FIN205 Topic 7: Valuation of intangible assets

Valuation of business less net tangible assets employed methods

A common method that has been utilised to value identifiable intangible assets has been to determine the fair market value of the business utilising those assets and to then subtract the fair value of the net tangible assets (NTAs) employed in that business. The entire resultant intangible component has then been allocated to the identifiable intangible assets which are the subject of review. This method, however, fails to take account of any proportion of the total value of the business that may be contributed by other intangible factors. That is, it implicitly assumes that: • there are no other identifiable intangible assets utilised in the business or entity (or if there are, the assets have no value) • no value should be ascribed to the unidentifiable aspects of the intangible component of the value of the business or entity. In particular, there is no goodwill resulting from the combination of the assets and management and their interaction with the market.

Alternative acquisition methods

Identifiable intangible assets can be acquired in a number of ways including the acquisition of the entire business, the acquisition of the identifiable intangible asset alone or some form of licensing arrangement. It is important to consider the most beneficial way in which an acquiring entity can obtain the benefit that it anticipates will flow from control of an identifiable intangible asset. This benefit should entail consideration of the vendor's financial position and objectives, with the aim of structuring a mutually beneficial acquisition agreement.

Quality of profit cover

It is important when using the relief from royalty method that the notional royalty is realistic, in absolute terms. It must also be sufficiently covered by earnings (after normalised levels of interest but before notional royalty payments). Finally, the earnings must be quality earnings and are (at least) maintainable over the life of the royalty agreement.

Transition period

Many identifiable intangible assets, and particularly those involving new processes and technology, have been developed by small teams of individuals who do not have the financial ability to commercialise their processes and ideas. Larger organisations which acquire the rights developed by these individuals need to ensure that they consider the extent to which these individuals can contribute during the initial years of commercialisation and the extent to which these individuals need to be restrained from developing competitive technology which could dilute the value of the organisation's investment. The normal means of achieving these ends is via a service agreement, potentially linked to bonus payments calculated with reference to the commercial success of the product or process. Frequently, such agreements are attractive to the vendors as a means of providing ongoing involvement in the development of the product and as a means of 'topping up' the initial vendor consideration received. Such agreements need to be carefully structured to ensure that subsequent disputes between the parties do not disrupt the commercialisation phase.

Topic learning outcomes

On completing this topic, students should be able to: • distinguish between an identifiable and unidentifiable intangible asset • explain the accounting and legal reporting requirements for intangible assets • explain the links between identifiable intangible assets and other intangible assets • apply the various methods of valuing intangible assets and know when to use them • explain the importance of relying on more than one valuation method • discuss the need to crosscheck valuations against different methodologies for overall reasonableness.

Limitations of marginal cash flow method

This method is the most rigorous and theoretically preferred method. In practice, however, it can be the most difficult for which to obtain reliable information and may imply a degree of precision beyond that justified by the real reliability of data.

Cross-checking the valuation

This part of the week describes the important final steps in the valuation process. Failing to follow these crucial steps may result in the valuation being materially incorrect. The valuation of identifiable intangible assets is a much more complex and subjective task than other valuations. For this reason, cross-checking the valuation is important. The objective of cross-checking is to confirm the value indicated by the preferred valuation methodology. Accordingly, having selected an appropriate valuation methodology (after considering and taking into account its inherent limitations) and determining a fair market value, the valuer may need to compare with other relevant methodologies (after due allowance for their theoretical and practical limitations). As set out earlier in the topic, there are a number of possible acceptable methodologies which may be used to value an identifiable intangible asset. However, these approaches are not equally appropriate alternatives. There is no one method which is always the 'best' method, nor is any one method necessarily a useful cross-check against another in every circumstance. It is a matter for the valuer to exercise their judgment in determining which approach is the most appropriate in view of all of the prevailing circumstances. The alternative method selected for any cross-check will also depend on all the relevant information being available. Provided the relevant information is available, and depending on the circumstances of the valuation, it may be appropriate to utilise alternative valuation methodologies to calculate values that may be compared with the value produced by the primary or preferred methodology as a cross-check on that value. If the alternative methodology or methodologies produces values similar to the value produced by the primary or preferred methodology, some comfort is gained that the primary or preferred methodology has produced a reasonable result. If the alternative methodologies produce values that are consistent among themselves but are highly dissimilar to the value produced by the primary or preferred valuation methodology, this may indicate that the valuation produced by the primary or preferred valuation methodology should be evaluated again in order to ensure it is appropriate. In this case, the primary valuation should also be recalculated to ensure that no errors have been made. It may even be the case that the cross-check indicates that one or more of the methodologies cannot be relied on.

Unidentifiable intangible assets

Unidentifiable intangible assets include goodwill, good management, good labour relations and in the context of transactions, synergies. AASB 138 categorises all such unidentifiable intangible assets as 'goodwill'. There are three recognised categories of goodwill: • name goodwill (or commercial goodwill) is derived from the name of the business or the names of the products it sells. It comes from the favourable reputation that either the business or its products (or both) build up over a period of time • personal goodwill is derived from the people associated with a business and is based on their experience and skills and their unique personal contribution to the business • goodwill intrinsic to land (locational goodwill) comes from the ability of land to produce income. It is based on the land's unique location and its ability to generate business. Examples include hotels and shopping centres.

