Academic journal article Accounting Horizons

The Information Content of Royalty Income

Academic journal article Accounting Horizons

The Information Content of Royalty Income

Article excerpt

SYNOPSIS: The rise of intangible assets in size and contribution to corporate growth over the past quarter century was accompanied by a steep increase in the rate and scope of patenting. Consequently, many patent-rich companies, particularly in the science-based and high-tech industries, are extensively engaged in the licensing and sale of patents. We examine various valuation and disclosure aspects of the outcome of patent licensing--royalty income. Our findings indicate the following: (1) royalty income is highly relevant to securities valuation, (2) the intensity of royalty income provides investors with an important signal about the quality and prospects of firms' R & D expenditures, and (3) a substantial number of companies engaged in patent licensing do not disclose royalty income in financial reports.

Keywords: Patent licensing; royalty income; intangibles; disclosure.

Data Availability: Data are available from sources identified in the text.

INTRODUCTION

Corporate investment in intangible assets--research and development (R & D), software, brand enhancement, employee training, and the development of unique organizational designs and processes (organization capital)--was estimated at $1 trillion in 2000, rivaling the corporate sector's investment in physical (tangible) assets (Nakamura 2003). The S & P 500's average market-to-book ratio surpassed 4.5 in September 2003, indicating that the value of intangible assets, proxied by the difference between market and book values, substantially exceeds the value of physical and financial assets. (1) Various studies indicate that the returns on intangible investments, particularly R & D, are substantially higher than returns on physical assets and firms' cost of capital, implying that intangibles are the major contributor to corporate earnings and growth (Nadiri 1993; Hall 1996; Cameron 1998). The prominence of intangibles among corporate assets naturally creates incentives to trade in these assets in order to provide firms with liquidity and risk-sharing opportunities.

Trade in intangibles is, however, hindered by the relatively high information asymmetry between potential sellers and buyers of intangibles. For example, developers of drugs or software products enjoy a large informational advantage over prospective buyers of such in-process R & D, compared with the relatively low information asymmetries in the markets for commercial real estate or commodities. Markets in certain intangibles, such as human capital or organizational designs, are further retarded because of the hazy property rights over such assets; who owns the value of employee training--the employer or employee? Active markets require low information asymmetries and clearly defined and transferable property rights, which are absent for many intangibles.

With such inherent limitations on the marketability of intangibles, it is interesting to note that trade prospers for patents--an important segment of intangibles and the focus of our study. (2) The rise of intangible assets over the past 20 years was accompanied by a fast increase in patenting, particularly in the U.S., Europe, and Japan. For example, U.S. patent applications (grants) in the 1960s and 1970s ranged between 80,000 and 100,000 (50,000 and 75,000) annually. The activity increased to 100,000 and 150,000 (60,000 and 90,000) in the 1980s and exploded to 326,502 (166,039) in 2001 (U.S. Patent and Trademark Office [USPTO] 2003). With deep patent portfolios, business enterprises increasingly engage in trade via patent licensing or sales. Indeed, aggregate royalty income from patent licensing has increased in the U.S. from $15 billion in 1990 to more than $110 billion in 1999 (Rivette and Kline 2000b, 59). (3) IBM, Texas Instruments, and Dow Chemical, along with others, have independent functions dedicated to the licensing of patents, and an increasing number of consultants provide specialized services for the valuation of patents and identification of potential licensees. …

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