Understand valuation of intangible assets for IBBI Exam

While intangible assets are increasingly important to estimate true corporate value, the current accounting standards make it difficult to capture them in financial statements.

Understand valuation of intangible assets for IBBI Exam

What are intangible assets?

As the name implies, intangible assets are assets that lack physical properties but are used in the production of goods and services. As such, intangible assets may represent a technology, legal right or advantage which help the growth of the company. They should create wealth or profits in a measurable amount. Examples are an advantage in pricing, which affects revenues and profits, an advantage in the volume of goods and services produced, their quality and their delivery, an advantage which increases their market share, etc. There is two usages of intangible assets, direct and indirect usage. Exploiting intangibles in an entity’s own business operation is known as direct use, while the usage through a license fee or royalty is known as indirect use.

Valuation Approaches

Since intangible assets have no physical properties, they are a bit complicated to value. The process of valuation of intangibles involves recognising the volatility, longevity, and problems of protection and enforcement of these rights. The three most accepted valuation approaches are the Cost, Market and Income approaches. The Cost approach involves establishing the value of an asset by estimating its current or replacement cost after deducting any accrued depreciation. The market approach involves valuing an asset through examination and comparison of recent sales of comparable assets. The income approach involves estimating the value of an income-producing asset through capitalization of its expected future cash flows during its remaining useful life.

The Cost and Market approaches are not considered appropriate approaches for some specific situations like valuing franchise rights because the cost to recreate the assets does not reflect its true economic value. Due to such limitations on the utilization of the Cost and Market approaches, an Income approach is usually utilised to value these assets. Generally speaking, the Income Approach is the set of methods of estimating the worth for a business, business ownership interest, or tangible or intangible assets that convert anticipated economic benefits into a present value amount.

The Income Approach is more relevant

For valuing assets that are thought to be key drivers of profits, variations of the Income approach are usually applied. The incremental or Excess Cash Flow Method is one such variation of the Income approach. The regular discounted cash flow method recognises only the cash flow generated by the group of assets. Cash flow attributable to a subject asset is measured as total cash flow generated by a group of assets, including the subject asset, less cash flow generated by contributory assets within the group aside from the main asset. The net present value of such remaining cash flows provides an estimate of the value of the subject asset.

The multi-period excess earnings method (MPEEM) and the Greenfield method are two variations of the excess cash flow method. Both methods share a standard objective; subtract the return related to contributory assets from the entire cash flows generated by a business so as to isolate the cash flows of the intangible asset being valued.

Accounting Standards obscure intangible assets of an organisation

While intangible assets are increasingly important to estimate true corporate value, the current accounting standards make it difficult to capture them in financial statements. This lack of information can affect valuations in a negative way. Nowadays, intangible asset valuation is complicated and as such, it is hard to evaluate them only based on accounting metrics from corporate financial statements. More is needed. Two economists, Feng Gu and Baruch Lev have highlighted the shortcomings.  “The end of accounting” stresses the necessity for valuation methods derived from key performance indicators (KPIs) outside the framework of generally accepted accounting principles (GAAP).

With these challenges, does the current framework of accounting standards recognise any methodologies for intangibles valuation? And how can they be integrated with non-generally accepted accounting principles’ KPIs to assess a firm’s competitive position?

The International Glossary of Business Valuation defines intangible assets as “non-physical assets like franchises, trademarks, patents, copyrights, goodwill, equities, mineral rights, securities and contracts (as distinguished from physical assets) that grant rights and privileges, and have value for the owner”. Accounting standards features a separate definition of goodwill: “the difference between the cost of investment and the value of the acquisition entity, which is the sum of all the value of assets acquired and liabilities assumed.”

Investing in intangible assets is risky

Financial analysts note that the build-up of intangible capital has spurred market capitalization in favour of firms that best leverage the benefits of technological advancements. However, they also observe that intangible capital is still tough to use as collateral for debt financing. The increase in intangible capital investment through equity financing has probably exceeded the rate of overall investment financed through traditional and conservative modes of financing such as bank debt.