Brand strength

Valuable brands generally have a number of features which include: • brand leadership — the leading brand in a market measured by characteristics such as market share, pre-eminent reputation and overall profitability is generally a much more valuable brand, with greater stability of value than lower ranking brands • longevity — long established brands tend to command greater and more durable consumer loyalty than recently launched brands • brand maintenance — brands which have been consistently and systematically promoted with quality support are likely to be more valuable than those which have not had similar advantages • awareness, recognition and inclination to buy — since brands involve customer perception, many companies systematically track brand awareness, brand recognition and customer inclination to buy. Clearly, brands which consistently score well on these criteria are more valuable than those that do not (after due allowance for advertising and marketing costs).

Preferred methodologies

While most of the methods described above have practical and/or theoretical limitations, the following methodologies are preferred due to their emphasis on separating out the benefits associated with the identifiable intangible being valued: • comparable sales (of the intangible asset) • NPV of marginal cash flows • relief from royalties. In practice, however, there are many situations where the preferred methodologies cannot be used due to lack of readily available information, particularly in relation to comparable market transactions and NPV, In such circumstances, those methodologies which are less preferred on theoretical grounds (such as the excess profits method) may have to be used. In such cases it is even more important that appropriate cross-checks are made.

Loss makers and sleepers

While the value of an identifiable intangible asset is generally limited by the above normal level of net cash flow that its ownership and use generates, this is not always the sole, or a rigid, determinant of value. If it were so, this would mean that presently unprofitable or under-utilised identifiable intangible assets had no value. This lack of value is not necessarily the case. It would wrongly imply that actions taken to increase profitability (such as sourcing cheaper materials or cutting overheads) would automatically increase the value of the identifiable intangible assets. It would also (again, wrongly) imply that actions which reduced profitability (such as price discounts or massive advertising campaigns) would reduce the value of the identifiable intangible assets. Clearly, there are circumstances where identifiable intangible assets are being so badly managed or are so under-utilised (referred to as 'sleepers', because their value can be re-awakened by a judicious marketing campaign) that their fair market value exceeds their present 'in use' value.

Royalty cover

A key reasonableness check assesses the extent to which the entity generates sufficient net profit from the use of the brand; trademark etc., to enable payment of the (notional) royalties. If the royalty payment — as a percentage of profits — is too large, there will be insufficient profits available, or at least insufficient profit cover, to support the calculated earning capacity of the identifiable intangible asset. In such instances, smaller (notional) royalty amounts should be used and the value of the identifiable intangible asset should be reduced. The extent of royalty cover varies from case to case, depending on the industry, anticipated growth profile and profitability. However, as a very broad guide, a royalty cover of three to four times would be much more likely to be sustainable than a lower cover over the long term, having regard or allowance for the return required by investors on other assets employed by the entity (e.g. plant and equipment). It should also be noted that at low levels of royalty cover, the imposition of a significant (notional) royalty charge against profits has a similar impact on enterprise value to the imposition of a substantial debt burden. That is, the quality of profits, their variability and the risk attached to profits being earned would all be adversely affected. Thus, the notional top-down entity valuation cross-checks for reasonableness should, at the very least, take these factors into account.

Brand valuation — UK experience

A study for the UK Institute of Chartered Accountants undertaken in 1989 revealed that brand valuations were based on methodologies that were inherently hazardous and concluded that to allow brands (whether acquired or internally generated) to continue to be included in the balance sheet would be highly unwise. The UK study also concluded that it is impossible to separate identifiable intangible assets from the business as a whole to ascertain their worth in a manner likely to meet the accountant's test of measurability. The study could find no valuation method in which it had any confidence, because the methods rely extensively on assessments of an uncertain future and no separate identifiable market exists in which brands (and other intangibles) are traded. This study also found that there was little popular support of brand valuations, with business analysts finding little use for them and providers of finance ignoring them. The study also noted that more brands fail (approximately 80%) than survive. Given that neither the International Accounting Standards Board (IASB) nor the US Financial Accounting Standards Board (FASB) come from a revaluation background (as Australia does), it is easy to see why revaluing identifiable intangible assets is effectively banned under IFRS. The following reading discusses the building and growth of brands and highlights the issues that need to be addressed to ensure that a brand is successful.

