Multi-period excess earnings method

Multi-period excess earnings method – Generally, the primary asset of a company is valued using the Multi-period excess earnings method (MPEEM), while a secondary intangible asset is valued using one of the other methods. The majority of acquired, going-concern companies own at least one asset that would be expected to be valued using the MPEEM.

The asset most responsible for the revenue and income-generating ability of a company is generally considered a primary asset. The primary asset often varies depending on the nature of a company and its industry. The primary asset of most service businesses is their customer relationships.

However, customer relationships are an important intangible asset for companies in many different industries. Customer-related intangible assets are a common type of intangible personal property. This is because nearly every company has recurring customer relationships.

In the MPEEM, the analyst estimates revenue and cash flow derived from the subject intangible asset, such as customer relationships, and then deducts portions of the cash flow that can be attributed to supporting, or contributory, assets. These contributory assets include trademarks and trade names or tangible assets that contributed to the generation of such cash flow. The resulting excess cash flow attributable to the subject asset is then discounted at a rate of return commensurate with the risk of the subject asset.

In applying the MPEEM, the analyst should perform the following procedures:Multi-period excess earnings method

  • Identify the asset(s) to be valued
  • Identify the stream of revenue associated with the subject asset
  • Estimate attrition rates for the subject asset
  • Estimate expenses and cash flow associated with the subject asset
  • Estimate and deduct contributory asset charges
  • Estimate the rate of return for the subject asset
  • Discount the remaining cash flow to present value
  • Add any tax amortization benefit, if applicable

The analyst should identify the expected life-span, or the remaining economic life of the subject asset. The analyst also should identify the revenue stream, or the cash flow, associated with the particular group of assets (including the subject asset and any contributory assets necessary to support the earnings associated with the subject asset), over the expected lifespan of the subject asset. This future revenue stream and cash flow are most commonly estimated using prospective financial information (PFI) prepared by company management.

For intangible asset valuations prepared for fair value accounting purposes only, the analysis should rely on market participant assumptions. Further, the analyst should consider that the appropriate growth rate to use for the revenue associated with the subject asset may be different than the consolidated company growth rate and may require stratification based on the customer mix or product mix.

Attrition

When valuing customer-related assets using the MPEEM, the analyst should identify the portion of revenue expected to be generated through repeat customers existing as of the valuation date. The estimated future revenue is derived from the revenue per customer and the number of retained customers. Because customer relationship assets derive value within a finite period, the number of customers providing repeat business is expected to decrease over time.

Attrition is the measurement of the rate of decay or loss of existing customers. The analyst may have to conduct statistical analysis of historical customer turnover and revenue growth rates to estimate the expected attrition. However, historical customer data may not be available and the analyst may have to rely on management estimates or industry data to develop customer attrition rates. Once estimated, the attrition rate or factor is then applied to the projected revenue stream in order to separate the revenue into existing and future customer revenue.

There are two factors that may affect attrition: inherent advantage and the nature of the business.

An inherent advantage exists when a customer gains a specific advantage in purchasing one company’s products or services over another (e.g., if a company has a unique product or there are high switching costs). Further, the company business model may be the principle driver of customer retention. For example, companies working on an engagement basis over long periods of time typically have lower attrition rates than companies without stable recurring revenue generating customer relationships.

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In addition, geographical reach, expected competitive environment, and the state of the industry may have an impact on customer attrition. If the company operates in an industry that is moving toward obsolescence, customer retention could potentially decrease. If competition is expected to increase, but the number of customers in the industry is not expected to increase significantly, customer retention can potentially decrease as well.

The type of analysis used to estimate the attrition rate may have a significant impact on the indicated attrition factors and the customer relationship value. In a constant rate attrition analysis, an attrition rate is identified for each period for which prior period customer purchase information is available. The analyst then concludes a single rate based on the attrition rates indicated for each period that is held constant throughout the remaining useful life of the subject customer relationship asset. This analysis focuses on the attrition of relationships or the revenue attributable to the relationships.

Although the constant rate attrition analysis requires only limited information about whether a customer made a purchase during each period, no distinction is made between customer relationships based on the size of the purchase or the age of the relationship.

Frequently, this factor may have a direct impact on the expected attrition rate and a significant impact on the customer relationship value. This is because revenue may be concentrated in a certain group and may not necessarily be reflected in the number of relationships that have been lost. For example, a company may lose only 2 customers but 20 percent of revenue, or on the contrary, lose 100 customers but only 1 percent of revenue.

An actuarial attrition analysis or a variable attrition rate analysis considers variations in attrition rates based on the age of the customer relationship. This analysis results in an indicated attrition rate for each relationship age. The use of this analysis typically requires at least five to seven years of purchase information to ascertain the relationship between age and attrition. The variation in attrition rates based on customer size can be incorporated in both the actuarial attrition analysis and the constant rate attrition analysis by focusing on revenue rather than on the customer relationships.

Once projected revenue attributable to the customer base existing as of the valuation date has been identified, the earnings can be estimated based on the expected profitability of the business. The analyst should consider only the operating costs relevant to the existing customer base from a market participant perspective.

Existing customer relationships may be more profitable than the company’s average profitability or future customer relationships because the company may have to incur expenses in developing new customers.

Expected sales and marketing costs necessary to acquire new customers and company-specific cost synergies are not relevant and should not be considered in projecting the earnings from existing customers. Typically, it is expected that near-term revenue and earnings would be generated by the existing assets for most companies.

In addition, increases or decreases in working capital should not be deducted from the customer relationship cash flow. Further, backlog revenue should be subtracted from the customer relationship revenue after applying any attrition factors.