As investments in intangibles grow, assessing the worth of these assets as drivers of enterprise value becomes ever more essential. Both IFRS and GAAP are “mixed models” with alternative ways to account for intangible assets. Generally, intangible assets acquired as part of a business combination must be measured at fair value at the time of the acquisition, included within the acquirer’s balance sheet, then subject to amortization or periodic impairment testing. Under IFRS, such assets are recognized as long as certain criteria are met.

An enterprise’s earnings generally include an amortization charge for the intangible assets that are within the record and have a determinable useful life. It may also include an impairment amount recognized on the goodwill or on the intangible assets that are capitalized and have an undetermined useful life.

Accounting Standards favour recognition of intangible assets only on acquisition

You may have difficulties with the comparability of companies with different growth strategies. This may be mostly because of the accounting treatment of intangible assets which were purchased or if they were created internally. A firm that has developed its portfolio of intangible assets through acquisition will probably have a better share of intangibles recognized in its balance sheet, especially more goodwill than one that developed intangible assets internally. This will affect financial ratios and reported earnings.

An example of this is Tesla vs. Amazon. Both companies are tech companies, although they operate in different fields. By looking at Tesla’s recent balance sheet, you can see that Goodwill and other intangible assets represent merely 1.17% of Tesla’s total assets (2020). On the other hand, Amazon’s intangible assets represent more than 8.95% of its total assets (2020). This reflects, in part, Amazon’s greater appetite for acquisitions.

It is important for valuation analyst to understand and know the different treatments used on internally created intangible assets versus purchased intangible assets. The importance lays in knowing and adjusting the valuations in order to make comparability as much as possible. Financial analysts should also keep in mind the impact of intangibles assets and their valuation in their investment decisions.

Below, you will find five of the more common valuation methods for intangible assets. These approaches are within the framework of the Cost, Market, and Income approaches. These approaches are often integrated into an analysis of non-GAAP KPIs and other conceptual frameworks.

1. Relief from Royalty Method (RRM)

The Relief from Royalty Method is utilized to find out the value of hypothetical royalty payments that might be saved by owning the asset instead of paying licensing fees for it. The rationale behind the RRM is fairly intuitive: Owning an intangible means the underlying entity doesn’t need to buy the privilege of utilising that asset. The RRM is often used to value domain names, trademarks, licenses, computer software, and in-progress research and development that can be tied to a specific revenue stream. Comparable data pertaining to royalty and license fees are required to perform this analysis. Generally, the RRM involves the following steps:

1. Projected financial statements for the entity: revenue, growth rates, and tax rates and working capital, capex and debt financing estimates. The data is generally obtained from the entity’s management.

2. Estimating a suitable royalty rate for the intangible asset based on an analysis of royalty rates from publicly available information for similar domain names and of the industry in question. Royalty rate information is out there on such databases as KtMINE and Royalty Source, among others.

3. Estimating the useful life of the asset.

4. Applying the royalty rate to the estimated revenue stream.

5. Estimating a discount rate for the after-tax royalty savings and discount to present value.

The RRM contains assumptions from both the market and income approach.

2. Multi-Period Excess Earnings Method (MPEEM)

The MPEEM may be a variation of discounted cash-flow analysis. Rather than taking a look at the entire entity, the MPEEM isolates the cash flows which will be related to one intangible and measures fair value by discounting them to present value. The MPEEM tends to be applied when one asset is the main factor of a firm’s value and therefore the related cash flows are often isolated from the firm’s overall cash flows.

Start-ups and technology firms are the main users of this approach. Computer software and customer relationships are some cash-generating intangible assets. They will be measured and will be assessed with fair value measurement using the MPEEM. The MPEEM usually involves the following steps:

1. Projecting financial information (PFI) — cash flows, revenue, expenses, etc. — for the entity.

2. Contributory asset charge is used to decrease the cash flows attributable to all other assets.

3. The contributory asset charger may be a sort of rent for the utilization of all other assets in generating total cash flows.

4. Calculating the cash flows attributable to the intangible asset and discount them to present value.

Assessing the CAC is often a challenge with MPEEM. The required returns on CAC must be according to an assessment of the return on individual asset classes and must reconcile to enterprise WACC. Also, the projection period for the financial information utilized in the model should reflect the calculated useful lifetime of the key asset. That may involve significant judgment.