Recognition criteria

AASB 138 sets out the criteria to recognise an intangible asset for accounting purposes. The criteria for recognition as an intangible asset are: • the resource is controlled by the entity • future economic benefits exist • separate identifiability — being capable of separation from the entity (individually or collectively) or arising from contractual legal rights. AASB 138 describes the nature of each of these criteria and includes additional requirements for compliance with the standard including identification, recognition and measurement, and measurement after recognition. In contrast to the previous accounting framework — that is, pre-International Financial Reporting Standards (IFRS), an intangible asset does not now have to be individually separable from the entity or the business to which it is attached in order for it to be recognised as a separate asset. Consequently, before the introduction of IFRS, many contracts with beneficial terms may not have been recognised as an asset of the entity because they were not assignable to third parties, or were not assignable without the approval of the other contracting parties. Now, in accordance with the requirements of AASB 138, such contracts are often required to be recognised as assets to the extent the identification criteria can be met. Control of the future economic benefits of a resource is required for it to be recognised as an asset. If the entity does not have the power to control those benefits or restrict the ability of others to access those benefits, then the recourse is not considered attributable to the entity. In other jurisdictions, the resource of an in-place and trained workforce has previously been recognised as — and given the status of — an intangible asset in business enterprises. AASB 138 specifically refers to such a resource and notes that the entity usually has insufficient control over the expected future benefits arising from the workforce and their training to meet the definition of an asset. It is important to note that intangible assets are only required to be recognised for accounting purposes as a result of a business combination (merger or acquisition). Internally generated intangible assets (e.g. goodwill) are unable to be recognised as an asset.

Limitations of excess profits method

Although this method theoretically relies on the future economic benefits obtained from the use of the assets, it has the following major limitations: • the required rate of return may reflect risk and other factors which cannot be separately assessed with precision • the method does not allocate between any constituent components (such as different brand names), unless other intangible assets are first identified and an appropriate return is deducted from future maintainable profits. As for the gross profit differential method, the excess profits method assumes that the entire excess return over the required rate of return on the assets (for an unbranded product) is attributable to the presence of the intangible asset identified, (e.g. customer contract). It ignores the possibility that other intangible factors including goodwill may have an influence on the excess profits being earned • the valuation of some of the tangible assets employed may also incorporate some of the intangible value (e.g. plant and machinery may be valued on the basis of 'value in use') • information about technological developments from potentially competitive products is generally not available and/or its impact is difficult to assess • the assets being valued may not be employed in the best possible manner. In other words, this method implies an 'existing use' basis for the valuation. This is why it is important to determine the basis of the valuation initially and to use an appropriate methodology • asset values and reported profits may be calculated on different bases • theoretically, any company earning an excess profit margin will generally have that margin eroded over time by competitive pressures • branded products, if successful, generally have the benefit of lower depreciation charges (because of fully depreciated assets or assets acquired at a lower historic cost base) and the benefit of the learning curve at all levels of operation • the required rate of return may be taken into account in setting the sale price of the product. The inherent theoretical and practical difficulties associated with this method suggest that it be adopted as a primary valuation methodology only if caution is exercised. This method is used in a remainder value context, in that the values and economic rentals (contributory asset charges) of all the other identified assets are deducted from the earnings of the business acquired. The remaining earnings are asserted to be those attributable to the asset in question, the customers and the relationships arising from the contracts with customers. The use of this approach inherently assumes that all other tangible and intangible assets have been identified before the residual asset, (e.g. customer contract) can be valued. This approach is common given the difficulties in directly assessing the value of customer contracts using one of the other methods discussed.

Intangible assets

An asset is a resource that is controlled by an entity as a result of past events, from which future economic benefits are expected to flow to the entity. Australian Accounting Standard, AASB 138 Intangible Assets, states that: an intangible asset is an 'identifiable non-monetary asset without physical substance' and an asset is 'a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow' to the entity.

Link between identifiable intangible assets and goodwill

An identifiable intangible asset may be employed with a number of other identifiable intangible assets (e.g. the brand name of a beer and its secret formulation). The degree of difficulty and cost associated with determining, so far as it is possible to do so, a reasonably accurate allocation of the future economic benefits to the individual assets, needs to be considered with respect to the benefits of the valuation. The future economic benefits may be so highly dependent on the other assets employed in the business that they are incapable of being properly segregated. In the past, some people have taken an incorrect approach to accounting for intangible assets. They have either treated the total difference between the acquisition price of the business and the value of the NTA as goodwill, without regard to identifiable intangible assets. Alternatively, they have attributed the whole of the difference to one category of identifiable intangible asset and ignored, among other things: • whether or not this value is sustainable • the value of other identifiable intangibles • the value of any goodwill.

Global brands

Brands that are internationally recognised and accepted are inherently stronger than local brands. This success is attributable to the substantial investment made in their development and maintenance, their consistent positioning, their established 'routinised' preference, incremental demand from people who travel internationally on business or holidays and their diversified geographic distribution. These features make them less vulnerable to, or more able to sustain, competition or other pressures in any one market. Example: Global brands McDonalds and Coca-Cola are well-known global brands. They each offer customers reassurance as to quality and consistency at an affordable price. Their product attracts customers around the world because it is a product they know, trust and like, even where there are alternatives which may offer better value based on lower price, superior attributes or even a combination of both. However, it is also important to note that brand recognition and value varies significantly from region to region. This may be due to fundamental differences in economic factors, such as per capita income or simply, cultural differences.

