Valuation assignments must estimate the value of intangibles, recognising the volatility, on-going creation and problems with protection and enforcement. Business valuation analysts have been independently valuing intangible assets for many years, usually in the context of an exchange between owners (transaction), for estate and gift tax purposes or as part of a litigation assignment. Knowledge underlies the creation of value. Some of the questions that need to be answered include the following:
- What would a willing buyer pay to employ the intangible asset?
- What is the useful life of this asset?
- What portion of the operating income does this asset generate?
Financial reporting concepts require measurement of these separable intangible assets from the overall goodwill in a purchase price allocation, attributable to an acquisition (price paid over tangible assets and assumed tangible liabilities) and periodic testing of intangible assets and unallocated residual goodwill for impairment.
Is an intangible asset valuation assignment different from a more standard, or traditional, business valuation assignment? Well, yes and no. While it is true that one particular valuation method might be wrong precisely for a particular intangible asset, there are usually several valuation methods that would be approximately right, and while arguments exist for the use of each of these methods, there may be no clear winner.
In undertaking the intangibles assignment, there are common planning elements for all valuation assignments, such as the following:
- Purpose and objective of the analysis
- Defining the subject intangible asset
- Understanding the legal rights subject to analysis
- Date of value
- Highest and best use considerations
- Report writing—telling a story analysis should be replicable1
However, data collection will probably be different in the intangibles assignment. We need to consider the following:
- History and development of the intangible asset
- Owner or operator, or both
- Licensee or licensor, or both
- Industry operations and pricing data
- Competitive environment
- Commercial comparative intangible assets, cost and treatment
The minor exception to approaches and methods to be used in intangible asset valuation assignments is that the asset based approach will be referred to as the cost approach. There will be a few minor twists in the application of these approaches, but they are similar. As in all valuations, all three approaches should be considered. Here are a few ideas on methodologies and the inherent struggles in using each one.
Observable (one might say “findable”) market based transactions of identical or substantially similar intangible assets recently exchanged in an arm’s length transaction are often difficult to obtain. Publicly traded data usually represents a market capitalisation of the enterprise, not singular intangible assets. Market data from market participants is often used in income based models, such as determining reasonable royalty rates and discount rates. Direct market evidence is usually available in the valuation of internet domain names, carbon emission rights and US Federal Communications Committee licenses (for radio stations, for example). Consider the following:
- Search for sale/license transactional data
- Issue of comparability and timing
- Selecting/adjusting price multiples
- Selecting/adjusting royalty rates
Income based models are best used when the intangible asset is income producing or when it allows an asset to generate cash flow. Just as in other valuation assignments, an income approach technique converts future benefits (such as cash flows or earnings) to a single, discounted amount, usually as a result of increased turnover or cost savings. We have the traditional two choices of either capitalising a single period of benefits or discounting a future stream of benefits. One of the primary difficulties within an income approach method is distinguishing the cash flows uniquely related to the intangible asset from the cash flows related to the whole company.
Income models examine a discount rate from either (1) a weighted average cost of capital (WACC), (2) a weighted average return on assets (WARA), or (3) an internal rate of return (IRR) to the investor. Among the most common income based methods is the relief from royalty method, where one directly estimates cost savings (or income enhancement) from using an intangible such as a trademark or patent. Under the relief from royalty method, value is based on the avoided third party license payment for the right to employ the asset to earn benefits. A multi-period excess earnings model begins with an estimate of total income reduced by contributions from all other tangible and intangible assets, yielding residual income (or excess) that is then discounted to present value. Income based methods are usually employed to value customer related intangibles, trade names, and covenants not tocomplete. Consider the following with regards to the income approach:
- Separation of revenue streams and related expenses
- The expected useful life of the intangible asset
- Alternative measures of income
- Operating earnings of the intangible asset
- Royalty rate income that might be earned by the intangible asset
- Direct capitalisation methods
- Residual value considerations
- Discount rate selection
- Alternative valuation methods including real options techniques and Monte Carlo models
- Tax amortization benefit (more controversial)
Cost based analyses are based on the economic principle of substitution and usually ignore the amount, timing and duration of future economic benefits, as well as the risk of performance within a competitive environment. Historical cost reflects only the actual cost that had been incurred to develop the asset. Reproduction cost new implies the current cost of an identical new property. Replacement cost new implies the current cost of a similar new property having the nearest equivalent utility to the property being valued. In most cases, replacement cost new is the most direct and meaningful cost based means of estimating the value of an asset.
Once replacement cost new is estimated, various forms of obsolescence must be considered, such as functional, technological and economic. Physical deterioration is common for tangible assets, but not for intangibles, although overuse or deterioration of tangible assets could affect value of specific intangibles and the business enterprise.
The following formula could be used in this approach:
Less Curable functional and technological obsolescence
Equals Replacement cost new
Less Incurable functional and technological obsolescence
Less External economic obsolescence
Less Physical deterioration
Equals Pre-tax value of the intangible asset (absent any depreciation benefit)
Cost based models are best used for valuing an assembled workforce, engineering drawings or designs and internally developed software where no direct cash flow is generated. Consider the following:
- Hard and soft costs are included
- Cost measurements
- Reproduction cost new (exact duplicate)
- Replacement cost new (equal utility)
- Measuring functional and economic obsolescence
- Replacement cost new less depreciation
Intangible Valuation Approach Summary
While different valuation analysts may approach the valuation assignment differently, the following table illustrates how I believe you should approach the valuation for certain types of intangibles.
Type of intangible asset
|Internally developed software|