Valuing Intangible Assets
One of the topics that frequently comes up for discussion at the Reed Business School (in relation to accounting) is attributing value to intangible assets including intellectual property. It can […]
One of the topics that frequently comes up for discussion at the Reed Business School (in relation to accounting) is attributing value to intangible assets including intellectual property. It can cause some heated debate around the vaguer aspects, so we thought we’d share a blog post on the basics to keep the conversation going.
Often seen as the most important asset of a powerful company, intellectual capital (or intellectual property) is generally the foundation for market dominance and continuing profitability. It is usually the key focus in mergers and acquisitions and big businesses are often prepared to sacrifice a lot for it – so how do you value it?
Historically, accounting standards have struggled to represent the worth of Intellectual Property Rights (IPRs) in company accounts and IPRs are often under-valued, under-managed or under-exploited. How does an asset generate return and what discount rate should be applied to that return? The cardinal rule of commercial valuation is: value cannot be stated in the abstract – all that can be stated is the value of a thing in a particular place, at a particular time, in particular circumstances.
Calculating the value of intangible assets should not be a problem if they have been formally protected through trademarks, patents or copyright. But with things like know how, (which can include the talents, skill and knowledge of the workforce), training systems, technical processes, customer data, distribution networks, etc. valuation becomes more challenging. These assets may be equally valuable but more difficult to identify in terms of the earnings and profits they generate.
In order to effectively value intangible assets, we must first understand the four widely-recognised concepts of valuing:
- Owner value: owner-led determination of price based on their view of value if they were deprived of the property;
- Market value: comparison to similar assets recently sold;
- Fair value: equitability-driven to both the buyer and the seller;
- Tax value: the most complex, involving investment value, liquidation value, and going concern value.
There are three broad method groups for valuation intangible assets, which are: market based, cost based, or based on estimates of past and future economic benefits.
Independent experts prefer to determine a market value by referencing comparable market transactions, but of course comparable transaction can be hard to identify. Intellectual property is generally not developed to be sold, while many sales are usually only a small part of a larger transaction, the details of which are usually kept extremely confidential.
Cost-based methodologies assess the “cost to create” or the “cost to replace” a given asset, yet while being simple in theory, can be wildly inaccurate given changes in the time value of money and maintenance factors.
The methods of valuation flowing from an estimate of past and future economic benefits (also referred to as the income methods) can be broken down in to four limbs; 1) capitalization of historic profits, 2) gross profit differential methods, 3) excess profits methods, and 4) the relief from royalty method. This is easily the most complex section to understand, so if you’d like to know more about it, we’d recommend reading this article which breaks down some of the specifics with a worked example from IBM.
While much of the above methodology is widely used by the financial community, it is worth pointing out that valuation can often be more of an art than a science, drawing upon law, economics, finance, accounting, and investment in different combinations to get to figures that “feel” right. However, valuation should always assess industry/sector norms in in relation to the fundamental theoretical framework of valuation: context is all-important.