...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. Some investment companies attempt to "securitize" patents by selling securities backed by the royalties earned from patent portfolios, akin to mortgage-backed securities. The patent licensing market is expected to grow rapidly. A 1998 survey by the technology licensing firm BTG International found that 67 percent of U.S. companies own identified technology assets that they do not exploit in either internal development or licensing, creating a large potential for trade (Rivette and Kline 2000b, 58-59). (4)

Most patent licensing transactions are concentrated in the chemicals, software, electrical and nonelectrical machinery, engineering and professional services, semiconductor, and particularly in the pharmaceutics and biotech sectors. The semiconductors industry has recently seen a significant growth in "fabless" or "chipless" companies, which specialize in the design of chip modules and then sell or license the patented designs to manufacturing companies (Linden and Somaya 1999).

In this study, we examine various valuation and disclosure aspects of royalty income from patent licensing. Based on a sample of 198 companies that disclosed royalty income, we draw the following conclusions:

* The information conveyed to investors by royalty income is highly relevant. Regressions of stock returns on royalty income and control variables indicate that the multiple assigned by investors to royalty income is approximately three times larger than the earnings multiple, apparently indicating the higher persistence (quality) of the former.

* Royalty income conveys to investors an important signal about the quality and prospects of the generally uncertain R & D expenditures. The ability of royalty-intensive companies to market their patents--the outcome of R & D efforts--enhances investors' confidence in the technological capabilities of these companies, and in the prospects of their R & D.

* Despite the evident valuation relevance of royalty income, a substantial number of companies engaged in patent licensing choose not to report this item.

The next section discusses our sample and provides summary statistics, followed by the presentation of the valuation implications of royalty income, the evidence on the signaling role of royalty income regarding R & D, and comments on disclosure issues.

SAMPLE AND SUMMARY STATISTICS

We obtained our sample by conducting an automated keyword search of "royalties," "licensing income," and similar terms in corporate annual reports and 10-K filings available on Nexis for the period 1990-1998. (5) A total of 198 companies were identified as reporting annual royalty income from the licensing of patents. (6) The number of firms that disclosed royalty income varies by year, with the highest in 1996 (188 firms) and the lowest in 1990 (94 firms). Financial statement data for our tests were retrieved from Compustat, and stock prices and returns were obtained from the CRSP monthly files.

Table 1 presents the industry composition of the sample. Typical R & D-intensive industries dominate the sample, with pharmaceutics...

NOTE: All illustrations and photos have been removed from this article.



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