3. The Distributor Method

This is a variant of MPEEM. The Distributor method relies upon market-based distributor data or other appropriate market inputs to value customer relationships. It may even be viewed as a profit split method, in which function-specific profit is allocated to the identified assets. The underlying theory is that a business consists of varied functional components (such as manufacturing, distribution, and intellectual property) which, if available, market-based data could also be used to reasonably isolate the revenue, earnings, and income associated with these functional areas.

One of the pros of using the Distributor Method is that it utilises market-based data. This data supports the selection of profitability and other inputs related to customer-related, thereby allowing the potential use of the MPEEM to value other assets of the business if appropriate. When evaluating customer-related intangible assets under the Distributor Method, margins utilised should be similar to those utilized by distributors or other businesses that have characteristics similar to the customer-related intangible assets being evaluated.

Finally, a superior distribution function of an entity may realize higher margins because they are providing additional value in the form of services. There could also be additional situations where a specific group of companies provides an appropriate proxy for the customer-relationship function.

The Distributor Method found utility in valuing customer relationships in the consumer-packaged-goods (CPG) space. The impetus for a far better methodology was the frequent unexpected value attributed to customer relationships during a few CPG industry mergers within the early 2000s that appeared to be inconsistent with management’s deal rationale and a general understanding of the drivers of the acquired business.

The Distributor method has now become an analytical tool for a variety of contexts, including purchase price allocations, assessing the risk profile of a takeover target and the appropriateness of the discount rate to value acquisitions.

4. Replacement Cost Method

This method requires an assessment of the cost for the new intangible asset. In specific, the cost to construct at current prices as of the date of the analysis, an intangible with an equivalent utility to the main intangible, using modern materials, production standards, design, and layout and quality workmanship.

It weighs the tax impact of the asset’s amortization (depreciation charge), which is most relevant if the intangible is taken into account within the framework of the valuation of an overall enterprise. A pre-tax asset valuation could also be more suitable under certain circumstances, particularly if the asset is valued on a stand-alone basis. The estimate of the obsolescence percentage is additionally critical for this model.

Choosing an appropriate valuation technique

For the most part, the valuation analyst’s selection of intangible asset valuation approaches is a process of elimination. If there are sufficient reliable data to perform all three valuation approaches, then the analyst will typically apply all three approaches. If there are insufficient guideline sale or license transaction data available, then the analyst may have to rely on the cost approach by default. In the instance of intangible assets that do not generate measurable cash flows, then the cost approach may be relied upon.

In order to perform this valuation, there are a few steps to follow:

1. Conclude which approach is relevant for the subject intangible asset -  cost or market or income approach.

2. Confirm that adequate current information is available to perform relevant calculations.

4. Include all appropriate components of cost or price.

5. Identified and quantified any necessary allowance for physical deterioration.

6. Identified and quantified any necessary allowance for functional obsolescence.

7. Identified and quantified any necessary allowance for economic obsolescence.

8. Subtract all depreciation and obsolescence allowances from the current cost measure to conclude a value indication.

9. Consider the impact of tax

Ideally, the analyst would also have to consider the valuation impact under an alternative approach. For instance, if the cost approach is considered, it would be helpful if the valuer evaluates the asset value under income and market approaches.  However, in an intangible asset valuation, it is relatively uncommon for the valuation analyst to be able to synthesize multiple value indications.

5. Premium Profit Method

This method involves comparing the forecast profit stream or cash flows that would be earned by a business using the intangible asset with those that would be earned by a business that does not use the intangible asset. The value of the brand is decided supported by the difference between the estimated cash flows that might be earned by a business using the brand compared with the earnings of a business that doesn't use the brand. This difference represents the extra cash flows associated with the brand. Brand value calculation is effected by applying the acceptable discount rate to estimated future brand cash flows. The discount rate must reflect the risk associated with such future cash flows.

Some or all of the following valuation inputs are required to use the premium profits method:

• Project profit, cost savings or cash flows expected to be generated by an entity using the intangible asset;

• Project profit, cost savings or cash flows expected to be generated by an entity not using the intangible asset;

• An appropriate capitalisation multiple or discount rates to capitalise forecasted profit or cash flows.

