At first glance, the income approach methodology appears very simple because it is based on determining the future income streams that can be, or will be, generated from the intellectual property or intangible assets being valued. The income approach is a widely-used IP valuation methodology; however, it can be complex, and one must decide how to measure the “income” attributable to the asset.
A brief example illustrates this: an unsophisticated analyst might see that a branded product earns a profit margin 30 percent higher than its unbranded counterparts, and the expert is tempted to attribute the entire 30 percent to the trademark or brand. In fact, only some portion of that 30 percent may be attributable to the actual intellectual property, as the balance of the increased profit may be due to cheaper ingredients or more efficient manufacturing of the branded product. With these caveats in mind, the three basic parameters of the income approach are:
- future income stream
- duration of income stream
- risk or discount rate associated with the income stream generation
The subtleties come in identifying the alternative measures of economic income that can be used in this sort of analysis. These can include net revenues, gross income, gross profit, operating income, income before tax, operating cash flow, EBITDA, net cash flow, expected incremental income, etc.
The most common error in applying this approach is the expert’s lack of differentiation between the income generated by the total business enterprise, or the business enterprise value, and the value of the income generated by the intellectual property within that business. When valuing intellectual property, in order to use the income approach, it is critical to be able to separate the stream of income that the intellectual property is generating (and therefore its value,) from the value of the business as a whole, and then apply an appropriate discount rate and life span.
In summary, when using the income approach, the intellectual property or intangible asset values calculated represent the worth or present value of the future economic benefit/income that will (or should have) accrued to its owner. This requires projection of future income, an estimate of the duration of the income stream and/or useful life, and an estimate of the risk associated with generating the income stream, also known as the discount rate. Although at first glance it may seem less precise than the cost approach, due to the inclusion of multiple estimates, often the information needed to make these estimates can be accurately developed and verified based on market conditions and market data.
A key benefit of the income approach is that it provides the expert analyst the ability to perform sensitivity analyses by adjusting the various parameters, such as income levels or discount rate. This allows the expert to better understand the performance of the various factors driving value, and enables estimates of upper and lower limits to a range of value. An example is shown below.
INCOME APPROACH TO VALUATION
Annual Income Generated from IP $100,000
Number of years of income generation 8
Gross value of income streams $800,000
Discount rate adjustment 15.0%
Net value of income streams = $450,000