TRAPS, PITFALLS AND SNARES IN THE VALUATION OF TECHNOLOGY

Unlike ordinary physical and financial assets, innovative technology is disturbingly intangible, often financially invisible, very risky, and dependent on linkages to other assets for realizing its value. OVERVIEW: In a world where financial wizards are seeking to maximize value for shareholders through corporate restructuring, mergers, acquisitions, and spin-offs, there is no escaping the question of how one values technology. The consequences of mis-valuing it, however, can be unfortunate. This article introduces the prevailing free cash flow method for valuation and the significant pitfalls that can occur in misuse of hurdle rates or miscalculating horizon value. It is equally important to recognize that much of the value of RD examples range from Genentech to Netscape. Investment decisions make the need for valuation of technology inescapable. And financial analysis may be too important to leave to the financial analysts. Valuing Assets There is a well-established textbook method for valuing assets, based on discounting future free cash flow from an investment at the rate that can be earned by alternative investments of comparable risk (4, pp. 11-52). Readers unfamiliar with the method would be advised to consult a finance text. I do not quarrel with this approach, and shall summarize it below as a starting point for subsequent discussion. Briefly, free cash flow is the sum of net income, and, if applicable, depreciation, less net capital investments required to sustain the asset. The discount rate is often also referred to as the cost of money (C). Two terms are often used in association with this form of analysis: net present value (NPV) and internal rate of return (IRR). NPV is calculated by discounting the cash flow of each successive year (n) by the cost of money, at a rate (1/C)n. Case A in Table 1 calculates the NPV of a $1000 investment with cash flows of $300/yr for five years, assuming a discount rate of 12%. …