Valuing Intangible Assets (#334)
/What is an Intangible Asset?
Intangible assets have no physical substance, so their value is derived from any associated legal rights. For example, the value of a broadcasting license is the legal right to keep anyone else from using the associated radio frequency. It should generate some sort of value for you, such as when the owner of a taxi license rents it out in order to generate an inflow of rental payments.
There are lots of examples of intangible assets, such as Internet domain names, copyrights, royalty agreements, trademarks, and mining rights.
Why Value an Intangible Asset?
There are several good reasons why you might want to place a value on an intangible asset. For example, you might want to account for an asset acquired in an acquisition, or maybe you want to know how much to sell it for, or maybe to set a transfer price when you want to shift it between subsidiaries. From the perspective of an accountant, the most likely reason for valuing an intangible asset is because you acquired it as part of a business combination.
How to Value an Intangible Asset
The accounting standards say that the asset should be recorded at its fair value. Fair value is defined as the estimated price at which an asset can be sold in an orderly transaction to a third party under current market conditions. An orderly transaction means that there’s no pressure to sell.
Well, that’s a nice accounting definition, but when it comes to intangible assets, a valuation can be pretty hard to do. So, within that concept of fair value, what are your options? There are three, and they are the market approach, the income approach, and the cost approach.
Under the market approach, you use the prices associated with actual market transactions for similar assets. Under the income approach, you derive a value from estimated future cash flows. And under the cost approach, you derive an estimate of the cost to replace the asset.
So, when would you pick one method over another? The market approach might be the best choice when there’s an active market for the sale of similar assets, such as the sale of franchises or perhaps broadcast licenses. It’s an especially good idea when there have been similar sales or licensing transactions recently, and especially when there have been a lot of them. With lots of this type of information on hand, it’s easier to defend any valuation you might derive.
On the other hand, the market approach is probably a bad idea when the other transactions in the marketplace are for assets that are quite a bit different from your intangible asset. In this case, you’d have to make such a large adjustment to the market data that your conclusion could be questioned. Or, the market data involves the sale of a bundle of assets, which makes it too difficult to tease out the value of just the one asset that you’re interested in.
The income approach might be a better option when the asset produces either operating income or licensing income. This would be a good choice for valuing franchise agreements, where there’s a clearly discernible cash flow associated with each one.
And then we have the cost approach, which is basically for everything else. It’s especially useful when you intend to keep using the asset, because if you didn’t have the asset already, you’d have to create a substitute for it or obtain the use of such an asset from someone else, probably in exchange for a royalty payment. On the other hand, the cost approach should not be used to value older intangible assets, since they might not have much of a useful life left.
In short, the valuation method chosen will depend on a lot of factors. For an especially valuable asset, you might need to use several methods, and then derive a midpoint valuation based on the results.
Now, how do they work? For the market approach, you have three options. First, you could search for information about the sales of similar assets outside the company, or the rates at which comparable assets are being licensed to third parties. You might be able to find this information in online databases, though you may have to pay an access fee. Another option is to run a comparison of the profit margins being earned by similar businesses that do and do not own a similar asset, where the difference is assumed to be profit generated by the asset.
That’s a tough one to justify, since there are lots of reasons for that profit differential – including the competence of management and the experience level of the work force. And finally, you could use the relief from royalty method, which is based on the royalty rate that the organization would otherwise have to pay a third party to use a similar asset. That last one is a distinct possibility, if there are licensing deals available. In short, the method used depends on the circumstances.
Moving along, how would the income approach work? That has three components. First, you need to estimate the income directly associated with the asset. For example, a patent could be used to generate a flat fee from a licensee, or a percentage of revenue, or maybe a profit split. Or, when it’s not possible to directly measure the income generated by an asset, you could compare the owner’s actual income to a benchmark measure, such as the industry’s average profitability level. Any income generated above that benchmark amount is assumed to be due to the asset.
There’s also a more complicated variation on the income approach, where you first identify all assets that contribute to the generation of income, such as working capital, real estate, and fixed assets. Then you assign a reasonable rate of return to each one. All income still left after these returns are subtracted out is assumed to be income associated with the intangible asset. This is obviously complicated, so it’s only used when there is no simpler method available.
On top of all that, the income approach also requires you to estimate the period of time over which the asset will generate income, since it usually has a limited usable life. To be conservative, you’d normally assume that this period of time is the shortest one over which income can be reasonably expected.
And finally, you’ll need to discount this stream of cash flows to a present value, which is forward-looking, and incorporates your risk of being able to achieve the expected income level. So if your future income estimates for an asset are pretty rough, then it would make sense to use a higher discount rate.
Which leaves us with how to derive a valuation using the cost approach. The typical assumption is that you’re deriving the replacement cost new, which is the cost that would be incurred to create an asset of the same utility level of the current asset, but by using the most modern approach to the work. Taking this approach tends to result in a somewhat lower cost. At a minimum, the costs to include would be all direct and indirect replacement costs. On top of that, you’d add on the developer’s profit, which is the return that the developer expects on funds invested in the development process. This might be calculated as a percentage mark-up, or as a percentage return on the direct and indirect costs.
Once you’ve compiled the asset’s presumed replacement cost, you’ll also need to subtract out a deduction for obsolescence, on the grounds that the asset being valued is usually not new; instead, it may be approaching the end of its useful life, which might call for quite a large obsolescence deduction. Another type of obsolescence to consider is external obsolescence, which is a decline in the value of an asset that’s caused by external events, such as the passage of a law that eliminates the use of taxi licenses in two years. If so, any taxi licenses you own will be completely obsolete as soon as that law goes into effect.
So, that was a lot to stuff into a single episode. The main takeaway is that you’ll need to adjust the valuation method chosen, based on the type of asset and the availability of valuation information. In some cases, this is a major chore, which is best left to a professional appraiser who will charge you a pile of money to prepare a thick report. I suggest that you only use an appraiser when the asset is quite valuable, or when the range of possible values is really broad. In short, when there’s a risk of really screwing up a valuation, dump the work onto a licensed professional.