

Let's start by reviewing how government bonds are priced before turning to the valuation of common stocks. A bondholder receives fixed, semi-annual interest payments until maturity, at which point the face value of the bond is returned. To illustrate, in July 2004 the US Treasury issued US$11 billion of 2.375% 20-year TIP bonds for a US$1,000 investment (Treasury Inflation Protected Securities). These bonds pay an initial coupon each six months of US$11.88 (2.375% * US$1,000 = US$23.75/2 = US$11.88). When the bond matures in 2025 you receive a final interest payment of US$11.88 plus the US$1,000 face value.

What would you be willing to pay for this cash flow stream? At the time of issuance the market yield on 20-year TIP bonds was approximately 2.47%, representing the real rate of return investors expected on a long term Treasury security. This return is also the discount rate used to derive the present value or price of the bonds. Discounting the semiannual coupon payments and end-of-maturity return of principal gives a predicted value for each bond of US$986.90, compared to its actual market price of US$987.58.

Is the near identical result coincidental? Hardly. Whether valuing government or corporate bonds, the approach is the same. Bond markets are generally accepted as very efficient, resulting in an almost 100% agreement between predicted and actual prices. This is not to say prices do not fluctuate, even dramatically. However, as newinformation becomes available to investors on such factors as inflation or credit quality, these data are quickly evaluated and reflected into a new bond price.

Common stocks are valued by the same pricing mechanism used for bonds. However, despite the similarities in approach, there are noteworthy differences. The expected cash flow to stockholders is typically quarterly dividends rather than semi-annual coupon payments. The term to maturity is indefinite, not finite. And the discount rate used for common stock valuations, known as the cost of equity capital or required rate of return, involves a more complex calculation than the easily observable discount rate for bonds. A deeper understanding of the assumptions behind the derivation of the required rate of return will help minimise common, and sometimes costly, mistakes found in IP valuations.

A Closer Look at Risk and Return

The nominal yield-to-maturity offered by a Treasury bond represents the risk-free rate of return since there is no risk of default. However, an investment in common stock contains default risk for which investors want compensation in the form of a higher return. Studies show that this additional compensation, known as the Market Risk Premium, averages about 5% over the longterm Treasury rate. Therefore, as of January 2005 the required rate of return sought from a stock of average market risk consisted of the long-term Treasury bond rate of 4.7% plus the 5% market risk premium to equal 9.7%.

However, not all investments are of average risk, some are higher, some lower. How does one know the difference and measure whether more or less return is required? The answer depends on both the amount of risk and the type of risk assumed.

Risk is defined by the variability in an asset's return and measured by the standard deviation around an expected outcome. Even though managers do not typically express risk in terms of a statistical measure, they instinctively understand the idea that the more unpredictable the return, the greater the risk.

To illustrate, let's say you are the CEO of Apache Oil, a publicly traded oil exploration and production company. Your chief geologist has presented a US$100 million investment opportunity in a marshy section of southern Louisiana called the Greater Underwater Louisiana Properties (GULP). You've seen the geological tests and the survey looks promising, but you know there are risks with this type of drilling. Many things can happen, and some of the possible outcomes are not attractive. You know that production problems can eat away profits: drill bits crack, holes vibrate, experienced labour is scarce. On the other hand, striking a gusher could lead to enormous profits. In short, you are surrounded by uncertainty. When asked what discount rate should be used for the project, you do not hesitate: 30% to compensate for the risk. Unfortunately, requiring a 30% minimum return would make your bid uncompetitive. Do your competitors know something you do not?

The risk you see (dry holes, faulty drill bits, perhaps even the loss of your job) does translate into highly unpredictable returns, but much of this variability is unique risk specific to the perils surrounding GULP. Let's evaluate GULP from a capital market perspective, specifically that of a rational investor with a portfolio of investments. If GULP were the only investment in the portfolio, the variability of the portfolio's returns would be the same as GULP's, and that investor, like you, would probably want a 30% return. But rational investors do not put all of their eggs in one Change 2 Intellectual Asset Management June/July 2005 www.iam-magazine.com basket. They diversify. And diversification provides an important financial benefit: it eliminates unique risk. That is, the return variabilities of specific projects cancel each other out when part of a well-diversified portfolio. Research shows that most unique risk can be eliminated with as few as 10 stocks in a portfolio. However, even diversification has its limits. Some risk remains no matter how diversified the portfolio. This risk is known as market risk. Market risk stems from the fact that there are broad economic factors affecting all companies (eg, inflation). The capital markets are concerned about the level of market risk in an investment but not its unique risk since this can be eliminated through diversification.The effects of diversification on risk reduction are illustrated in figure 1.

