The P/E ratio for technology stock Cisco Systems at its 2000 high was 196. The metric, which divides a stock's price by its earnings-per-share, meant a buyer would have to wait nearly 200 years to recover the initial investment based on the company's then-current earnings, and this is without taking the time value of money into account.
Cisco ended up falling sharply in price and, fourteen years later, still has not reached its 2000 level.
Cisco Systems Price/Earnings Ratio, December 1996, May 2011
Source: WSJ.com
Regardless whether the asset is stocks, real estate or a music royalty interest, buying any asset means you are buying future income. At 196 times earnings, Cisco was extremely overvalued considering the long term average P/E in the stock market had been about 15 up until that time.
Valuation is even more important with royalty interests then with stocks, because, unlike stocks, royalty interests are not liquid. An investor should buy music royalties with the intention of holding them in perpetuity. If you pay too much, you run the risk either of not making your money back or earning poor long-term returns relative to other opportunities.
One simple way of evaluating a music royalty investment is to look at the royalties as a percentage of the auction's offering price. The royalty/initial investment stream is very similar to a bond's coupon/initial payment stream.
But unlike conventional bonds, future music royalties are variable and may be much higher or lower than expected.
Source: Royalty Exchange, Inc., Howard Simons
When looking at historical data of twenty-one auctions completed on Royalty Exchange, Inc., royalty payments as a percentage of initial sale prices varied from Country Wide, which sold with royalties at 0.17% of the auction price to Timothy Clayton, which sold with royalties at 26% of the total.
A high valuation equates to lower royalties as a percentage of the sale price, such as was the case with Country Wide. A "cheap" auction, all things being equal, is one where current royalties represent a larger percentage of the sale or offering price, as with Timothy Clayton.
Of course, when it comes to any factor of investment or economics, all things are never equal.
There are a myriad of unknowns when it comes to music royalties, and unlike a bond whose yield is fixed, the income derived from a music royalty interest will change over time based on its use. The Country Wide auction whose royalties were initially 0.17% of the sale price ended up yielding 20% of the sale price a few quarters later and 30% of the sale price the quarter following that. Based on that initial sale price, 50% of the buyer's cost would have been recouped in half a year.
Based on the initial sale price, Timothy Clayton's royalty stream's income gradually fell, from 26.4% of the sale price to 9.6% two years later.
One constant: comparatively high returns. Based on sale prices complied from Royalty Exchange, Inc. royalty auctions income as a percentage of sale prices was overwhelmingly outpacing corporate and high yield bond yields as of August 2014.
For more information on royalty investing check out these other Royalty Review articles by guest columnist and investment analyst, Jonathan Hoenig:
"Let Royalties Help Slice the Pie"
"When Music Appears in a Film"
DISCLOSURE: JONATHAN HOENIG IS THE AUTHOR OF ROYALTY REVIEW. THE OPINIONS EXPRESSED HERE BELONG TO JONATHAN HOENIG. MR. HOENIG RUNS THE CAPITALISTPIG HEDGE FUND, IS A REGULAR CONTRIBUTOR TO FOXNEWS, AND IS A PRIVATE MUSIC ROYALTY INVESTOR. HE IS ALSO AN INVESTOR IN AND PAID ADVISOR OF ROYALTY EXCHANGE, INC., THE PARENT COMPANY OF ROYALTY INSIDER. THE ROYALTY REVIEW COLUMN IS PRESENTED FOR INFORMATION PURPOSES ONLY AND SHOULD NOT BE CONSTRUED AS A RECOMMENDATION, SOLICITATION OR ADVICE. FOLLOW @THEROYALTYMKT TO RECEIVE ON-GOING MUSIC ROYALTY NEWS AND ANALYSIS WRITTEN BY JONATHAN HOENIG.
