How to Think of Royalties

Sep 12, 2014

Let's define our terms.

A stock is ownership in a company. Buying a stock, even one share, means you literally own a small piece of the company's assets. You're entitled to vote at the annual meeting and receive dividends if there are any.

A bond is a loan made over a specific period of time. Often called fixed income, when you buy a bond, you're loaning a company or government money. The borrower pays interest on the debt, usually at a fixed interest rate.

Commodities are basic goods, interchangeable and fungible, such as oil, wheat or even currencies like the Euro or Yen. An investment in commodities is nearly self-evident: You profit when their value rises, allowing you to sell at a higher price, regardless if it's exchange-traded products or the physical gold bars, oil or corn itself.

Royalties are something quite different, a unique investment that by its very structure offers an inherent diversification for traditional portfolios. In many ways, an investor in a royalty stream is in a position similar to that of an art buyer who must assess the ability of a painting or sculpture to retain an appeal for the next buyer.

Unlike investing in art, however, the profit comes not from the sale of the artwork but its use. Royalties generate income whose value can never go below zero. Moreover, unlike artwork or commodities, the accounting, storage and insurance cost of a royalty investment are negligible. And as mentioned above, royalties also offer inherent diversification because performance is uncorrelated with the fluctuations experienced in the stock market and the economy at large.

Although royalties generate income, they're not bonds in that there's no future lump sum payment at which the initial investment is returned, and they're not stocks because investors have no ownership in the underlying asset, only the income based on its use.

So what is it? Think of a royalty investment as a variable income stream with a long-term embedded call option. As with stock options, a call gives the owner the right to benefit from the rise in a particular asset during a specific time period.

As with a bond, royalty investors receive regular income, but the embedded call option means they are also in a position to directly benefit from increased use of the underlying asset, in this case, the intellectual property.

Like any investment, there's risk: while royalty payments cannot be negative, the net return on a royalty investment can be negative if the realized net present value of payments received fails to cover the initial purchase price.

But the major appeal of royalties' embedded call option is that, unlike financial options, which cover a specific number of shares of stock, a bond, or the amount of a commodity, the intellectual property producing a royalty is infinitely duplicated. This is why Don McLean still earns $300,000 annually from American Pie, a 4-minute song he released 43 years ago.

Coming next week: Introduction to music royalty valuation analysis.