We can quantify a stock's market risk by measuring how sensitive the stock's returns are to movements in the overall market. The sensitivity of a stock's return to market movements is called its beta. The average beta of the market portfolio of stocks is 1.0. Stocks that are more sensitive to market movements have a beta greater than 1.0. Stocks that are less sensitive to market changes have a beta less than 1.0.

Since beta measures market risk, it can be used to adjust the average market risk premium up or down to determine a riskadjusted required rate of return: Required Rate of Return = Risk Free Rate + (Beta* Market Risk Premium).

The returns from a stock with a beta of 1.0 move exactly in step with the market so the Market Risk Premium remains 5% (1.0 x 5%). Returns from a stock with a beta of 2.0 would be twice as sensitive to market movements, requiring a Market Risk Premium of 10% (2.0 x 5%). Similarly, a 0.5 beta means the stock's returns are less sensitive to market changes and, in this case, would require a Market Risk Premium of 2.5% (0.5 x 5%).

Taking an investor's perspective on risk has very important implications for estimating discount rates used in the valuation of assets, both tangible and intangible. Let's see how the CEO of Apache Oil might want to rethink the 30% discount rate proposed for GULP. Apache Oil's beta is .85, consistent with the .90 average beta for the exploration and production industry. This means the required return on Apache's stock is only 9.0% (4.7% +.85 * 5%). If the GULP project has similar market risk as Apache, arguably so since exploration and production is its core business, then the required return on the underwater project would be close to Apache's overall required return of 9.0%.

Separating unique project risk from market risk is not an easy task for most managers. The natural tendency is to overstate discount rates, particularly when project returns face great uncertainty. Managers should start with an estimate of the market risk of their company, a more easily obtainable figure. Company market risk is adjusted up or down depending on whether the project has more or less perceived sensitivity to the market than the company. Factors that may result in greater market risk include the project's operating leverage (fixed costs as a percentage of total costs) or amount of debt financing (debt payments act as a fixed cost).

Discounting for Riskier Projects

By how much should a discount rate be increased if a project is perceived as riskier? There is no precise answer to this question, although great sums of money can be spent searching for one. However, there is a way to get a sensible, and inexpensive, estimate. An overview of the betas across a wide range of public companies can give management a better sense of the reasonable range for project market risk such as GULP. Figure 2 shows a distribution of the betas and corresponding required return for the 1,636 public companies followed by Value Line.

The market-weighted beta of the Value Line companies is 1.04, consistent with the expected beta for the overall market of 1.0. However, perhaps surprisingly, the absolute range of betas (and thus market risk) is relatively narrow. Fully 83% of the companies fall within +/- 2% of the 9.7% average required return. In fact, the highest observable required return is 17.2%, and there are only 2 companies that command such a rate. Only 2% of companies, 27, have a beta greater than 2.0 (required rate of return greater than 14.7%).

Average industry betas provide further illustration of diversification's risk reducing power (see Table 1). Very different businesses have remarkably similar betas and market risk. We see that exploring for oil, researching for new drugs, mining for gold, and shopping for groceries have about the same market risk. Only in the capital markets is it riskier in the grocery aisles than in the oil patch.

And the 30% required return for the GULP project? You won't find it in the capital markets nor should you in your valuation of IP.

Merck and Fosamax

Let's apply the cash flow model and our new understanding of risk to Merck's common stock. Prior to the Fosamax announcement, one respected industry analyst projected the company's dividends to remain flat at US$1.52 per share through 2008 followed by relatively modest increases of 4% to 5% thereafter. Even before the Fosamax announcement, Merck faced a cloudy earnings future following the recent market withdrawal of Vioxx, a leading pain reliever, and the 2006 loss of patent protection on the company's leading drug, Zocor, a cholesterol medication. The analyst's annual dividend projection is shown in Table 2 with corresponding present values using Merck's overall required rate of return of 8.7% (4.7% + .8 * 5.0%). The chart also shows the present value of all dividends beyond 2008.

Using the discounted cash flow model produces a predicted value of US$32.89 for Merck's stock compared to its January 2005 price of US$31.08. The close relationship between Merck's predicted value per share and its actual share price is consistent with that found for other companies, particularly those that are well covered by the Wall Street investment community. Figure 3 shows the correlation between predicted and actual share prices for the Dow Jones 30 industrial companies.

