Chapter 4: How to Value Royalty Streams
Whether you are buying stocks, real estate or music assets, it’s critical to remember that you are purchasing the future value of income.
A classic example of when investors forgot this lesson happened not long ago. Back in 2000, the Nasdaq traded at nosebleed levels. The Price-to-Earnings ratio of the Nasdaq sat at 175, according to data from Nasdaq and Bloomberg.
This massive valuation level means that investors would have to wait 175 years to recover an initial investment tied to the average company listed on the index. And that is without setting a discount rate or factoring the time value of money.
That was at the height of the Dot-Com Bubble. Sixteen years later, the Nasdaq’s P/E ratio sits at 32. That’s still a bit high, but it’s far more rational than the events of the early 2000s.
Properly valuing royalties may be more important than valuing stocks, bonds, mutual funds, or ETFs. That’s because royalty investments are considered illiquid assets.
This means investors can’t buy or sell intellectual property on a daily basis like traditional investments. When considering a purchase in IP, investors should plan on holding them in perpetuity.
When buying these assets, investors want to ensure they obtain a fair price. Paying too much runs the risk either of not making the money back or earning poor long-term returns compared to other investment opportunities.
Also, investors need to consider that royalty streams are variable.
In one quarter, royalty payments may be higher than the average quarterly payouts. In the following quarter, they may fall below the historical average. When considering a deal, start by understanding individual risk tolerance.
Are you a conservative investor who is only willing to pay a lower multiple for an asset? Or are you willing to be aggressive and pay more in the hopes that this asset will appreciate in value or increase royalty payouts over time?
This decision will help you reach personal exceptions for future earnings.
Selecting a Valuation Method
It’s possible to apply simpler valuation methods for intellectual property in the music space than the methods used for other types of investments.
While these methods are not as advanced as statistical decision trees or Black- Sholes models, investors can incorporate different techniques to improve forecasting expectations.
The two most popular approaches to value for intellectual property in the music sector are:
The Income Approach: Value assets based on revenues recorded through use over time.
The Market Approach: Assess the sale of similar assets in previous market conditions.
The Income Approach
The value of intellectual property is best defined by its ability to generate income in the future. An income-based method calculates the future royalty expectations to determine a present value by using “the time value of money.”
Several different income methods exist that investors can use when assessing the value of royalty streams. The most common is the discounted cash flow (DCF) method.
Discounted Cash Flow (DCF) Method
This method determines the value of intellectual property by examining the present value of expected cash flows in the future. Investors want to evaluate the expected cash flows in future years and then use an appropriate discount rate to determine present value.
Investors must understand the “Time Value of Money” (TVM) and their expected risk when projecting growth or decay of annual royalty streams. As a reminder, TVM is the concept that capital available today – in the present – is worth more than the same amount of money at a future date due to the possible earning capacity.
When using the income approach, the goal is to determine three important measurements for the associated royalty asset.
The projected future revenue stream
The payback period and lifecycle
The risks associated with this asset’s ability to generate revenue
Royalty owners can explore the data from PROs to determine past income payments. The payback period is defined by the amount of time it will take to recoup the initial investment using the Time Value of Money. This guide breaks down additional factors in Chapter 5 to determine the risks associated with the asset.
How to Use the Income Approach
Income generation is the most reliable data point used to value the current net present value of a royalty stream and its future revenue potential.
Let’s consider a hypothetical. Say that a copyright has 10 years left before it becomes public domain.
This royalty stream is expected to provide $10,000 in the first of these 10 years. One might project that these royalties will decline by 5% annually over the duration of the copyright based on the risk factors at play.
We can determine, based on that 5% annual decline, how much money this royalty stream may generate over the next decade. In the example below, the royalty stream is expected to make roughly $80,252 over 10 years.
But that is not the Present Value of this expected income, which can be determined through simple calculations in Microsoft Excel.
Using an empty frame in Excel, Type “=NPV”
At this point, a prompt will ask you for two different types of data.
“Rate” represents your assigned discount rate. Let’s enter “0.1” or 10%.
“Value” represents the total royalties expected for a particular year.
Since we want to obtain the Net Present Value of all 10 years, we will highlight all of these figures.
If we assume a discount rate of 10% each year, we can find that the present value of our expected cash flows is $51,277.40. This would be our value of the intellectual property.
The income approach provides a simple way to project the value of future cash flows. The information required to complete this valuation is typically available during the auction process.
The Market Approach
Music royalties are not liquid assets. They are not commonly traded. There is no financial exchange that allows you to buy and sell them each day.
With the market approach, we want to compare the assets to other assets that have sold on the market to set a valuation.
Two primary steps exist in this valuation method:
- The screening process
- The adjustment process
The screening process involves seeking information on comparative attributes. You can look at historical transactions to find similar assets, the value of their royalty streams, and their sales price.
These transactions give us a baseline to compare what has happened in the past to today’s marketplace. Once we have found similar assets with similar attributes, it is time to compare the conditions of the marketplace over time.
The adjustment process – a process of due diligence – centers on our ability to understand more about the assets and the environments in which they perform. That due diligence process helps us “adjust” our expectations of this asset compared to the performance and attributes of others.
In the next chapter, we will discuss that due diligence process.