So why do the CAPM, build-up method, and similar models fall short when deriving a discount rate for IP projects? For starters, they "look backwards" by relying on historical information. It's "like trying to drive a car forward by looking in the rearview mirror," quipped Mike Pellegrino in BVR's teleconference this afternoon -"IP Cost of Capital Model: A new model for calculating discount rates for IP projects."
Mike finds many of these traditional models "woefully inadequate." A few reasons:
- All are based on stock price valuations of companies—not IP projects
- A company represents an income portfolio, provides diversification—unlike IP projects
- They lack precision—they don’t take into account the risk involved in the approval/success rate
- The “alpha” factor in the discount rate really just a random guess
- “Alpha” factor guesses should be easy to discredit under Daubert
To regurgitate the obvious, IP project valuations have unique aspects that the traditional cost of capital models do not take into account. For a model to accurately derive the cost of capital for IP projects, it would have to take into account its unique aspects: the target rate of return, the success rate of commercializing the IP, the time it takes to generate the return, and the associated expenses (carried interest and VC management fees). Better yet, the model should be forward looking, employ empirical data and be testable, work for all types of investors, work for IP in all stages of development, and work in every major industry. The answer? Mike has developed a model that takes all this critical factors into account. Read more in his new book, BVR's Guide to Intellectual Property Valuation.