The Investment Value of an Idea

The value of an idea derives from its ability to solve our problems. It ends when a fully developed better idea arrives. No one knows how long development will take, but the probability that the challenger will arrive in a given year is the “mortality rate” for the old champion. We can calculate the present value of the old idea by adding the mortality rate to the market discount rate. The addition of the mortality rate increases the sensitivity of the discounted value to shortterm prospects for the economy. The value of an idea derives from its ability to solve our problems. It ends when better solutions arrive. Fortunately for the old idea, the better one does not arrive until its development is complete—until human ingenuity has removed the last obstacle to its practical application. But no one knows how long that process will take.The probability that the challenger will arrive in a given year is, of course, the “mortality rate” for the old champion. And as it turns out, we can calculate the present value of the old idea by simply adding the mortality rate to the market discount rate.Adding the extra term has two curious effects:Until the challenger arrives, the old idea rewards its owner with a rate of return that includes the mortality rate as well as the market discount rate.Sensitivity of the discounted value to short-term prospects for the economy increases.The equity in a publicly owned corporation or real estate is a rough measure of the value in the asset that is available to lenders. Leverage is an indication that the risk in an asset is low in relation to its value and that the remaining value can be freed up to bear risks that are high in relation to their value. One source of such risk—the main source—is the ideas being developed by entrepreneurs.The level of risk in ideas can be so high that, especially in the early stages of research and development, lenders will resist attempts at incorporation, which would limit the assets subject to their claim. But if they must forgo the protections afforded by incorporation, “entrepreneurs” will scrimp on expenses—even working, when possible, in their own basements or garages, most of which are attached to houses with mortgages.We can express our ignorance of the actuarial risk posed to a current champion by a challenger with a probability that development will be completed in a given year. When we do so, we find thatthe risk of sudden death can be incorporated into estimates of investment value by simply adding the appropriate mortality rate to the market discount rate;ideas for which the Damoclean sword has not yet fallen will reward investors with rates of return higher than the market rate. Shares of their corporate owners will behave like growth stocks;an idea will exhibit more systematic risk than conventional investment assets with the same value. Because it cannot be diversified away, this risk places special burdens on the owner's capacity for risk bearing.