Valuing IP

The rational pricing mechanism used to price bonds and common stocks is also the same used for valuing IP. One would naturally expect this to be the case. After all, why would investors who own the company's capital (which includes IP) suddenly decide to adopt a different valuation model for IP?

Let's return to the Fosamax patent. The 28th January 2005 court ruling invalidating the Fosamax patent opened the door to generic competition in the US market 10 years earlier than expected. Security analysts immediately assessed the damage to Merck's investors. US Fosamax sales were US$1.8 billion in 2004, generating estimated after-tax cash flow of US$700 million, and expected to grow at 8% a year in the future. However, with generic competition beginning in February 2008, Fosamax was estimated to lose over 85% of new prescription share within several months, a decline in line with the experience of other brand name drugs facing intense generic competition.

Analysts from Prudential and Morgan Stanley estimated Merck's 2008 EPS would fall between US$0.35 and US$0.40, equating to a drop in net income of about US$800 to US$900 million. By 2018 the lost net income from US Fosamax sales would rise to US$2.1 billion. Using a discount rate of 8.7%, the same as Merck's overall required rate of return, the present value of the lost Fosamax cash flow from 2008 to 2018 is US$7.1 billion. On the day of the federal appeals court announcement Merck's market value declined US$6.95 billion.

The US Fosamax patent was worth approximately US$7 billion to Merck's shareholders. The same day the patent was invalidated, the capital markets reflected this loss in the valuation of Merck's stock price.

Product and IP

value Some IP, such as the Fosamax patent on a drug's main compound, can be modelled as a standalone product with discrete revenues and expenses. The majority of IP, however, is not a standalone product but supports a specific feature that is part of a larger product offering.

In these cases, IP value is not easily separated from the product's overall value, neither is it especially worthwhile for management to try and do so. For example, you would not try to calculate the value of a bumper to a car. Consumers buy cars, bumpers included.

This is not to say that a directional understanding of IP's value contribution to a product cannot be estimated. Management should start by first asking whether the overall product is value producing followed by an assessment of IP's contribution to that value. General areas of examination include:

• Determine the product's competitive position. That is, is the product advantaged and economically profitable (value creating)?
• If the product is advantaged, identify the source of the advantage from either a differentiation and/or relative cost perspective. For example, a truly differentiated product can command a premium price without losing market share. Is this what we are seeing in the market?
• Identify the specific product features and services contributing to the product's source of advantage.
• Link IP, if any, to those product features and services.
• Assess the degree to which IP has contributed to the specific product features and services providing the differentiation and cost advantage.

This approach determines whether product-related IP contributes to value, not how much it contributes. If a specific IP value is required, such as may be necessary in an acquisition, then two valuation scenarios are required: Scenario 1 - the value of the product strategy with IP; and Scenario 2 - the value of the product without IP. The difference between scenarios 1 and 2 is the value created by the IP.

Understand Value

The valuation of IP has become a necessary business skill, particularly in mergers and acquisitions where management may be required to determine how much of the purchase price should be attributable to intangible assets. In most cases the discounted cash flow model as described herein is an appropriate pricing model. In some complex situations, particularly those involving options on future strategic direction, the uncertainty in the cash flow forecasts is better handled through a combination of DCF and decision tree analysis. Decision tree analysis is beyond the scope of this discussion but many information sources are readily available on its application to valuation, particularly to research and development programmes. Ultimately, however, the lesson from the capital markets is straightforward. Value comes down to an estimation of three variables: expected cash flow, time horizon and discount rate. If you use a model that strays from this methodology: caveat emptor.

Finally, restricting valuation skills to M&A activity is short-sighted. As IP becomes an integral part of business strategy, its value should be understood before it is granted, not just when it is bought or sold. Many companies have recognised this need and have implemented more formal invention submission processes for the review and approval of investments in IP. While some companies have started to ask the right questions, the processes are generally simplistic with few adopting the sophisticated valuation techniques used when buying or selling IP. As a result, many of today's IP grants are being made without an understanding of whether they are winning or losing for shareholders.

About CPA Global

With clients in over 100 countries, CPA Global is a leading provider of legal process outsourcing and the world's top intellectual property (IP) management specialist. Founded in 1969, CPA Global provides lifecycle management services for intellectual property such as patent, design and trademark searching, watching, renewals, and portfolio strategy in over 181 jurisdictions. CPA Global is also a leader in the growing market for outsourced contract management and litigation support services, helping law firms and corporations to realize value by managing risk, cost and capacity. CPA Global employs over 1,000 people in 16 offices in 8 countries. www.cpaglobal.com