Value of intangible assets

Intangible Assets are defined as “non-physical assets such as franchises, trademarks, patents, copyrights, goodwill, equities, mineral rights, securities and contracts (as distinguished from physical assets) that grant rights and privileges, and have value for the owner” or simply assets that lack physical substance except for Financial Assets.

Over the years, intangible assets are increasingly important to the corporate world, yet most mainstream accounting standards fail to exhibit them correctly in financial statements.

Types of intangible Assets

Valuing methods vary based on the type of the intangible asset. Therefore, types of intangible assets are as given below:

• Customer
• Technology
• Contracts
• Marketing
• Artistic

Some of the types are given above, we will discuss which valuing method Is to be applied to which type later in this article.

Approaches to Valuing Intangible Assets

Valuation methods differ on the approach we take while valuing the asset, commonly there are 3 approaches:

• Income Approach:

It is based on PV of expected future cash flows to be attained from ownership of the asset.

• Market Approach:

It is based on sale or licensing of similar assets in the market place.

• Cost Approach:

It is based on the cost incurred to reproduce or replace the asset.

There are multiple Valuation methods under the approaches. Let’s take a look at them

Relief from Royalty Method

This method is based on a fairly simple intuition that, owning an intangible asset means that the entity would not have to pay for the privilege of using the asset. Basically, this method calculates the value based on hypothetical royalty which would be saved by owning the asset rather than licensing or renting it.

Calculating Value using RRM involves the following steps:

• Estimate the cost savings based on the hypothetical royalty payment.
• Discount the estimated cost savings to a present value and calculate sum
• Add the value of the tax amortization benefit to the present value of the cash flows

Royalty rate information is often available on databases such as KtMINE and Royalty Source and also SEC filings. To be fair, this valuation method also uses the market approach,  as we assume the prices available in market also that is royalty rate.

Key assumptions made in RRM:

• Net revenue should reflect all revenues associated with the intangible asset until the remaining life of the asset.
• Prospective profits to be realised, costs to be saved, or return on assets to be used in the business
• Royalty payments as a percentage of revenue vary widely, depending upon the profitability of the product and the industry and market being served.
• Discount rate will be based on the riskiness of the intangible asset considered in isolation.

Multi Period Excess earnings Method or MPEEM

The MPEM is based on the discounted Cash-flow analysis method and tries correct its flaws. MPEM isolates the cash flows to a single intangible asset rather than focusing on the whole entity and measures its fair value by discounting them to present value. This method is used when the predicted revenue and earnings generated by the entity cannot be directly identified.

Those assets used in realizing expected future cash flows for the subject intangible asset are called Contributory Assets. One of the challenges to this method is calculation of the Contributory Asset Charge or CAC. Here is how to calculate it:

• (Normalised level of required contributory asset) x (After-tax cost of financing) = total return on the contributory asset.
• (Sum of annual returns as derived in step 1) ÷ (Sum of revenues of the Target) = Normalised CAC %
• (Normalised CAC % derived in Step 2) X (Revenues attributable to the intangible asset) = yearly CACs

MPEE Method usually involves the following steps:

• Projecting financial information (PFI) — cash flows, revenue, expenses, etc. — for the entity.
• Subtracting the cash flows attributable to all other assets through a contributory asset charge (CAC).
• Calculating the cash flows attributable to the intangible asset subject to valuation and discount them to present value.

Note that the required returns on the CAC must be in tally with the assessment of risk of the individual asset class and the Projected financial information used in MPEEM should fairly reflect the estimated useful life of the asset.

Assumptions made in MPEEM:

• Attrition rate
• Probability of contract renewals
• Existing customer growth rate
• Contributory asset charges

‍

With and Without Method

Also known as Incremental Cash Flow method, this method calculates the intangible asset’s value by calculating the difference between two Discounted Cash-Flow models, that is, one with the asset in place and another without the asset. This method is widely used to calculate the valuation of non-compete agreements. 

WWM usually involves the following steps:

• Calculate the free cash flows for the “With Scenario”
• Calculate the free cash flows for the “Without Scenario”
• Calculate the difference in the free cash flows to arrive at the incremental cash flows
• Incremental after-tax cash flows are present valued using an appropriate risk-adjusted discount rate.
• Tax amortisation benefit is added, as appropriate, to arrive at the value of the Intangible Asset.

Replacement Cost Method

This method is based on the intuition that a prudent investor would pay no more for an asset than the cost to develop or construct an asset of equal utility. This method requires an assessment of the replacement cost for the intangible asset that is at current prices which has equivalent utility to the asset and using modern materials and standards. This method is usually used for Assembled workforce, Internally developed or Internally used non-marketable software. 

‍