| Intangible Asset Valuation A common question in business valuation today is what are intangible assets and what are some of the reasons we value intangible assets? The reasons are as diverse as the intangible assets themselves. Often we value intangible assets because we are required to do so, often by the government.1 Likewise, there are times where it is desirable to value intangible assets for internal business purposes, whether they are related to taxation or not. For example, determining the appropriate value of an intangible asset (or set of intangible assets) may be necessary or useful for corporate planning, establishing royalty rates, intercompany transfer prices or even litigation dispute and resolution (although often this is tied into taxation related reasons!). Regardless of the reason, it is necessary to value intangible assets carefully and appropriately. The purpose of the intangible asset valuation is often to understand not only what the intangible asset is (and does) but also how it affects the bottom line. An ethical and conscientious valuation expert will keep this in mind, and will not fall prey to the desire to value an intangible asset in a biased manner. This discussion focuses on an introduction to intangible asset valuation, including examining the definition of intangible assets, the various types and reasons for valuing them, and of course, some of the more commonly relied upon intangible asset valuation methods. The journey begins with what may seem a simple question: what is an intangible asset? Even with this seemingly straightforward question we begin to see that intangible asset valuation can often be a subjective and tricky issue. The answer to our question actually depends on whom you ask. Different valuation experts and valuation organizations have different definitions, often depending on the specific purpose and function of the intangible asset under consideration. For example, Section 197 and Section 482 of the Internal Revenue Code provide two different generalized definitions of intangible assets (albeit there are certainly similarities within the definitions).2 Likewise, other organizations and individuals have defined intangible assets from both broad and narrow perspectives. For the purpose of this discussion, one of the best definitions of intangible assets can be found in Robert Reilly and Robert Schweihs book, Valuing Intangible Assets.3 The authors define intangible assets in a narrow sense, applying a set of strict criteria, including that an intangible asset has the following attributes:
It should be noted that all of these points, except for the first one, are applicable to tangible assets as well as intangible assets. It is important to remember the distinction between that which is tangible, e.g., physical in nature and touch, and that which is intangible. Before investigating the different types of intangible assets and why we are interested in valuing them, take a few moments to examine the following list of line items. In particular ask yourself which of the following items are intangible assets.
Each of these items can fit into one of three categories: tangible asset, intangible asset or a characteristic of an asset. The tangible assets are relatively straightforward, considering the physical nature requirement. The two acres of undeveloped land and the tobacco manufacturing plant are tangible assets, as they can be seen and touched, as well as valued. The remaining line items fall into either the intangible asset category or the characteristic category. The difference is that some of the items are not really assets themselves per se; rather they are characteristics that imply some intangible value is present. Notably, the trademark, the composition, the loan portfolio and the company workforce are distinct and identifiable intangible assets. However, the longevity of a particular company and the monopoly position are not actually assets, but characteristics of intangible assets. They have no value as stand-alone "assets," but lend credence to the existence of corresponding intangible assets. For example, the monopoly position enjoyed by a particular drug company may be due to the existence of a patent, proprietary technology or some other intangible asset (whose nature is characterized by the monopoly position). One should be mindful that the distinction between intangible assets and characteristics of intangible assets is important, especially when valuing a particular intangible asset or set of intangible assets. So what are some types of intangible assets? Generally, intangible assets fall into a variety of categories, with some common ones listed below with an example of each.
Clearly there is some commonality among these categories. They are not meant to be exclusive, but rather an indication of the wide variety of intangible assets present in today's business environment. Furthermore, intangible assets are not a new occurrence, as many of the above categories (and intangible assets) have been around for a long time. What has changed is the value that is placed on intangible assets in the modern day occupational setting, thereby creating a wide variety of reasons to value intangible assets. Understanding the reason for the intangible asset valuation, whether for tax purposes, corporate planning, or dispute resolution, is paramount when considering the nature of the intangible asset under investigation. Once we have identified the intangible asset or assets, along with the reason we are conducting our valuation, we need to apply the appropriate methodology. Typically, valuation experts and appraisers employ a variety of methods and compare the final results to ensure that they are reasonable and accurate. It is erroneous to determine the value of an intangible asset using only one method. All too often there is a range of values for the intangible asset, depending on which method is employed. Hopefully, the methods will generally give similar results, although there are cases where a particular method may give an outlier. The reason for using multiple valuation methods is to ensure that the results are reasonable and you have not erroneously chosen to use just one method that happens to result in an outlier result. So what are some methods that can be used in valuing intangible assets? Usually the valuation methods are derived from three universal approaches used in the valuation theory. These are the Cost Approach, the Market Approach and the Income Approach. As we shall see, there is not only a large subset of methods within each approach, but also a large amount of overlap between different approaches. For example, it is rare to use an income approach that does not consider some of the market approach and vice versa. The Cost Approach is based on the premise that a willing buyer would pay no more for an intangible asset than the cost to produce such asset. In other words, why pay more for an already created software program if it would cost you less to develop it yourself (forgetting about copyrights for the time being). Alternatively, when considering market conditions and the time value of money, it may be more prudent to purchase the asset "as is," if in the long run the cost to develop it yourself proves higher than the purchase price. So how does the Cost Approach relate to intangible asset valuation? To gain insight into the value of the intangible asset under investigation, valuation experts often look to the Cost Approach to tell them how much it would take to "re-create" the asset, thereby giving an indication of the value. The Cost Approach typically involves two types of cost, reproduction cost and replacement cost. The difference between the two involves the effect of time that is the time between when the asset was originally "constructed" and the current time of