Valuing patents is a crucial aspect of intellectual property management and financial analysis. Patents, as intangible assets, often hold significant value for companies, driving innovation and providing competitive advantages. However, accurately determining the value of a patent poses unique challenges due to the inherent uncertainties and risks associated with their future economic benefits. One widely recognized method for patent valuation is the Income Approach, which involves converting anticipated economic benefits into a present value. A critical element of this approach is the selection of an appropriate discount rate, which should reflect the specific risks related to the patent.
This article explores how the Weighted Average Cost of Capital (WACC), typically used to assess the overall cost of capital for a company, can be adapted to calculate the valuation of patents. By understanding the relationship between WACC and patent-specific risks, we can make informed adjustments to arrive at a more accurate valuation. This ensures that the unique risk profile of patents is appropriately accounted for, leading to more reliable and defensible valuation outcomes. We will outline a step-by-step approach to using WACC for patent valuation, highlighting the key adjustments and considerations necessary to reflect the higher risk associated with patents.
Determine the WACC:
Calculate the WACC: WACC is the average rate of return a company is expected to pay its security holders to finance its assets. It combines the cost of equity and the cost of debt, weighted by their proportions in the company's capital structure.
Identify the Patent-Specific Risks:
Assess Risks: Identify the unique risks associated with the patent, such as technological uncertainty, market adoption, legal challenges, and obsolescence. Patents often carry higher risk due to their innovative nature and potential for rapid obsolescence or legal disputes.
Adjust the WACC for Patent-Specific Risks:
Increase the Discount Rate: Since patents typically involve higher risk than the average company project, the WACC needs to be adjusted upwards to reflect this. This adjustment is often done by adding a risk premium to the WACC. Adjusted Discount Rate = WACC + Risk Premium
The risk premium can vary but is often in the range of 10-30% or more, depending on the specific risks associated with the patent.
Estimate Future Cash Flows from the Patent:
Forecast Cash Flows: Estimate the expected future cash flows the patent is likely to generate. This involves projecting revenues, costs, and other financial metrics directly attributable to the patent.
Discount the Future Cash Flows to Present Value:
Present Value Calculation: Use the adjusted discount rate to discount the projected future cash flows back to their present value.
Example Calculation:
Determine WACC:
Assume a company’s WACC is 10%.
Identify Patent-Specific Risks:
After assessment, you determine a risk premium of 15% due to the patent’s specific risks.
Adjust the WACC for Patent-Specific Risks:
Adjusted discount rate = 10% (WACC) + 15% (Risk Premium) = 25%
Estimate Future Cash Flows:
Forecasted cash flows from the patent are $1 million per year for 5 years.
Discount the Future Cash Flows to Present Value:
The present value of the patent, given the adjusted discount rate, is $2,689,280. This method ensures the patent's valuation appropriately reflects its higher risk profile compared to the company's overall WACC.
The discount rate should align with the riskiness of the cash flows and the assumptions used in modeling these cash flows. A common mistake is using discount rates that do not properly reflect the risk of future cash flows. It is often seen that future benefits from the subject property are discounted using the company's weighted average cost of capital (WACC) or by adding a small risk premium to the WACC. Typically discount rates for patent valuations should be much higher than the WACC of the organization that owns the asset.
The WACC represents the weighted cost of a company's total equity and debt, capturing the risk associated with all the company’s assets and operations. Like how equity usually requires a higher return than the WACC and debt a lower return, certain assets will demand returns higher or lower than the WACC based on their risk profile.
Using WACC to estimate the required return for patent assets fails to account for the higher risk associated with intangible assets, necessitating a higher rate of return, given that patent-specific risks such as claim construction, validity, infringement, and technology churn can significantly impact the value of a patent but may not apply to other company assets. Further, patents are typically linked to cutting-edge projects or new products, which generally entail greater risk premiums.
Depending on the specific risks of the patent being valued, discount rates for patent valuations can range from 20 to 40 percent or even higher in some cases.
Another common mishandling of discount rates involves recognizing the risk associated with realizing the forecasted future net cash flows. Financial literature often views intangibles as the riskiest asset class. Thus, to value IP and patents accurately, it is essential to recognize the associated risks, either by adjusting the forecasted cash flows or the discount rate. Common errors include double-counting risks by incorporating the same risk into multiple inputs or mismatching discount rates to cash flows. For example, for a patented emerging technology with high barriers to success, analysts may apply low growth rates and adjust cash flows to depressed levels while also using a high discount rate that captures most of the same risks. Analysts should be vigilant to avoid double or triple counting risks in their models when developing the discount rate.
Ultimately, understanding and applying these principles can lead to more informed decision-making and better financial outcomes. As companies continue to innovate and expand their portfolios of intangible assets, the ability to accurately value patents will remain a critical skill for financial analysts, intellectual property managers, and business leaders alike.
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