Appendix D. Risk and Uncertainty
| Author | Russell L. Parr |
| Profession | President of Intellectual Property Research Associates |
| Pages | 598-617 |
APPENDIX D
RISK AND UNCERTAINTY
William J. Murphy
Determining the future benets of ownership is at the heart of all three methods of valuation:
the cost approach, the market approach, and the income approach. As the reader can easily
imagine, the valuation problem under each approach becomes one of looking into the future
to determine what those future benets might be. Since no one has a crystal ball of sufcient
clarity to precisely calculate this benet stream, the search for methods that can assist in
the forecasting process has drawn widespread attention.
The standard method for incorporating future risks into income valuation calculations
is through the discount rate. The main shortcoming is the loss of information because the
discount rate is an accumulation of future risk and uncertainty estimates and predictions
rolled into a single number. As a consequence of this aggregation, important distinctions
can be lost and insights can be occluded by generalization.
The pervasive availability of computers and, more particularly, specialized software, to
aid in the forecasting process, coupled with procedures grounded in statistics and probabil-
ities, have added a number of sophisticated techniques to the intellectual property valuation
process that can take us beyond the discount rate. This appendix addresses a specic col-
lection of popular modern methods that can be extremely useful in helping one incorporate
uncertainty and risk into the valuation process.
It is rst useful to explore the concepts of uncertainty, probability, and risk as they
pertain to the valuation of intellectual property assets. These concepts were introduced in
Chapters 8 and 9. and play a signicant role in valuation. This is especially true for various
intellectual property assets where future events or developments might have a signicant
effect on the value of the assets and those future events or developmentshave a high degree
of uncertainty surrounding them.
RISK VERSUS UNCERTAINTY
Over the past 86 years, a debate has smoldered over what exactly is meant by risk and
uncertainty.1For some, the two are separate and distinct concepts. For others, the two are
interchangeable. While a denitive answer is not critical to the techniques put forward in
this chapter, an appreciation of the debate can provide useful insights.
1The debate can be traced to University of Chicago economist Frank H. Knight, who argued in his now-famous
1921 paper entitled “Risk, Uncertainty and Prot” (Houghton Mifin Co. 1921) that there was a distinc-
tion between risk (randomness with knowable probabilities) and uncertainty (randomness with unknowable
probabilities).
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Risk versus Uncertainty 599
For those who argue that an important distinction exists, the term risk refers to situations
where the outcomes and relative probabilities associated withthose outcomes are known but
exactly which one of the possible outcomes will occur is not known.2Selecting a random
card from a shufed deck would be an example. The risk of selecting the ace of hearts is
known (1 in 52), but whether the ace of hearts will be selected next is not. In the intellectual
property valuation context, one could say that there is a risk that a specic patent applica-
tion will be granted or not, since the outcome is known (yes or no), and furthermore, by
examining past examples and patent ofce practices, it should be possible to assign relative
probabilities to each of those outcomes.
Correspondingly, those adhering to this precision in terminology would limit the appli-
cation of the term uncertainty to situations where the outcomes and relative occurrences are
not known, where they cannot be expressed in terms of specic mathematical probabilities.3
In contrast to risk, for those who observe the distinction, the use of the term uncertainty
would be limited to circumstances where there is no basis on which to form any calculable
probability. For example, the likelihood that any specic patent will be instrumental in the
development of a new industry would be characterized as uncertain since any probability
assessment would be more conjecture than not.
The difference between the two concepts is starkly illustrated by the incredible six-year
history of Long-Term Capital Management, a hedge fund founded by an elite collection of
nancial experts, including Nobel Prize–winning economists Myron Scholes and Robert
C. Merton, the former vice chairman of Salomon Brothers, John Meriwether, and former
vice chairman of the Board of Governors of the Federal Reserve System David Mullins,
among others. Long-Term Capital Management created immense wealth for a period of
time by controlling and managing investment risk, but eventually succumbed to a series of
political uncertainties that were not in the company’s sophisticated investment models.
No matter where the reader comes out on this debate, there are important insights to
be gleaned from recognition of the subtle distinction between the concepts.4Because the
decision analysis method discussed in this chapter is founded on the ability to decompose a
situation into various decisions, chance occurrences, and outcomes, and then using mathe-
matical techniques to logically frame and recompose the inputs to derive a result, the need
to deal with probabilities is required.5But it may be that the probabilities used are merely
subjectively assigned expressions of beliefs representing uncertainty rather than known
2Although in common usage the term risk generally is used to express a positive probability of something bad
happening, a negative result is not a requirement.
3John Maynard Keynes endorsed the distinction between risk and uncertainty, as can be seen in this quote from
his article, “The General Theory of Employment,” Quarterly Journal of Economics 51 (1937): 213–214:
By “uncertain” knowledge, let me explain, I do not mean merely to distinguish what is known
for certain from what is only probable. The game of roulette is not subject, in this sense, to
uncertainty.... The sense in which I am using the termis that in whichthe prospectof a
European war is uncertain, or the price of copper and the rate of interest twenty years hence …
About these matters there is no scientic basis on which to form any calculable probability
whatever. We simply do not know.
4The decision analysis method examined later in this chapter requires an assessment of what is generally referred
to as “risk” in the various decision analysis software packages. The reader is advised to reect on the potential
difference between the concepts of risk and uncertainty when making such an assessment.
5The reader may recognize a resemblance to the notion of expected utility,rst propounded by famous mathemati-
cian Daniel Bernoulli in the early 1700s. Bernoulli argued that the valuation of a risky venture could be thought
of as the sum of utilities from the possible expected outcomes weighted by the probabilities of those outcomes.
Exposition of a New Theory on the Measurement of Risk (1738).
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