IP value for investors: pulchritudo in oculo conspicientis est

All original art is unique. By definition, everything original that was ever painted, sculpted, written or sung is the result of the inspiration and insight, skill and craftsmanship of its author. Whether such creativity springs from manus Dei or temere fortuna is a philosophical debate, but what is objectively true is that such original works are not all equally valuable.

The value of unique objects is entirely subjective. There are no benchmarks for the relative value of uniqueness, only fashions and obsessions or situations that give rise to contextual premia. Therefore, a survey of the value of such objects invariably generates a wide range of bids arising from the idiosyncratic motivations for ownership. Price formation is opaque and intermediaries add a great deal of value often shielding the identity of the buyer. For this reason, art auction houses and investment banks flourish.

When Gauguin’s Nafea Faa Ipoipo sold for $300 million in February 2015, the record-breaking price reflected the provenance and quality of the painting and the buyer's cost of capital. However, its primary value was in its rarity, since such masterpieces come to market only once in a lifetime. A similar contextual premium arose when bankrupt Nortel sold its unique patent portfolio back in 2011 to the now defunct Rockstar consortium. The $4.5 billion price obtained was many multiples of investment banks’ estimates, reflecting the strategic value of the asset at that particular point in time.

Most intellectual property is by definition unique, but like most art it is not uniquely valuable. Its utility and differentiation have merit only in the subjective analysis of buyers which is primarily contextual. This is particularly true for patents, which confer optionality on future technologies sometimes not yet deployed and monopolies on contemporary technologies that provide a competitive moat for pricing. Sometimes they also provide a tactical advantage in the legal battles that are an integral part of corporate strategy and first-to-market land grabs.

Like art, intellectual property is notoriously difficult to value and since 60% of gross domestic product and 80% of corporate value now lies in intangible assets, this poses a significant problem for company analysts, investors and rating agencies. 

One solution to this conundrum is the approach taken by Warren Buffet and other value-oriented investors who have long recognised the importance of intellectual property as a component of what they describe as the "intrinsic value" of a business. By focusing their investment thesis around this concept rather than book value, they are able to build IP value into a 'buy, hold, sell' decision.

Intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life. This is an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Moreover, two people looking at the same set of facts will almost inevitably come up with different intrinsic value figures. One of the major variables driving this divergence is a view on the company’s ability to maintain its market share and margins (which is strongly influenced by intellectual property).

Berkshire Hathaway regularly reports per-share book value (because it is required to do so and it is an easily calculable number), this information is of limited use for making investment decisions. This is because a company’s intellectual property (its culture, business model, data, brands, trademarks and patents) can dramatically affect the forecast of future balance sheet strength and profit and loss projections, which therefore will frequently fail to reflect the intrinsic value of the company.

Buffet explains this in classic style in one of his investor letters, where he discusses the value of a college education. The outcome of a successful student will depend on the career he or she develops as a result of the education, set against the opportunity cost of attending college. The result is clear only in hindsight, is subject to the actions taken along the way and is not calculable by summing the cost of university tuition on day one and discounting backwards.

However, intrinsic value derived from intellectual property is not only misrepresented in equity analysts’ company reports. The much bigger debt markets also fail to capture this impact, primarily because of their reliance on ratings.

Only about 18% of active firms are rated by the major credit rating agencies, and these tend to be large often containing a significant amount of intellectual property. The credit ratings issued by agencies remain the most common and widely used measure of corporate credit quality. Investors use credit ratings to make portfolio allocation decisions – in particular, pension funds, banks and insurance companies use credit ratings as investment screens and to allocate regulatory capital. Central banks use credit ratings as proxies for the quality of collateral. Corporate executives evaluate corporate policies partly on the basis of how their credit rating may be affected, so ratings drive behaviour and compliance.

Credit rating agencies such as Standard & Poor’s employ analysts to evaluate and express an opinion on the relative creditworthiness of issuers and the relative credit quality of debt issues. In rating an issuer, analysts conduct a review of the financial performance, policies and risk management strategies of that issuer looking at cash-flow generation, indebtedness, velocity of income growth and interest cover.

In addition to evaluating financial data, they also weigh qualitative information on corporate strategy and competitiveness primarily through meetings with management. Most agencies state that intellectual property is an element of their analysis, but the primary inputs are traditional and intrinsic value is not well represented.

This approach, combined with the broad classification of risk into, for example, AAA and BB, results in a wide dispersion of risk within apparently homogenous categories. For example, it appears that, especially for investment grade issuers, credit ratings are in fact not particularly well related to raw default probability.

In a regression of log default probability on ratings for non-investment grade companies, 80% of the variation in default probability is not explained by the rating given.

For investment grade issuers, the relationship is even weaker: credit rating only explains 3% of the variation in default probability.

It turns out that default probability is much better reflected in credit default swap spreads (what the active traders in the market think about risk), and in my opinion also by an intrinsic value analysis that prioritises the broad intellectual property of the business (including management style and culture) for predictive purposes.

For those who wish to form a view of the value of a company or probability of default and capture the contribution of intellectual property in your analysis, I would summarise these observations as follows:

• Intrinsic value is a better guide for investment than book value.
• Credit analysis relates to two economically different aspects of risk – raw default probability (expected pay-off) and systematic default risk or the tendency to default in bad times (discount rate).
• Ratings are a good predictor of systemic risk and a bad predictor of idiosyncratic default probability because they are dominated by a simple default prediction model based on book value, not intrinsic value.

In this context, intellectual property is one of the most valuable idiosyncratic inputs to a valuation exercise that is, by virtue of the unique nature of the asset, going to be heavily qualitative. Some call it art; I prefer to call it judgement.