Advanced valuation methods: the real options approach

While discounted cash flows and cost methods are still largely applied to evaluate patents (see chapter 5), recent attention has been given to the real options approach, which allows to account for the intrinsic uncertainty and flexibility of patents. The attractiveness of the real options approach is due to the fact that it considers a patent as a contingent claim on the value of another asset, that is, for instance, the present value of the expected cash flows from a new product based on the underlying innovation. Accordingly, patents can be considered analogous to financial options and evaluated applying the methods developed for these securities. The real options approach has the advantage to consider patent characteristics in a more comprehensive way, but its application is still limited by several problems, of which the most important is the difficulty to transfer the methods developed for financial options to patents. The objective of this chapter is to present the real options approach, explain how it can be applied to patents, illustrate the valuation formulas and discuss the limitations. It has however to be remarked that each valuation context (i.e., patent licensing, patent damages, IP-backed finance) is very specific, and the real options method can be applied in several different ways. Each valuation will then require a careful construction of the model. This chapter will provide the basis to understand the method and its applications, but, given the very broad set of theoretical and methodological works and professional applications, the valuation of each specific patent might require further analysis.