About the Approach
The income approach tries to determine the current value of the subject IP’s future income flow over the course of its economic life. When employing the Income Approach, primary parameters that influence value are given special attention:
- Revenue or profit derived from the use of the IP;
- Predicted characteristics of the specified revenue or income in terms of growth;
- Predicted revenue or income duration; risk involved with generating revenue or income forecasts; and,
- The percentage of revenue or income that can be traced back to the relevant IP.
These factors are based on observations of relevant markets, such as market size, growth trends, participant market share dynamics, and overall market risk characteristics. A thorough understanding of the individual intangibles’ features, such as stage of development, distinctive qualities such as bankruptcy or market leadership, and pertinent pricing information linked with the products that incorporate the subject IP, is also essential.
The Income Approach makes use of an intellectual property’s ability to produce cash flow. Most scenarios and intangible assets can benefit from the Income Approach. The worth of the subject property is defined as the present value of the projected net economic benefits to be gained over the property’s useful life, according to this method, which is based on discounted cash flow theory. Future income or cash flow associated to the firm, business segment, or product line under consideration is estimated when employing the Income Approach to value intellectual property. To assess the current worth of the operation, the expected cash flow is discounted using present value calculations. It is now important to determine the percentage of this value that may be attributed to intellectual property.
Accurate understanding of the competitive and economic environment in force during the proper time period for the valuation is required to produce an accurate revenue prediction. It must also appropriately portray a reasonable assessment of the property’s remaining economic life. A multitude of elements must be considered when estimating a property’s useful economic life, including probable obsolescence, past usage, patent expiration, and so on. A prediction of future revenue, for example, should not go beyond the scope of a patent’s protection. When assessing a trademark with a 25-year history of success in the marketplace, however, a two- or three-year anticipated lifespan may be overly conservative. Keep in mind that the estimated remaining economic life of the assets is based on the property’s expected prospects as well as its history.
Amount of Income or Economic Benefits
The most difficult aspect of a valuation is estimating the amount of money that intellectual property is capable of delivering in the future. It can necessitate a great deal of detective work as well as a thorough understanding of the market. In general, intellectual property either increases revenue or lowers costs. Profits will be made in any (or both) cases, which is the goal. We must also determine what type of exploitation is most likely to be the property’s “single most successful use.”
Time span of income or the economic life
The economic life of a structure or equipment is significantly easier to predict than that of intellectual property. To begin, it’s easy to slip into the trap of focusing solely on intellectual property’s legal life:
- If a trademark is utilized in commerce continuously, it has perpetual rights.
- Patent rights are valid for 20 years;
- The author’s copyright lasts for the rest of his or her life plus 60 years;
- Secret technology remains secret for as long as it remains secret.
However, we must consider the intellectual property’s economic life or the duration during which the intellectual property can be expected to provide a financial advantage to its owner.
Advantages and Disadvantages of this approach
Some of the advantages of the Income Approach are given as follows:
- Market transactions are not required: Without the necessity for comparable market transactions, captures predicted future rewards to the owner.
- Requirements for forecasted cash flows: Based on the technology’s cash flows or earnings; or dependent on the technology’s cost savings.
- The income approach uses a discount rate that accounts for systematic risk to evaluate the present value of cash flows from an IP asset.
- It depicts the relationship between a security’s return on investment and the total market portfolio’s return.
- The income approach considers the systematic component of risk, which is determined using the CAPM technique; the statistical measure of systematic risk is ß (Beta).
- No matter how fascinating the advantages look, one needs to look at the disadvantages to weigh their options. Let’s look at some of the disadvantages of this approach.
- Subjective cash flow allocation is required.
- The transition of theory into practice necessitates restricting assumptions.
- Internal reporting systems do not always provide the most up-to-date information.
Capital Asset Pricing Model (CAPM)
CAPM is an asset pricing equilibrium model that posits that a security’s expected return is a positive linear function of its sensitivity to changes in the market portfolio’s return. The critical variable in the CAPM is termed “beta,” a statistical measure of threat that has become as well-known as the CAPM itself, and is often used interchangeably. Financial managers have long recognized that certain initiatives are riskier than others and necessitate a higher rate of return.
Of course, a dangerous investment is one whose return is unknown in advance; in this situation, only the anticipated or average rate of return may be predicted. This viewpoint is captured by the simple CAPM Model. The needed rate of return of an investment rises in direct proportion to its beta, according to the simple CAPM. The CAPM also implies that when valuing common equities, investors are only concerned with systematic risk. The sensitivity or co-variance of a security’s return to changes in the economy as a whole, as measured by beta, is its systematic risk. High beta assets accentuate broad market movements, performing exceedingly well when the market rises and extremely poorly when the market falls.
Contributed by:– Nidhi Jha, Legal intern at LLL
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