Separating identifiable intangible assets from other intangible assets

Conventionally — although not always correctly — the total value of intangible assets is measured by deducting the value of identifiable net assets (i.e. net of liabilities) from the value of shareholder equity. Determining the value of specific components of the intangible assets — such as brand names, licences, trademarks, customer lists and goodwill — is more difficult. However, valuation practitioners have developed methods to estimate these values. Due to the differing accounting treatments for goodwill and identifiable intangible assets, there was a tendency, prior to IFRS, for many companies to overvalue their identifiable intangible assets and undervalue goodwill (e.g. the inflated value of television and radio licences in the 1980s) on the basis that goodwill was previously required to be amortised over its useful life. The introduction of IFRS has resulted in more companies preferring to identify fewer intangible assets and allocate more value (residual value) to goodwill in a business combination. However, the recent financial crisis has tested this approach following a series of goodwill impairments being reported by Australian listed companies. Under IFRS, goodwill (and in some cases identified intangible assets) are not amortised, but instead tested for impairment on an annual basis (further described in section 6 of this topic). All other intangible assets are amortised over their respective remaining useful lives. Under the efficient market hypothesis, the market should not be fooled by management's attempts to increase EPS by reducing the relative value of identifiable intangibles, as opposed to goodwill. Indeed, many stockmarket analysts reporting to Australian institutional investors add back intangible asset amortisation and impairment (which clearly has no cash flow impact) in assessing the value of securities. Despite the fact that intangible asset amortisation has no cash flow impact and is added back by virtually all major investors in forming their investment decisions, the amortisation remains a focus and consistently generates questions in investor briefings by companies. In recent times (e.g. at the onset of the financial crisis), there has been a focus on the level of goodwill accumulated in businesses, particularly where the goodwill has arisen from acquisitions at the peak of capital markets immediately prior to the financial crisis emerging in 2008.

Impairment of intangible assets

During the global financial crisis, several Australian listed companies reported an impairment of intangible assets (primarily goodwill) that had previously been recognised as a result of recent acquisitions. The reporting of an impairment resulted from the carrying value of the intangible asset exceeding the recoverable amount at the time the impairment test was conducted. The announcement of an impairment or asset write-down may have included, but not been limited to, one of the following: • the original acquisition being conducted at a price in excess of the fair value of the asset or business at the time of acquisition • the realisation of a special premium (e.g. through buyer specific synergies) not eventuating as originally anticipated • insufficient value being allocated to amortising intangible assets • a fundamental decline in the expected profitability (say from loss of competitive position) of the business. In spite of the above factors, companies continue to report to investors the prospective EPS impact of a recently completed acquisition, after allowing for the expected amortisation of identified intangible assets with a finite life. Despite intangible asset amortisation having no effect on cash flows, the introduction of IFRS has renewed the focus on amortising versus non-amortising (e.g. goodwill) intangible assets.

Why value intangible assets

For many modern companies, a significant amount of their market capitalisation lies in intangible assets. However, many companies trade at multiples of their net tangible asset backing, particularly those companies that do not require significant fixed assets. In order to manage shareholder value, companies need to recognise the importance of their intangible assets, measure their value and changes in that value, and properly manage what is often their largest single asset (or group of assets). Despite the self-evident importance of intangible asset values, many companies have no formalised process for measuring their value other than by way of measuring their total value inherent in the value of the business. From an analytical and accounting perspective, intangible assets are categorised into: • identifiable intangible assets (e.g. trademarks, licences, customer contracts) • unidentifiable intangible assets which are residual components of value and which are commonly referred to as 'goodwill' (e.g. reputation, management capability, market share). Apart from the sound commercial management of what is often an important and valuable asset to an entity, the valuation of identifiable intangible assets is also required for: • accounting purposes in takeovers and for asset revaluations and impairment testing under Australian Accounting Standards • mergers, takeovers, capital raisings and floats (particularly if they form a significant portion of the value of the company) • determining capital gains tax (CGT) liabilities • claiming deductions for income tax purposes (in some cases) • stamp duty.

Amortisation of intangible asset values

Given the long-established practice, at least in pre-IFRS Australia, of companies arbitraging between goodwill and identifiable intangible assets, there has been a longstanding debate as to whether identifiable intangible asset values should be amortised. Historically, many companies did not amortise identifiable intangible assets on the (purported) grounds that the asset did not have a finite useful life; and/or that sufficient annual maintenance costs are incurred that either the identifiable intangible asset did not depreciate in value or that if it did, the extent of annual diminution in value was not material. Proponents of the view that identifiable asset values should be amortised cite the accounting standard requirements in order to depreciate plant, machinery and buildings. Where depreciation is appropriate, the annual depreciation charge is a function of the nature of the asset, its expected useful life and its estimated residual value. From a valuation perspective, the better economic answer is that identifiable intangible assets should only be amortised if their value falls. However, given the widespread valuation errors that occur in practice and the relative rarity of write-downs of identifiable asset values other than in crisis situations, the pragmatic economic response that an annual impairment assessment is sufficient to determine the necessary level of amortisation is less reliable than its proponents claim. However, this is what AASB 136 now requires. To further complicate matters, the impairment test under AASB 136 may be ineffective as the otherwise expected impairment write-down may be delayed, or avoided, as the write-down may be shadowed by: • the value of other identifiable intangible assets whose revaluation is largely prohibited under IFRS • the value of unrecognised internally generated goodwill • the unrecognised value of other intangible assets in the same cash-generating unit (CGU). The CGU is the new reference point under IFRS for impairment testing. CGU replaces asset classes chosen as the reference point before IFRS. Source: Lonergan 2005. At a practical level and bearing in mind that amortisation has no annual cash flow effect on the entity, it is prudent to at least cross-check the royalty cover, gross profit differential and other relevant methods after allowing for notional amortisation of the identifiable intangible asset value over its expected useful life or 20 years, whichever is shorter.

