Measuring Intangible Assets Value- Valutrics
The value attached to intangible assets has increased many-fold in the internet based economy. For example, while firms like Microsoft or Coca-Cola only report traditional assets in their balance sheets, it accounts for less than 5 per cent of their total market value.
In the new economy, value creation relies on the transformation from tangible assets to intangible assets, with firms likely to generate much of their value through intangible assets (such as proprietary processes, brands, strong relationships and knowledge) as differentiating factors. The drivers of value creation in modern competitive environments lie in a firm’s intangible assets rather than its physical and financial capital as they underline future performance and growth.
This resource is the main source of sustainable competitive advantage, and is rare, inimitable and non-substitutable.
Management of Intangible Assets
The main purpose of management of intangibles is to enhance the firm’s value through the creation of competitive advantages. One key reason for measuring intangible assets is to assess drivers of performance and competitive advantage so as to make better strategic decisions. Another key interest for measuring intangibles comes from the broad gap between what firms disclose in their mandatory financial reports and what really matters for market valuation. Intangible assets have become, in recent years, the core focus of firms, investors, accountants, Wall Street analysts and regulators alike in their attempts to understand and reduce the huge gap between a firm’s book and market values. Intangible asset valuation is critical from both accounting and business perspectives. The ability to clearly identify, measure, value and account for intangible assets is a serious problem for company managers, investors and governments.
Intangibles are normally neither reported externally nor integrated in internal management accounting. Progressive and good practice firms are expected to identify, measure, report, communicate, evaluate and monitor important intangibles in the management control process.
Financial profit alone cannot guarantee the long-term survival and growth of firms. To be sustainable, firms need to identify and be able to manage intangibles, including organisational learning and growth, internal processes and customer value propositions. The first phase in the analysis is thus the identification of the strategic objectives of the firm. Once this first phase has been accomplished, the measurement and monitoring of those related intangibles must be done.
These phases can be distinguished in the management of intangibles as explained below:
1. Identification of intangibles;
2. Measurement of intangibles; and
3. Monitoring of intangibles.
Identification of intangibles
In the identification phase, firms usually focus only on those intangibles linked to the present or future value drivers of the firm, making it necessary to enquire about their strategic objectives. Every firm will identify a set of critical intangibles that might help to reach the strategic objectives of the firm or enhance the firm’s competitive advantage.
According to the Statement of Financial Accounting Standards (SFAS) of the Financial Accounting Standards Board (FASB), most identifiable intangible assets fall into one of five categories – marketing-related, customer-related, artistic-related, contract-related or technology-related, as explained below:
1. Marketing-related intangible assets include trademarks, trade names, service marks, newspaper mastheads, Internet domain names, non-
competition agreements.
2. Customer-related intangible assets include customer lists, order or production backlogs, customer contracts and customer relationships, including non-contractual relationships.
3. Artistic-related intangible assets include plays, operas, ballets, books, magazines, newspapers, pictures and photographs.
4. Contract-based intangible assets include licensing and royalty agreements, advertising, construction, service or supply agreements, lease agreements, franchise agreements and employment contracts.
5. Technology-based intangible assets include patented technology, computer software, unpatented technology (know-how), databases, and trade secrets such as secret formulas, processes and recipes.
The result of the identification phase is a network of intangibles related to the strategic objectives. Once an intangible asset has been identified, it needs to be measured and valued. Despite intangible assets’ lack of physical substance and relationship to other assets, which makes them difficult to isolate and measure, there are several methodologies to measure and value an identified intangible asset.
Intangibles Measurement Approaches
1 Income approach
According to the income approach, income and expense data relating to the intangible asset are valued and estimated by using a discounted cash flow methodology (DCF), such as net present value (NPV), which is linked to the expected benefits from future returns on such assets. There are three basic steps to a feasible measurement of intangible assets:
a. Identify the asset from which the stream of expected future economic return occurs;
b. Estimate the expected future cash flows over time; and finally,
c. Assign an appropriate measure of risk to expected future cash flows by using the Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT) or other financial approaches.
The income approach seeks to identify and quantify, in terms of present value, the future earnings attributable to the asset on the basis of future economic benefits derived from asset ownership. The main income methods are ‘Relief from Royalty’ and ‘Excess Earnings’. ‘Relief from Royalty’ is based on estimating the price a business would pay for the use of an intangible asset if it did not own the asset, or the cost savings of not having to pay a royalty. The basis of the Excess Earnings methodology is that the value of an intangible asset is the present value of the earnings it generates, net of a reasonable return on other assets also contributing to that stream of earnings.
2 Market approach
The market approach estimates the fair value of intangible assets by comparing these assets with actual sales of similar assets in the marketplace. The market approach is also called the ‘sales comparison’ approach.
This approach generally assumes that intangible assets can be valued by observing transactions of comparable assets in the marketplace. The more heterogeneous assets are, the more difficult it is to apply this approach. Intangible assets such as brands cannot be sold separately from other business assets. It may therefore be difficult to observe benchmark prices paid in outright sales for comparable assets, as such transactions are infrequent and details are rarely fully disclosed. As there is no active market for some intangibles, this comparable approach has limitations. Many valuable intangibles are unique by nature and unless there are transactions of such specific assets under consideration, a price comparison approach may not be helpful for valuation. Therefore this approach can be difficult to apply in practice.
3 Cost approach
Under the cost approach, intangible assets are valued based on the ‘cost to create’ (development cost) or ‘cost to recreate’ (replacement cost) a similar kind of intangible asset, with comparable consumer appeal or equivalent commercial utility. The cost approach considers the book cost (reported in the traditional financial statements) or the replacement cost.