Capitalizing brand cash flows

The premium profit method is often utilized to value assets whose use will save costs (for instance through lower labour hours) translating into additional profit. The following may be a simple example of the use of the premium profits method. Suppose a brand is being valued and the profit after tax in the most recent reporting period for the business using the brand was Rs. 2,000 crores. A comparable business is identified that does not use a brand and its profit after tax in the most recent reporting period was Rs. 800 crore. Thus, the incremental post-tax profit achieved through using the brand was Rs. 1,200 crore. This incremental profit could be capitalised using an appropriate multiple drawn from price-earnings ratios that are typical in the market for similar types of business.

For valuing brands, market-based valuation or the royalty relief method of valuation methods may be possible. Any method that uses DCF principles is a generally accepted approach to brand valuation and provides a greater depth of understanding of the dynamics of the brand.

While brand valuations are often based on a multiple of historical earnings, it's clear that past performance is not any guarantee of future performance. Investors base their judgments on expected future returns instead of actual historical returns. However, historical results are analysed to accurately forecast the long-term. Valuations supported by projected cash flows are therefore most preferred approach with the condition that such forecasts must be credible.

6. The Greenfield Method

The Greenfield method assumes that a company is started from scratch and owns only the subject asset. Therefore, the company must make investments, either directly through the purchase of assets or indirectly through the incurred start-up costs and losses, to build an operation comparable to the one in which the subject asset is utilized as of the current measurement date. Conceptually, investments made during the start-up period recreate the other assets required to support the business.

The key inputs and considerations needed for this methodology are:

• Start-up cash flow forecast, including capital costs

• Expected ramp-up period and pattern

• Start-up-type discount rate

• Tax amortization benefit

• Support for start-up levels of income and capital costs

• Support for length and pattern of ramp-up

• Assumption around competition and market share

• Incremental risk premiums in the discount rate to reflect start-up nature of cash flows

Conceptual Similarity between the MPEEM and Greenfield Method

If the contributory asset charges (CAC) are properly calculated, the MPEEM and Greenfield method must produce similar results. From an economical perspective, that is an investor who would be indifferent between leasing and buying the contributory assets.

To be clear, the MPEEM and therefore the Greenfield method aren't different approaches; i.e., they both model incremental or excess income related to the subject asset. As such, both methods of valuation may produce different results depending on given inputs and assumptions. Therefore, it can't be said that one approach is more appropriate simply as a function of being a special variation of an equivalent methodology, unencumbered by the complexities of the opposite. However, we do believe that one approach could also be better than the opposite given the precise attributes of a specific company.

7. With and Without Method (WWM)

With this method, the intangible asset value is estimated as the difference between two discounted cash-flow models: one that represents the cash flows for the commercial enterprise with the asset in place, and another without it. The WWM is often used to value noncompeting agreements, franchises, and processes and technologies.

There are a few things to keep in mind when utilizing this method:

Free cash flow forecast for business with asset

• Enterprise-wide discount rate

• Expected life of the business

• Free cash flow forecast excluding subject asset

• Enterprise-wide discount rate excluding asset

• Expected period to replace asset + costs

• Tax amortization benefit

When you perform the valuation of a business's intangible assets, you would require skills to spot and understand the intangible assets of the business. Examples of assets that are considered intangibles include property rights, trademarks, customer data, client loyalty and technology. Sometimes, non-compete agreements are also considered to be intangible assets.

Conclusion

In today’s economy, the price provided by intangible assets must be captured in enterprise valuation. New methodologies need to be developed for more reliable valuation results. Such methodologies must provide new perspectives on the true value of an entity. Cost, Market and Income approaches should be integrated with analysis of non-GAAP KPIs and other conceptual frameworks.

A valuation assignment is performed to determine the worth of an intangible asset of an entity. Even within an equivalent valuation approach, different methods will typically end in different value indications.

Intangibles comprise intangible assets and intangible liabilities. International Accounting Standards are interested only in identifiable intangible assets which have to fulfil the requirements of identifiability, ability to control, and the existence of expected future economic benefits. Other intangible resources – which do not satisfy the aforesaid three criteria – shall remain unrecognised, just like internally generated goodwill. Despite the methods listed above, the valuation of intangibles remains a complicated task.