Relief from royalty method

In addition, valuation practitioners may consider applying a discounted cash flow (DCF) approach to valuing an intangible asset, particularly where the business experiences fluctuating sales, or is in a period of growth or decline.

Example: Identifiable intangible assets

Identifiable intangibles set out in the illustrative examples that accompany AASB 3, include: • market-related intangible assets: - trademarks, trade names, service marks, collective marks and certification marks - internet domain names - trade dress (unique colour, shape or package design) - newspaper mastheads - non-competition agreements • customer-related intangibles assets: - customer lists - order or production backlog - customer contracts and related customer relationship - non-contractual customer relationships • artistic-related intangible assets: - plays, operas, ballets - books, magazines, newspapers and other literary works - musical works such as compositions, song lyrics and advertising jingles - pictures and photographs - video and audiovisual material, including films, music videos and television programmes • contract-based intangible assets: - licensing, royalty and standstill agreements - advertising, construction, management, service or supply contracts - lease agreements - construction permits - franchise agreements - operating and broadcasting rights - use rights such as drilling, water, air, mineral, timber-cutting and route authorities - servicing contracts such as mortgage servicing contracts - employment contracts with pricing that is beneficial to the employer • technology-based intangible assets: - patented technology - computer software and mask works - unpatented technology - databases - trade secrets such as secret formulas, processes or recipes.

Legal and reporting requirements

In Australia, compliance with accounting standards is mandatory by law for reporting entities (in essence, all large companies). Section 296 of the Corporations Act 2001 requires compliance with accounting standards and regulations. Section 297 requires that the accounts present a true and fair view. AASB 138 outlines the recognition of internally generated goodwill. This recognition is consistent with accounting standards throughout the world. The standard states that this recognition is because it is not an identifiable resource (i.e. it is not separable, nor does it arise from contractual or other legal rights) controlled by the entity that can be measured reliably at cost. Intangible assets that meet the criteria for recognition shall be initially measured at cost and where the cost method is adopted, shall be carried at cost less any accumulated amortisation and impairment losses (as required under AASB 136 Impairment of assets). After initial recognition at cost, intangible assets may be carried at fair value (less any amortisation and impairment losses) where the fair value can be determined by reference to an active market for the assets. On the acquisition of a business, the cost of the underlying assets acquired must be recognised at their fair value at the time of the acquisition in accordance with AASB 3. The accounting standards require that purchased goodwill be measured as the difference between the purchase consideration (including equity or debt issuance costs directly attributable to the business combination) and the fair value of the identifiable net assets (including identifiable intangible assets acquired). As goodwill is a 'residual value', it is important that the net tangible assets (NTA) and identifiable intangible assets be correctly valued. Section 294(4) of the Corporations Act previously required that assets were not carried in excess of their notional replacement cost; however, that section has been repealed (Company Law Review Act 1998). AASB 138 requires that intangible assets be carried at their cost (or if able to be revalued under the standard, the revalued amount) less any accumulated amortisation and accumulated impairment losses. An impairment loss is measured as the difference between the carrying amount and the assets recoverable amount as per AASB 136. 'Recoverable amount' was defined as the net amount that is expected to be recovered through the cash inflows and outflows arising from its continued use and subsequent disposal. AASB 136 requires that the recoverable amount be estimated whenever there is an indication that the asset may be impaired, and that an impairment loss be recognised whenever the recoverable amount is less than the carrying value of the asset. The recoverable amount of an asset is the higher of its fair value and its value in use, both calculated using the net present value method. This standard includes a list of indicators of impairment to be considered at each balance date. AASB 138 'Intangible Assets' now prohibits the revaluation of identifiable intangible assets such as brands, mastheads, publishing titles and customer lists. This standard requires that intangible assets can only be revalued if fair value can be determined by reference to an active market (in practical terms there is no active market for most intangible assets) and that an intangible asset must be amortised over the best estimate of its useful life where it is finite. In some cases, intangible assets may have an indefinite useful life to the extent that there is no foreseeable limit to the period over which economic benefits are expected to be generated.

