Traditional Income Approach
Undervalues Domain Names
Domain-name ownership
confers the owner with two types
of rights. The first is related
to managerial flexibility, such
as when to develop an associated
Web site and when to abandon the
operation of the Web site while
retaining ownership of the domain
name itself. The second right is
associated with trademarks. If a
domain name is trademarkable, the
owner has the right to legal protection;
that is, the owner can prevent anyone
else from claiming the domain name,
if he/she wishes to exercise that
right. The options available to
the trademark owner are to take
the trademark violator to court,
to buy the domain name, or to take
no action. This flexibility has
value, which is embedded in an option.
These options are valuable managerial
tools that cannot be ignored.
A domain name can
also create value to the owner by
generating income from an active
e-commerce Web site. In fact, even
if a domain name does not have an
active Web site, it can still be
generating income as measured by
cost savings associated with preventing
a cyber squatter or competitor from
siphoning away sales.
Thus, the value of
a domain name comes in two forms:
(1) earnings and (2) options to
take actions. The latter component
can be broken down into (a) managerial
flexibility (referred to in finance
literature as real options) and
(b) a trademark-related option.
| Hence, the value of a domain
name is the sum of the value
of its earnings, the value of
its managerial flexibility,
and the value of its trademark
option. |
The income approach
to valuation, also called the Discounted
Cash Flow (DCF) method, is one of
the tools used to value any asset,
including domain names; the earnings
represent the additional or incremental
cash flows the domain name is expected
to generate to the owner over the
life of the domain name. However,
this technique does not capture
the value of flexibility options.
Thus, an appraiser can use the DCF
method to estimate the earnings
component and use option-pricing-theory
models to estimate the two option
components separately. Although
in principle an appraiser can use
decision-tree analysis to estimate
flexibility options, an option-pricing
methodology can be much simpler
to formulate. Moreover, DCF techniques
require estimating the risk of cash
flows, whereas the option-pricing
methodology overcomes this difficulty,
especially when this risk is not
constant, as assumed by the DCF
method.
Let's look at the
trademark-option component by considering
the action of a cyber squatter (someone
who registers a domain name that
constitutes a trademark infringement).
Such an action is equivalent to
writing a put option on the domain
name, in that the cyber squatter
is legally obligated to surrender
the domain name. However, the owner
of the domain name has the option
to surrender the domain name, litigate,
or take no action. One could use
discounted decision-tree methods
to value such a domain name by considering
the different actions and counter-actions
that an owner of the trademark and
a cyber-squatter can take and the
consequences of each action. However,
this process would at best be cumbersome,
compared with an option-pricing
model. In fact, even if a domain
name has no associated trademark,
as long as that domain name is trademarkable,
it has a higher value (other things
being equal) than a non-trademarkable
domain name of a generic word. Obviously,
the higher the value of a trademark,
the higher the value of the associated
domain name. However, an analyst
has to be careful in distinguishing
between the contribution to value
from the trademark and that from
the earnings component.
In sum, taking account
of flexibility options and trademark
options embedded in domain names
provides a more accurate domain-name
appraisal than using the DCF method
alone.
Alex
Tajirian, President & CEO
DomainMart
Opinion