Valuation of intellectual property. A real option approach
| Pages | 339-356 |
| DOI | https://doi.org/10.1108/14691930510611094 |
| Date | 01 September 2005 |
| Published date | 01 September 2005 |
| Author | Jow‐Ran Chang,Mao‐Wei Hung,Feng‐Tse Tsai |
| Subject Matter | Accounting & finance,HR & organizational behaviour,Information & knowledge management |
Valuation of intellectual property
A real option approach
Jow-Ran Chang
Department of Quantitative Finance, National Tsing Hua University, Taiwan
Mao-Wei Hung and Feng-Tse Tsai
College of Management, National Taiwan University, Taiwan
Abstract
Purpose – This paper aims to provide a new approach to evaluate intellectual property (IP) and uses
a cautious view of how volatility impacts the economic value of IPs.
Design/methodology/approach – Real option is a useful tool for valuing investments under
uncertainty and if it is applied to the valuation of IP with some modifications, it is also widely
accepted. However, it is still debatable whether there is a constant rate-of-return. This paper
incorporates a sensitivity variable to account for the volatility of the expected rate of return. Thus,
rate-of-return can be a constant or increase with volatility.
Findings – First, it was found in the simple model that Vega may be negative when the option is deep
in the money. Second, in the general model, the option can be seen as a sequence of options and under
the constant rate-of-return shortfall setting, it resembles traditional financial options with positive
Vega.
Originality/value – The scenario set-up allows the authors to explain why uncertainties of future
cash flows drive firms to invest now instead of later.
Keywords Knowledge economy,Intellectual property, Intangibleassets, Rate of return
Paper type Research paper
Introduction
The network economy accelerates the acquirement of knowledge while the knowledge
economy promotes the accumulation of knowledge. Knowing the value of
knowledge-based asse ts is essential in order t o evaluate a firm accuratel y.
Knowledge-based assets are increasingly significant, especially for high-technology
companies. Evidence shows that these firms spend a lot on research and development
(R&D) and heavily emphasize intellectual property (IP) rights and patents. IPs provide
firms with a wide array of growth opportunities and competitive edge.
IP refers to know-how, patents, copyrights, trademarks or designs, trade secrets, etc.
IP is usually inseparable from the enterprise and can be traded in mergers and
acquisitions (M&A) or transferred in bankruptcy situations. Besides, intellectu al
capital is a crucial asset in order for a company to remain competitive. For example,
patents can legally exclude potential entrants from manufacturing and selling the
company’s patented products. Therefore, investment projects in IP or trade and
transfers of IP not only have to take future cash inflows into discretionary
consideration, but also strategic decision making. Moreover, firms need to devote
themselves to putting most of their IPs under the protection of law. Thus, intellectual
property right” is a hot issue.
In the knowledge economy, more and more IPs follow hard to the heel of new
technologies and valuation of IP becomes a critical issue. Managers have to tell their
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Valuation of
intellectual
property
339
Journal of Intellectual Capital
Vol. 6 No. 3, 2005
pp. 339-356
qEmerald Group Publishing Limited
1469-1930
DOI 10.1108/14691930510611094
bosses the value of the project for new technology and negotiators must show the fair
market value of the IP if they are to deal with a technology transfer project in an
exchange market. Besides, accountants need to enlist the true value of these intangible
assets in the balance sheet even though they have no market value for such assets. Due
to the intangibility of intellectual capital, it is hard to assess the “hidden” value of these
assets. Although some valuation approaches can approximately measure the assets’
value, they usually leave out their latent value.
In traditional financial worlds, the book value of a firm mainly consists of tangible
assets. However, in the wake of placing more attention on intangible assets such as IP,
many researchers have been trying to find the fair value for these assets. In most
books, the income approach, cost approach, market approach, discount cash flow (DCF)
and real option method (ROM), which may be combined with game models are
mentioned. All of them are adopted in reality, but none of them are satisfactory.
However, the ROM surpasses others in considering uncertain situations in the future
with well-defined models.
Real options are derived from financial options and are applied to pricing
investment projects. The value of an investment project depends on its investment
opportunities in the future and this opportunity is an option. Unlike financial options,
real options must satisfy the characteristics of a project such as flexibility,
irreversibility and infinite life. Flexibility means firms have the right, but not the
obligation, to “exercise” the project. This is also known as the call-type option.
Moreover, firms have the right but not the obligation to “abandon” the project and this
is equivalent to a put-type option. Irreversibility means that when firms decide to
invest, they lose future investment opportunities and pay a sunk cost. This concept is
similar to exercising an option with a “strike price”. An interesting aspect of real option
is that it has infinite life without “maturity”. Therefore, we have to modify the
option-pricing model in certain ways. Real options hold most of the properties inherent
in financial options, thus we can easily follow an option-pricing method to construct
the valuation process.
Furthermore, we are more interested in the amount invested in R&D or intellectual
capital investments when the future market is uncertain. If we use ROM and take
investment opportunity as a financial option, higher uncertainty will heighten the
option value and inhibit the investment. Following this, firms will eventually red uce
R&D or intellectual capital outlays under an uncertain world. However, in the real
world, we find that many firms do not cut their investments on intellectual capital, but
instead raise their expenses on these investments. The rationale behind this
phenomenon is that R&D investments may bring more cash flows when future price is
more volatile, and can easily cover those initial outlay costs. Some firms increase
investment for strategic concerns because they want to seize future markets. And some
firms increase investments in uncertain circumstances as a bet for their profit targets.
ROM
The option pricing theory (Black and Scholes, 1973; Merton, 1974) is a significant
contribution to asset pricing theories. Binomial tree model proposed by Cox, Ross, and
Rubinstein (CRR) is an auxiliary difference method in option valuation. CRR explains
the structure of an option better than a formula and converges well with the Black and
Scholes (1973) formula. ROM extends its applications to capital budgeting for valuing
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