Capitalisation of historical profits

In essence, the capitalisation of historic profits method determines the value of a brand name by multiplying the historical profitability of a brand by a multiple that had been assessed after examining the relative strengths of the brand. While this method recognises some of the factors that should be considered in the valuation of a brand name, its major shortcomings are as follows: • being based upon the historic profitability of a brand, it does not take account of future profit growth or decline attributable to the brand • net tangible assets fundamental to the generation of profits are not separately assessed with the use of total profits as a base for the valuation, resulting in a significant over-valuation • the selection of the capitalisation multiple is made without reference to the established markets for securities and accordingly, this method will not allow any reconciliation to be made between the total value for the business and the values of its component parts, including industry brand names. In many cases, past performance will give some indication of the future. However, given that the fair market value of an asset is based on its future net economic benefits rather than past benefits, this is a critical failing of this method. Moreover, it is inherently difficult to identify the proportion of past profits which has been generated by the particular identifiable intangible asset. Some valuers of brand names consider that this approach provides the best determinant of brand value and apply a multiple of earnings to either historical or forecast profits (or combination of both). The appropriate multiple is determined by examining the characteristics that are unique to the brand (see section 7.1 below for some of these factors).

Definition of fair market value

In most business or equity valuations, 'fair market value' is usually defined as (Lonergan 2003): the amount for which an asset would be exchanged between a knowledgeable, willing, but not anxious seller and a knowledgeable, willing, but not anxious buyer acting at arm's length in an open and unrestricted market. While this definition is also widely applied to valuations of intangible assets, as with all valuations, it is important that due consideration is given to the underlying purpose of the valuation. A clear distinction often needs to be made between value determined on an 'existing use' basis as compared with value determined on an 'available use' basis. The idea being that 'available use' recognises that an asset is not always put to its most efficient use, or that when combined with other assets it can have an extended use. The IFRS has, however, adopted the term 'fair value' to represent the concept noted in the previous paragraph as 'fair market value'. The 'fair value' nomenclature is already in use in Australia and elsewhere to describe something different to that required by the IFRS standards and is likely to be the cause of some confusion in the future.

Limitations of gross profit differential method

In reality, the gross profit differential method is almost impossible to apply with a high degree of reliability (or more importantly, to a level of reliability required by a prudent valuer or prudent preparer of financial statements). Its major limitations include: • the gross profit differential does not explicitly consider the net tangible assets employed and a reasonable required rate of return on those assets • the gross profit differential may principally be a reflection of factors other than the trademark or brand name (such as cost efficiencies in production and/or distribution attributable to economies of scale). These 'goodwill' factors should not be confused with the value of the actual identifiable intangible asset • information with respect to cost, volumes and marketing expenditure of the other products may not be available or reliable. This may particularly be the case in circumstances where the products are sold through mass retailing outlets • it may be difficult to find a suitable non-branded or generic product available for comparison and even if there is a similar generic product, it may not be strictly comparable due to differences in quantity, quality and/or availability • in practice, it is rare for there to be much (if any) empirical evidence on price elasticity or substitutability of the branded and generic product • it is sometimes difficult to ascertain how much of the margin difference is attributable to the brand name and how much to other factors (e.g. product formulation) • no allowance is made for trends in relative market share over time (e.g. a generic competitor may have only recently entered the market) • the gross profit differential method implicitly biases valuations in favour of industries with a lower proportion of variable costs to total costs. It should be noted, however, that market share held by generic brands is surprisingly high for many consumer products. Trends in generic market share penetration can have important implications for brand values.

Other factors contributing to profit margins

In some circumstances, the key driver of the value of intangible assets may be, for example, location or other goodwill-type features rather than the value of the patent, licence or brand encapsulated in the royalty rates. It is important to identify the real profit drivers of branded, licensed or patented products. For example, a product's market penetration may be driven by factors such as the physical location of its manufacturing or production plants (e.g. convenience of sugar mills to a sweets manufacturer), the existence and location of its distribution networks or the quality of service offered, and not by its patented technology, licensed product or brand name. These other factors are associated with what is generally referred to as 'goodwill'; they are not features of the patented or licensed branded product as such. Due allowance also has to be made for working capital and other assets required to operate the business.

Marginal cash flow method

In the marginal cash flow method, the value of the marginal cash flows that result from the employment of the intangibles is calculated using either the capitalisation or net present value (NPV) methods (i.e. cash flows with and without the intangible asset being employed). In some instances, in valuing a lease (NPV), current market rates and future cash flows might be readily determined together with the period over which they are expected to remain. In other situations, it may be extremely difficult — or even impossible — to quantify the future marginal cash flows which result from an individual intangible asset.

Expectations of future economic benefits

One fundamental criteria for an identifiable intangible asset is that there must be future economic benefits flowing from the intangible asset. This concept requires allocation of the cash flows utilised in the assessments of values to be those attributable, or flowing from the asset in question. Economic benefits represented by cash flow may derive from many different sources, and may do so in many and varied combinations of sources. The requirement of the standard to attribute value to each of the intangible assets identified mirrors the general valuation proposition that the asset's worth is defined by that which flows from it. The difficulty in business enterprises is that the economic benefits (represented by cash flow) are not normally recorded or managed by reference to the individual assets to which it relates. The standard means that the valuation techniques and methods discussed in the subsequent sections of this topic must be applied to the economic benefits attributable to the individual assets. Accordingly, a process of allocation of the entity's economic benefits between its assets is most often required in one form or other. Hence, the benefits of current advertising and other promotional and marketing activity which may not be attributable to the asset must be separated from the value of a brand name or trademark. Consequently, in assessing the future economic benefits of the brand name, it is important that cash flows are net of the ongoing costs associated with the maintenance of the brand name etc.