the valuation. Reproduction cost refers to the cost to actually reproduce an exact replica of the intangible asset, without considering changes over time that may affect the cost (e.g., increased efficiency through the use of computers). On the other hand, replacement cost involves examination of what it would take to build the asset using current knowledge and technology. Once the "cost" to either reproduce or replace the intangible asset has been determined, we must consider the effects of depreciation and obsolescence. The different obsolescence factors can be attributed to one of three categories: physical, functional, or economic. Physical obsolescence refers to the physical depreciation or the wear and tear the asset has suffered over time. As you can imagine, this type of obsolescence is rarely found in intangible assets, as there is nothing to physically deteriorate (other than the physical manifestations of the intangible asset). Functional obsolescence represents the decline in value suffered by the intangible asset due to loss of functionality, of which technological obsolescence is a subset. Here the intangible asset may be in pristine condition and still fully operational, but has lost some of its value due to functional changes in the marketplace. Lastly economic obsolescence (or external obsolescence) represents a loss in value due to conditions external to the intangible asset. One example is a loss in value due to a regulatory ruling that effects the intangible asset. After deriving the initial cost, we must adjust this cost by the amount of obsolescence we have quantified in our analysis. Only after we adjust for the obsolescence do we have a good handle on the value of the intangible asset. Another approach that is usually investigated is the market approach. Here, we look toward the market to give us an indication of the value of an intangible asset (or assets). The market approach is based on examination of similar intangible assets that have been transacted in the marketplace. Unfortunately this method depends heavily on the availability and comparability of data. If there are not enough publicly available transactions, or if the comparability of the transactions is suspect, then we are better off looking to another approach. If there are a reasonable number of transactions available for comparison, the first step in the market approach is to collect data on the transactions. Included in this step is the assessment of market conditions that prevailed at the time of the transactions and how things have changed in the market given the transaction date and the valuation date. The next step is to decide upon a common unit for comparison. Once we determine the units of comparison and make any appropriate market adjustments, we can apply the pricing multiple to our own intangible asset to derive a value. For example, suppose we are concerned with the value of the FCC license of a given radio station. The license allows the radio station operator to broadcast at a particular wavelength and wattage. If we wanted to know the value of the license we may consider the market method. We would begin by collecting data on publicly available transactions where comparable licenses have been bought or sold. After considering market factors, we could decide to compare the transactions to our own intangible asset on a common unit, such as price per watt, or price per listener. Again the decision of what comparable unit is left to the discretion of the valuation expert, and often hinges on the reliability of the data. Finally we apply the pricing multiple derived from our transaction and market analysis to our own subject intangible, thereby deriving a value for our intangible asset. The most relied upon approach in valuing intangible assets is the Income Approach.4 Here, we determine intangible asset value by examining the future or expected income our intangible asset will generate. There are two main types of income approaches, the yield capitalization and direct capitalization approach. Both are loosely premised on four steps: the determination of an appropriate income measure, the estimation of a time period, the projection of the income, and the appropriate determination of a capitalization rate. The differences mainly reside in the choice of a capitalization rate, as the yield capitalization rate (or discount rate) is applicable over a discrete time period, while the direct capitalization rate is applied to a single income projection. It is important to stress that the two rates, although both called capitalization rates, are different from one another. The yield capitalization method results in an intangible asset value determined from the sum of the present value of a stream of income attributable to the intangible asset over its life. One could argue that this method is preferable to the direct capitalization method (which is based on the assumption of constant income), as it allows for changes in the income stream. In addition to these two income approaches there are numerous other approaches that can be labeled "Income" or "Market" approaches; these include incremental income approaches, the profit split method, and royalty analyses. The incremental income approaches, which can include the yield and direct capitalization methods, are based on examination of the additional income accrued by the existence of the intangible asset. The profit split method looks to split the income between the intangible asset and other tangible and intangible assets associated with it. The main key is the percentage split that is applied, where one often looks to market transactions regarding royalty or transfer agreements to determine the appropriate split. Royalty analyses examine the payment a licensee pays a licensor for use of a discrete intangible asset. These methods can be based on the actual royalty income or hypothetical royalty income. The royalty cost savings or relief from royalty method is one method based on the premise of hypothetical royalty income. Here, we are concerned with the economic benefit obtained by not having to license the intangible asset from another party. The value of the intangible asset can be examined by looking at the present value of the income saved by not having to pay the royalty. For example, suppose we are interested in determining the value of a particular brand name. Through our research we have determined that 2002 sales will be $100 million, the long-term growth rate is 3 percent, the income tax rate is 37 percent, and our appropriate discount rate is 15 percent. In addition, after extensive review of market data we can determine that a market-derived royalty rate of 20 percent of sales is accurate. To determine the intangible value of our brand, we capitalize the after-tax brand royalty sales using our discount rate and long-term growth rate. Thus, our after-tax brand royalty sales are $12.6 million ($100 million times 20 percent times one minus the tax rate of 37 percent). The value of the intangible asset is $105 million, which is the $12.6 million divided by a capitalization rate of 12 percent (our 15 percent discount rate less our 3 percent long-term growth rate). Although this is a very simplified example, it does show the general methodology of the relief from royalty method. Regardless of the method, of which there are many, it is essential to fully understand the specific intangible asset in question, to determine the purpose of the valuation, and, of course, to consider a variety of valuation methods. Each method has its pros and cons, given the often subjective and data-intensive nature of valuation. The one key to remember is to never forget the ultimate goal: to reach a final conclusion of the value that best represents the intangible asset.
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