M & A
Unlike in accounting, where
the accounting for tangible assets and intangible assets is different, the same
is not the case in valuation. Whether an asset is a tangible asset or an
intangible asset, the concept of valuation does not change. However, globally
with the exchange of only intangible assets being infrequent and the market for
intangible assets not fully developed, the subjectivity involved in the
valuation of intangible assets is more than, say, for valuation of equity shares
or valuation of a business. In this article we will discuss the various methods
of valuation of intangible assets. We will not discuss the identification or
recognition of intangible assets here, but the valuation of an identified
intangible asset.
At the end of the discussion
we will also touch upon the recent acquisition of Cadbury by Kraft Foods.
Examples of intangible
assets :
Different industries have
different value drivers and thus different intangible assets. There is no
exhaustive list of intangible assets, but accounting guidance from US GAAP and
IFRS give us the following examples as given in the chart.
Approaches to valuation of
intangible assets :
Similar to valuation of any other asset,
there are three basic approaches to valuation of intangible assets viz. the cost
approach, the market approach and the income approach. Again as applicable to
valuation of any other asset, the use of any of the above approaches differs
from asset to asset and industry to industry. Also an intangible asset in one
industry may not be an intangible asset in another industry and the economic
benefit of the same intangible may differ from industry to industry and in the
same industry from company to company. The following are the generally accepted
methods that are used in valuation of intangible assets :
Cost approach :
l Valuation is based on the cost to reproduce or replace the asset and the
principle of substitution
l The valuation of an asset using the cost
approach is based upon the concept of replacement as an indicator of value
l The premise is that a prudent investor would pay no more for an asset than
the amount required to replace the asset afresh. Value is not the actual
historical cost of creating the subject intangible asset. It is also not the
sum of the costs for which the willing seller would like to be compensated
l The approach establishes value based on the cost of reproducing or
replacing the asset, less depreciation from physical deterioration and
functional obsolescence, if present and measurable
l Applications :
Reproduction cost
Replacement cost
Market approach :
l Valuation is based on transactions involving the sale or licence of
similar intangible assets in the market place and the principles of
competition and equilibrium
l Value is derived by analysing similar intangible assets that have recently
been sold or licensed and then comparing these transactions to the subject
intangible asset
l Applications :
Transaction multiples derived from (the sale or
licensing) of the comparative intangible asset.
Income approach :
l Valuation is based on the present value of expected future cash flows to
be derived from ownership of the asset and the principle of future benefits
l Value of the subject intangible asset is the present value of the expected
economic income to be earned from the ownership of a particular intangible
asset
l Primary applications :
Relief from royalty
Excess earnings
l Other applications :
Discounted cash flow
Incremental cash flows/profits
Profit split
Valuation methodologies for intangible assets :
Replacement cost method under
the cost approach :
This method represents the hypothetical cost that would be
incurred to replace the subject asset by a new asset of similar utility.
Reproduction cost method under
the cost approach :
This method represents the hypothetical cost that would be
incurred to recreate or reproduce (either by constructing or by acquiring) the
subject asset by a new asset of similar utility.
After establishing the replacement/reproduction costs,
adjustments are made to represent any losses in value resulting from physical
deterioration and from functional and economic obsolescence. The above methods
are generally used when a substitute can be developed in-house and are normally
used in valuing intangible assets like assembled workforce, internally developed
software, etc.
Comparable transactions method under the market approach :
l The value of an asset under this method is measured through an analysis of sales and offering prices for the comparable asset. Such prices are then adjusted for differences, if any, between the comparable asset and the subject asset. This method is similar to the comparable transaction multiples approach used in business valuations.
-> The two requisites in this approach are an active public market and an exchange of comparable assets.
-> The key is to select the most appropriate/ relevant transaction multiples involving intangible assets. The difficulty however is in finding comparable assets and the adjustments required to make it comparable to the subject asset.
-> On account of the infrequent activity happening in intangible assets, generally this method can be made applicable to brands only.
Relief from royalty method under the income approach:
-> This method is based on the principle of opportunity cost.
-> The value of an asset under this method is the present value of the future savings that is available to the owner on account of his owning the subject asset.
l Had the owner not owned the asset, he/she would have had to license in the asset for which it would have had to pay a royalty. By owning the asset, the owner is thus saving these costs. This savings is generally quantified in terms of royalty savings on revenues.
l The general steps to implement this method are:
- research licensing transactions with comparable assets to establish a range of market levels for royalty rates
- select a royalty rate or range of royalty rates
- apply the selected royalty rate to the future revenue stream attributable to the asset
- use the appropriate marginal tax rate to arrive at an after-tax royalty rate
- discount the resulting cash flow stream to the present using an appropriate risk-adjusted discount rate.
Excess earnings method under the income approach:
- This method is based on the principle of elimination and residual value and is similar to the discounted cash flow method except that it does not take into account the cash flows but the earnings.
- This method considers assets in isolation from all other assets. Assets do not generate cash flows in a vacuum — they also utilise contributory assets to generate earnings and hence to isolate the earnings attributable only to the subject asset, contributory charge on such assets are deducted.
The main steps under this method are:
- estimate and forecast the earnings from the subject asset
- deduct applicable tax charge on these earnings
- deduct an appropriate required rate of return on all other assets (tangible and intangible) used in obtaining such earnings — the residual earnings thus obtained are ‘excess earnings’ arising from the use in the business of the subject asset being valued
- assess an appropriate discount rate for the forecast after-tax excess earnings
- discount the excess earnings to obtain the value of the subject asset.
In addition to the above, there are also various adaptations of the income approach like the
- Discounted cash flows method
- Incremental cash flows/profits method
There are also various valuation concepts applicable generally and some specifically to intangible asset valuations like
- Tax amortisation benefit factor,
- Residual life of the intangible asset
- Return ‘on’ and return ‘off’
- Market value of invested capital
- Invested capital analysis
- Weighted average return on assets.
All of the above we shall discuss in the next article where we shall start with the purchase price allocation process and by a case study cover all the above points including the valuation of intangible assets under each of the approaches.
Cadbury acquisition:
On February 2, 2010 Kraft Foods’ Cadbury acquisition was valued at $ 18,546 million ($ 17,485 million net of cash and cash equivalents). As part of that acquisition, Kraft Foods acquired the following assets and assumed the following liabilities:
The above goodwill of $ 9.1 billion was attributable to Cadbury’s workforce and the significant synergies that were expected from the acquisition. Also $ 10.1 billion of the intangible assets acquired were expected to be having an indefinite life.
If we analyse the above details, the following observations can be made:
- 74% of the asset value paid was attributable to intangibles and goodwill (which is nothing but unidentified intangible).
- Though there is no official information available, Cadbury primarily being in the food and confectionery business, the intangible assets could primarily have been brands, trademarks, trade names, logos, marketing & distribution network, non-compete agreements and vendor relationships.
Brand Finance (R) Global 500 February 2010 summary report on the world’s most valuable brands ranks Cadbury brand at No. 274 with an enterprise value of USD 21,196 million and a brand value of USD 3,261 million which is about 15% of the enterprise value. The same report values Kraft at an enterprise value of USD 6,277 million and a brand value equivalent to USD 2,168 million which is 35% of the enterprise value. The Kraft brand has been ranked at No. 437.