Royalty rates

Only low or zero royalty rates should be applied to products whose profitability is primarily driven by other factors, such as geographic distribution. Generally, only low (or even zero) royalty rates would apply to: • low technology businesses (e.g. vinegar production) • products used by other manufacturers where brand names are of low importance (e.g. flour used in packaged cake mixes) • technology available from a number of potential suppliers • existence of a strong market-dominant competitor • businesses with a reliance on wholesale (business to business) relationships where the underlying product, service or tangible assets is more important to the customer. Conversely, higher royalty rates would apply to: • higher margin products • long established, widely recognised consumer brand names • products with high/dominant market share • products with unique patented technology features. In the following example in Table 1, the value of a brand for a retail fast food outlet is assessed.

Commercialisation costs

Prior to acquiring identifiable intangible assets, consideration should be given to the costs which will be incurred in either commercialising or supporting, on an ongoing basis, the identifiable intangible asset being acquired. In the case of new technologies, this may involve further research and development expenditure, tooling of plant and training of employees, significant market research and subsequent marketing expenditure plus initial start-up costs of production facilities. In the case of existing identifiable intangible assets, ongoing expenditure may be required in terms of further research and development, brand support or acquisition of specialised plant and equipment.

Brand maintenance costs

The imputed royalty value should be calculated net of the identifiable intangible asset owner's costs of maintaining the value of the intangible asset, such as ongoing product design costs, advertising, marketing, quality control, ongoing research, legal and administration costs depending on the basis of the arrangements utilised as exemplars of such royalty arrangements. Some royalties are payable on the basis that the owner (not licensee) will conduct the marketing and brand maintenance (similar to franchise arrangements). Most commonly, it is the licensee of the property who is charged with the responsibility to maintain the brand with such expenditure. A common misapplication of the method is to deduct maintenance costs from the notional royalties formulated, when the basis of those royalties is that the exploiter of the asset bears the cost. Consequently, in the context of utilising the method for the purposes of valuing an asset in the hands of the owner, the net cash flow to the owner excludes the maintenance costs and is a principal factor in the size of the royalty rate in the first instance. It is also relatively difficult in practice to obtain much, if any, debt finance against the security of a stand-alone royalty-producing asset. Thus, weighted average cost of capital (WACC) discount rates generally apply only to low levels of debt finance (say, between zero and 20%) in calculating the WACC discount rate. Notwithstanding this, where the intangible asset subject to valuation is an integral asset in generating future cash flows (i.e. inextricably linked to the operations), then an appropriate discount rate may approximate the WACC of an entity.

Limitations of relief from royalty method

The relief from royalty method is prone to the following errors: • the failure to recognise the variation in the future economic benefits which result from different intangible assets (including goodwill) • the possibility that reference rates (royalty percentages, royalty cover etc.) may be out of date and might not properly reflect current economic conditions • the normal rates are established on an average of a number of transactions about which detailed information is not usually available • reasonability tests of the maximum acceptable royalty rates, profit cover of royalty and percentage of total intangible value may be highly subjective • relatively small changes in assumptions can significantly affect value (e.g. a 1% change in royalty rate to 6% would increase the brand value by 20%) • full details of other licensing arrangements (including any limitations on the use of the licence) are rarely available • most licence arrangements incorporate an exclusive non-competitive geographic market and hence contain an element of locational goodwill. Unless the royalty is calculated solely on net profits after tax excluding the royalty, the liability to pay a royalty would increase the risk inherent in the future cash flows. This extra risk should be taken into account in establishing the appropriate discount rate or capitalisation rate. In reporting on an investigation into Burns Philp (discussed further below) ASIC correctly noted that the relief from royalty method was vulnerable to distortion if there were even 'relatively small changes in the revenues, royalty rates and discount rates used in calculating the valuations'.

Cost-based valuation methodologies: historical or replacement cost

The use of historical cost to value intangible assets is derived largely from accounting and not valuation practices. Even in accounting practice there are various market value constraints applied, including 'lower of cost or market', 'recoverable amount' etc. Clearly, the value of an identifiable intangible asset is derived from its future economic benefits, and not its cost. In particular, historical cost: • ignores the effect of inflation • ignores the time cost of money • implicitly (and incorrectly) assumes that there is a direct relationship between cost and prospective profits • may be distorted by differing accounting policies and/or arbitrary amortisation policies • may place an excessive valuation on less successful brands at which high levels of expenditure have been directed • may place low values on successful brands on which there has been relatively little expenditure or where the owner of the brand has 'struck it lucky' • assumes that costs incurred have been spent appropriately. For these reasons, historical cost is generally not an appropriate primary valuation methodology, but is often used as a cross-check or to establish a minimum limit on the value of an intangible asset. However, the current replacement cost (net of tax) of an identifiable intangible asset may be relevant to the valuation process in circumstances where the only barrier to entry is the cost of establishing a comparably successful brand. In these circumstances, the replacement cost (net of tax), if reliably determined, would represent a maximum value for the identifiable intangible asset. However, for some products it would be practically impossible to 'replace' a brand name. The cost basis is often used in valuing intangibles that are at an early stage of development or where the asset does not directly generate any cash flows by which another valuation method could be applied. For example, software platforms employed by a business rarely generate a return in their own right, but may be critical to the operations of a business. Accordingly, valuation practitioners often consider the replacement cost or opportunity cost of the asset in estimating fair value. However, for all the reasons stated above, historic cost valuations should be regarded as 'valuations of last resort'.

