Risk-Adjusted Income
| Author | Russell L. Parr |
| Profession | President of Intellectual Property Research Associates |
| Pages | 113-129 |
CHAPTER 9
RISK-ADJUSTED INCOME
Once the economic benets associated with a property are identied, another component
of the income approach is to reect the risk associated with actually receiving the expected
economic benets. Risk is simply acknowledgment that the future may not turn out as
expected despite careful planning. The risk is represented by the required investment rate
of return. When an investment project is risky and receipt ofeconomic benets is uncertain,
investors expect a high rate of return (think of early-stage venture capital investments). For
relatively safe investments, where receiving the economic benets is almost certain (think
of U.S. Treasury securities), investors will accept a lower rate of return. This chapter dis-
cusses methods for determining a proper rate of return to associate with intellectual property
valuations of varying risk.
An investment rate of return represents the compensation demanded by investors for
accepting the risk associated with a particular investment. Investment rates of return are
associated with all types of investments and assets, including real estate, common shares
of publicly traded and privately held companies, preferred stock of public and private com-
panies, U.S. Treasury and corporate bonds, capital budgeting decisions, and the value of
intellectual property. When determining the value of any type of investment, the rate of
return is a critical element for converting expected economic benets into a present value.
A comprehensive discussion of modern investment theory goes beyond the scope of this
book. Complete books and careers are dedicated to the study of the relationship between
risk and return. This chapter has been included to acquaint the reader with the basic con-
cepts of risk and return, and the vital role that these concepts play in determining the value
of intellectual property.
Investment rates of return used to convert expected streams of income and cash ow
into a value are also referred to as the cost of capital or a discount rate. These rates reect
a measure of investment risk. These terms will be used interchangeably throughout this
discussion.
When aiming to determine the value of an asset or investment, a stream of future eco-
nomic benets is dened. The future stream may include dividends, cash ows, royalty
income payments, capital appreciation, and/or other forms of economic advantage.
Economic returns from an investment must be determined with consideration for the:
• Amount of the expected returns
• Form in which they will be provided
• Timing of the returns
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114 Ch. 9 Risk-Adjusted Income
• Trend expected in the amount of returns
• Duration of the economic returns
• Risk of receiving the returns
REQUIRED RATE OF RETURN COMPONENTS
Investment rates of return, whether that of a stock portfolio or an investmentin intellectual
property, comprise:
•Real rate of return. Investors demand a real rate of return, also referred to as the
risk-free rate of return, for delayed use of their funds. This component of return
represents the amount that an investor wants for not having access to his or her
funds on a risk-free basis. Basically, we are talking about the cost to rent money
where there is absolutely no risk of receiving the rent or return of the principal
amount invested.
•Ination risk. Expectations associated with ination are another component of the
overall return demanded by investors. In addition to receiving compensation for
delaying access to the use of funds, an investor wants to receivefuture payments that
compensate for any ination that may occur during the investment period. It does
no good to earn 3% on a safe investment for 10 years when ination is running at
3%, 4%, 5%, or more during the investment period.
•Risk premium. Compensation is also required to compensate investorsfor the uncer-
tainty of receiving the expected economic benets associated with an investment
along with return of the principal amount initially invested.
Investors expect their investments to provide returns that compensate them for all three of
these elements of risk.
The risk-free rate is the basic value of money, assuming that there is no risk of default
on the principal and the expected earnings stream is guaranteed. Under this scenario the
investor has only sacriced the use of the money for a period of time. Typically, the rate on
long-term U.S. Treasury securities serves as a benchmark for the risk-free rate, but because
investors are interested in a real rate of return, a portion of the required rate of return must
include an amount that is sufcient to offset the effects of ination. Therefore, the rate of
return yielded by long-term Treasury securities represents two components of the required
rate of return: the real risk-free rate and the expected ination rate.
In July 2016, the Federal Reserve Bank of St. Louis reported the average rate provided
by 10-year U.S. Treasuries was 1.52%. During the year leading up to July 2016, ination,
as measured by the consumer price index, was 1.1%, indicating that the real, risk-free rate
of return that is demanded by investors is 0.42%.1
Unfortunately, most investments are not risk-free and must provide additional return
to compensate for other forms of risk. This additional risk is typically referred to as a risk
premium. It represents compensation for the possibility that actual returns will deviate from
those that are expected and the risk that the principal investment may not be returned. By
focusing on the yield that is provided by different xed-income securities, this principle
1Federal Reserve Bank of St. Louis.
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