A look at valuation approaches for intangible assets (Abridged Excerpt of CHP 2)
Valuing intangible business assets can be overwhelming at times. Between the different approaches and the myriad factors that go into each, it’s easy to miss a step. BVR’s recently released third edition of Benchmarking Identifiable Intangibles and Their Useful Lives in Business Combinations seeks to provide context to this dizzying array of factors with a look at the different approaches for valuing intangible assets—as well as empirical data from actual valuations. This teaser from Chapter 2 of the full book focuses on the approaches to valuing a business’s intangible assets and how to apply them.
The valuation of intangible assets relies on the three distinct approaches that are familiar to all valuation professionals:
- The cost approach uses the cost of reproduction or replacement of the asset;
- The market approach uses transactions involving similar assets as the basis for valuation of a specific asset; and
- The income approach estimates asset value based on the present value of a future income stream (remaining useful life of the asset is a critical element).
While knowing what these approaches are is obviously very important, understanding which method to use in a given situation can very easily make or break your valuation.
This technique reflects the amount that would be required to replace the service capacity of an asset. Oftentimes, this approach is referred to as the replacement cost.
Cost is most often defined in terms of either historical cost, reproduction cost, or replacement cost, as follows:
- Historical cost—considers the actual cost that had been incurred to develop the asset;
- Reproduction cost—considers the cost of producing an exact replica of an asset using the same or similar materials at current prices; and
- Replacement cost—considers the cost of acquiring a substitute asset of comparable utility.
For fair value projects, replacement cost new is the most meaningful basis of value when the views of market participants assessing an asset are considered.
When an intangible asset is less useful than its ideal replacement, its value should be adjusted to reflect loss of economic value due to:
- Functional (technological) obsolescence: impairment of its functional utility according to market standards at the valuation date;
- Economic obsolescence: market conditions, competitors; and
- Physical deterioration: not generally applicable to intangible assets.
The cost approach is often applied to value assets that are not directly responsible for the income generation of the business.
The income approach employs a range of valuation techniques that convert future amounts (e.g., cash flows, income, or expense savings) to a single current (i.e., discounted) amount. The fair value measurement is determined on the basis of the value indicated by market expectations at the valuation date about those future amounts.
Alternative methods within the income approach reflect differences in the quantification of the benefit stream. Key methods include:
- Multiperiod excess earnings method (MPEEM):
- Estimate total income for business or business unit;
- Deduct shares of income for all “required” assets; and
- Calculate present value of remaining income (excess earnings after returns for other required assets (contributory assets)) using appropriate risk-adjusted discount rates.
- Relief from royalty method:
- Estimate projected future revenues associated with an intangible asset;
- Develop estimate of royalty rate for use of the asset; and
- Calculate present value of royalty savings.
- Cost savings methods:
- Relief from royalty method (RFR method);
- Income increment/cost decrement method (with and without method, or WWM); and
- Direct estimate of cost savings.
- Greenfield or build-out methods.
The MPEEM is best suited for assets that “drive” surplus cash flow of an enterprise. These assets are referred to as primary or enabling assets.
Typically, in valuation engagements that use the income approach, there are availability and comparability issues with the market approach. Given this, the market approach is infrequently applied in the valuation of most intangible assets. To employ the market transaction method, the valuation will require:
- Arm’s-length market transaction data for similar, guideline assets; and
- Adjustment for material differences between guideline and subject asset.
A number of factors reduce the ability to employ the market approach to value intangible assets. These include:
- Intangible assets are often very unique;
- There is limited guideline transaction data for intangible assets;
- When intangibles are sold, they are typically sold with other components of a business enterprise; and
- If sold individually, transactions are not often subject to public disclosure.
To read more on this topic, be sure check out the complete guide, Benchmarking Identifiable Intangibles and Their Useful Lives in Business Combinations, 3rd edition. It delivers a compilation of reported, vetted, and carefully analyzed data, particularly focused on useful lives of intangible assets as reflected in almost 16,000 purchase price allocations. The guide reveals what intangibles are being discovered, categorized, and valued in specific industries, as well as provides remaining useful life guidance, noncompete agreement benchmarks, and industry benchmarks. Further, investors will see benchmark data they have never seen to target companies’ intangible property strength, amortization strategies, and composition of goodwill.
Add this book to your valuation toolkit and ensure that you are covering every aspect of your future valuations.