Identifiable intangible assets

There is no generally agreed definition of an identifiable intangible asset. The introduction of the Australian equivalents of IFRS has however, from an accounting perspective, formulated a common base for the financial reporting of such assets. It is generally accepted that the accounting and financial reporting definitions are the de facto standard for the identification and management of identifiable intangible assets. The relevant accounting standards for the identification and recognition of intangible assets are AASB 138 Intangible Assets and AASB 3 Business Combinations.

Limitations of valuation less NTA method

This method is clearly unacceptable for the valuation of identifiable intangible assets, as it fails to make the fundamental distinction between the respective identifiable and unidentifiable intangible assets of a business. However, this method would generally place an upper limit on the value of identifiable intangible assets on an existing use basis, provided that the fair market value of the business has been correctly assessed. Of course, it is possible to allocate the value of intangibles determined by this method across each of the various intangible assets (both identifiable and unidentifiable); however, this would require a high level of judgment on the part of the valuer, with usually little market evidence available to support the conclusions drawn.

Gross profit differential method

This method is commonly used for trademarks and brand names. In this method, the difference between the margin of a branded product and an unbranded product or generic product is utilised in the calculation of value. In determining the margin, both the prices and volumes need to be considered and full allowance needs to be made for the maintenance cost of the trademark or brand names. However, due to difficulties in defining the relevant components of gross profit, the actual methodology applied generally focuses upon sales price differentials (adjusted for differences in marketing costs).

Taxation consequences

When structuring the acquisition of intellectual property rights, both acquirers and vendors need to consider potential taxation considerations and, in particular, potential capital gains tax (CGT) issues. This complex issue is beyond the scope of this subject.

Identifying the real profit drivers

When valuing an identifiable intangible asset, it is important not to include in the value of that asset some other factor (or factors) which may be contributing to, or is the main driver of, profits and cash flow. There are a large number of factors which may enable an entity to generate above-average rates of return. The essential difficulty that arises in valuing identifiable intangible assets is in identifying the real drivers of business profitability. Care has to be taken to identify the real drivers of value and to correctly include such factors in the value of the identifiable intangible asset being assessed. It is important to distinguish between the value of the business and the value of the identifiable intangible assets.

Reconciliation of the valuation

Where an identifiable intangible asset being valued is material to the value of the business as a whole, the fair market value of the business should be reconciled to the fair market value of the identifiable net assets comprising the business (both tangible and intangible) and the resulting goodwill. The reconciliation should be reviewed to ensure that all the assets and liabilities have been properly valued and that there is sufficient allowance for goodwill, if appropriate. Appropriate consideration must also be given to issues such as royalty (or profit) cover and the long-term ability of the entity to generate profits (using appropriate accounting policies) and cash flows. In some cases, it is possible to consider the reconciliation of the valuation on the basis of the weighted average return on assets (WARA). The WARA process involves estimating an appropriate return that would be required by a prudent investor on each of the assets (tangible and intangible) and liabilities employed. The individual rates of return are applied to the fair market value of each balance, inclusive of goodwill. The WARA can be compared to an overall return, or WACC, that may be required to invest in the business in which the assets and liabilities are employed. This WARA calculation can allow an overall assessment of the reasonableness of the total fair market value of assets and liabilities. The approach can also highlight where too much or too little value has been allocated to goodwill as opposed to identified intangible assets. One major limitation of this approach is that it requires an estimate of an appropriate return on each category of asset and liability (e.g. plant and equipment, working capital), which is inherently subjective. A simplified example is contained in the table below.

Comparable market transactions

While actual transactions can be regarded as the most tangible evidence of value, identifiable intangibles are normally exchanged as part of the sale of a company or business and there is little or no secondary market in such items. It is therefore generally unlikely that there will be comparable sales of identifiable intangibles to refer to. However, even if there are 'comparable' sales, in reality it is generally difficult to compare them due to the individual circumstances of each transaction, particularly: • where the transaction recognised a special value to the purchaser (e.g. Incitec Pivot/Dyno Nobel) • if one or both parties to the transaction (or if the observer of the transaction) was not fully informed and/or did not act on a prudent basis • if economic conditions generally, and rates of return in particular, have changed • if the parties did not have comparable negotiating abilities • where the degree of comparability between the assets being valued differs. Observed transactions may represent certain values to the existing business or may reflect transactions where the identifiable intangible assets are (or are deemed to be) much more valuable to the new owner. The values observed will therefore depend on the specific identity and intended purpose of the purchaser. The valuer should take this into account, depending on whether the valuation is being conducted on an existing use or alternative use basis. On balance, comparable sales are an ideal test, but they can rarely be identified.