Contributory Assets

As discussed previously, there are other assets that need to be in place for companies to be able to extract value from customer-related assets. If the earnings from the customer relationship asset depend on other assets, the analyst needs to estimate the contributory asset charges to isolate the “excess” cash flow attributable to the customer relationship asset from the estimated earnings.

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Possible contributory assets may include working capital; machinery, equipment, land, and buildings; assembled workforce; and other intangible assets, such as brand name, trademark, technology, and noncompete agreements. Excess assets, such as excess land or capacity, that do not contribute to the projected cash flow associated with the customer relationships should not be considered as contributory assets.

In order to estimate the contributory asset charges, the analyst should:Multi-period excess earnings method

  • identify and value all contributory assets,
  • determine the revenue base,
  • estimated the rate of return for each contributory asset, and
  • subtract the earnings attributable to the contributory assets to estimate excess earnings attributable to the customer relationships.

Any costs associated with the other “supporting” assets that could contribute to the income from the customer relationship asset should be deducted. The amount that should be deducted is typically the alternative costs for the contributory assets or the income such assets would generate in a different use if they were not used in connection with the customer relationship asset.

In essence, the contributory asset charge represents the economic “rent,” or a charge equivalent to the return on and the return of, an asset necessary to produce the goods or services of the company. The analyst should, therefore, reduce the cash flow attributable to the customer relationship intangible asset by the required return on the contributory assets.

The contributory assets should be at market participant levels. In order to reflect market participant levels, the analyst may analyze the fundamentals of guideline publicly traded companies and industry peer group ratios, such as the working capital to sales ratio or fixed asset ratio.

To the extent that the projected cash flow reflects excess or deficit levels of contributory assets, the analyst should adjust the cash flow to reflect a normalized level. For example, if the company has negative or low working capital, but a market participant would need working capital as a contributory asset, the analyst may have to estimate a reasonable working capital charge based on the working capital of an industry peer group or guideline companies. The appropriate level of fixed assets should be determined for each year of the projection.

The required levels for some contributory assets, such as working capital, fixed assets, and workforce, are likely to scale with revenue. However, to estimate the contributory asset charge on the other intangible assets, such as trade name, the analyst may have to rely on an alternative valuation approach or method.

The return on and the return of assets used in the contributory asset charge should reflect the appropriate risk for each asset, with financing rates for the property and equipment and higher rates for intangible assets. The analyst should consider the level of debt and equity financing that can be obtained on an asset.

When more than one asset can be identified as a primary asset and the analyst chooses to apply a dual MPEEM to value both of the primary assets, there are several methods the analyst can use to estimate the contributory asset charges to be applied to both primary assets. Multi-period excess earnings method

These methods include the hierarchy method, the cross-charge method, the partial separation method, and the separation method. However, to avoid using a dual MPEEM and the related contributory asset charge issues, the analyst may apply the MPEEM to one primary asset and an alternative valuation method, such as the relief from royalty method or the “with and without” method, to the other primary asset. Multi-period excess earnings method

After adjusting the projected cash flow for contributory asset charges, the remaining “excess” cash flow is attributable to the customer relationship intangible asset. This “excess” cash flow is then discounted to a present value using an appropriate rate of return to estimate the market value of the customer relationship intangible asset. The analyst should determine whether a tax amortization benefit adjustment is appropriate in the analysis.

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When estimating an appropriate discount rate, the analyst should consider the risk in the customer relationship asset. The analyst should consider such risk factors as switching costs, product/service differentiation, barriers to entry, level of customer purchasing power, customer concentration, and competitive rivalry. Multi-period excess earnings method

The analyst should reconcile the internal rate of return with the discount rate as the reconciliation may highlight asset cost of capital issues, as well as allocation issues. If the internal rate of return exceeds the discount rate, there may be optimistic cash flow, unique synergies in the cash flow, or an inadequate risk assessment in the discount rate.

Strengths and Weaknesses of the MPEEM

There are several advantages and disadvantages in using the MPEEM to value the customer relationship intangible asset. Some of the advantages include the following:

  • The MPEEM is useful as a check on the reasonableness of a purchase price allocation. Multi-period excess earnings method
  • The MPEEM allows analysts to understand the relationship between revenue and earnings generated by existing assets, as well as revenue and earnings attributable to unidentified assets.
  • The MPEEM provides analysts with the ability to reconcile to the entity value and demonstrates that the calculation of contributory asset charges does not create or destroy the aggregate asset value. Multi-period excess earnings method

There are also several disadvantages or challenges when relying on the MPEEM that the analyst should consider. These include the following:

  • Reasonable remaining useful life may be difficult to estimate. Multi-period excess earnings method
  • The use of a finite remaining useful life for the customer relationships may significantly understate the value of the customer relationship intangible asset (effectively indicating that a thriving business will have no customer relationships in the future), thereby overstating the value of residual goodwill.
  • The MPEEM is dependent on the reasonable estimation of expected cash flow. Multi-period excess earnings method
  • Future assets may also be included by management in estimating the expected cash flow and excess income.
  • The value of cash flow beyond the projection period is not taken into consideration, as it is with a typical discounted cash flow analysis, due to attrition and the assumed finite remaining useful life of the intangible asset. Multi-period excess earnings method
  • Attrition rates may be difficult to estimate due to lack of historical data, erratic buying patterns, and difficulty in determining when a customer is considered to be lost.
  • The MPEEM suffers from the inability to recognize all relevant going-concern components in the contributory assets charges.
  • All “excess” income is attributed to an amortizable intangible asset and/or goodwill. Multi-period excess earnings method
  • When multiple intangible assets exist, “excess” income needs to be allocated amongst the intangible assets.

See also: Customer relationships – valuation

Multi-period excess earnings method

Multi-period excess earnings method

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