For intangible assets such as brands these costs generally relate to naming, research and product design, packaging, design, advertising and promotional costs. In the case of IT services, costs may include development and implementation costs. For human capital assets, such as the workforce, it would include the costs of recruitment and training. The cost approach is one of the fundamental methods of valuing intangible assets; among several cost approach methods, the most common are the reproduction cost method and the replacement cost method . Thus, for intangibles without an active market, this approach provides a useful benchmark for a valuation.
Intangibles Measurement Methods
There are four practical methods to measure intangible assets.
1 ROA method
This method is based on the concept of return on assets (ROA). ROA is the average pre-tax earnings of a firm for a period of time divided by the average tangible assets of the firm. A firm can compare this ratio with the firm’s industry average to calculate the difference between firm ROA and industry-average ROA. If this difference is positive, it is assumed that the firm has an excess value of intangibles in relation to the industry. If this excess is multiplied by the firm’s average tangible assets, the result will be the average annual excess earning over the industry. An estimate of the current value of its intangibles is obtained by dividing this excess earning by the firm’s weighted average cost of capital (WACC). WACC is equal to the after-tax weighted cost of debt plus the weighted cost of equity. This method is simple to use and the information needed is easily available from financial statements.
2 Market capitalisation method
This method is based on the concept of a valuation premium in the capital market and calculates the difference between a firm’s market capitalisation and its stockholders’ equity as the value of the intangible assets. The M/B ratio shows the excess of a firm’s market capitalisation over its stockholders’ equity and it can thus be deduced that this is due to the intangibles owned by the firm. To calculate the M/B ratio more accurately, the historical financial statements must be adjusted for inflation or replacement costs. This method provides a market measure of a firm’s valuation of intangibles. The market information on the firm’s stock price is readily available, but historical financial statements, as mentioned, should be adjusted for current replacement costs.
3 Direct identification method
The method is based on measuring the value of intangibles by first identifying its different components. Once these components are identified, they can be measured through indicators. This method is expensive and complex because of the large number of components that have to be identified and individually measured. However, this method is also the most accurate way to measure the value of intangibles, taking into account that the ROA and market capitalisation methods report the total value of intangibles but do not show any component.
4 Balanced Scorecard method
In the Balanced Scorecard method, various components of intangible assets are identified and indices are generated and reported in scorecards (Kaplan and Norton). The Balanced Scorecard concept is popular because it contains outcome measures and the performance driver of outcomes, linked together in cause–effect relationships. There are linkages between customers, internal process and learning/growth, and financial performance. The Balanced Scorecard strategy map (Kaplan and Norton) may be used to provide a framework to illustrate how the strategy of firms links intangible assets to value-creating processes. The measures in the four perspectives are linked together by cause–effect relationships. The firm builds the core competence and training to support the internal process. The internal process creates and delivers the customer value proposition. When customers are satisfied, sales and profit are delivered in terms of financial performance. The financial performance is the outcome and visible to observers. Hence the Balanced Scorecard attempts to expand the focus of managers by encouraging them to look beyond short-term financial performance measures towards intangible items crucial in the value-generation process.
Value drivers of intangible assets
The economic value of intangible assets is the measure of utility it brings to the business enterprise. The value of intangible assets depends on the business enterprise’s ability to transform intangible assets into financial returns. Intangible assets have been identified as the most critical resource of today’s business firm, yet most firms cannot clearly define such business drivers. Businesses have not clearly defined the best approach to valuing intangible assets. The business enterprise in this knowledge era has a need to become receptive and intelligent about its environment so as to gain knowledge from it and subsequently value its intangible resources. Intangibles are significant factors in value creation within the business firm and need to be managed like the traditional input factors of labour, capital and raw materials . The intellectual capital can provide tangible bottom-line results if the sources of value are extracted.
Successful management of intangible assets within the organisation positively affects the performance and market valuation of a business enterprise. The main objective of intangible asset management is the establishment of tools and indicators to manage knowledge and increase earnings within the business enterprise . It has been stated numerous times, by Baruch Lev, Michael Porter, Robert Kaplan and David Norton to name a few, that the nature of value within the business enterprise has changed and that new assets such as intangible assets cannot be measured with old tools.
The alignment of intangibles with strategic objectives and value drivers allows firms to focus their resources and activities on a set of objectives to achieve them more effectively and efficiently. A study provides empirical evidence that the Balanced Scorecard model, developed by Robert Kaplan and David Norton, adequately represents all eight of the value drivers of intangible assets.
As intangible assets are often referred to as organisational performance drivers, they provide causal relationships between intangible resources and organisational value creation. Intangible assets such as customer relationships and employee skills often result in higher customer satisfaction and loyalty, which in turn delivers shareholder value. . Strategy maps (Kaplan and Norton ) have been used as management tools to visualise the causal links between intangible value drivers and organisational performance outcome. Human capital, information capital and organisational capital are considered as value drivers for intangible assets in strategy maps.
The management of intangible assets is a complex and perplexing task, not least because the prevailing accounting system is designed primarily for tangible assets, to the exclusion of most intangible and intellectual capital assets. Intangible assets are levers for competitive advantage and sustainable performance; firms should therefore find ways to identify, measure and manage their key intangible assets, as well as disclose them to their stakeholders.
In today’s knowledge-based economy, a firm’s value is imperfectly measured by the value of its physical assets alone, as intangible assets create value and may decide a firm’s future growth potential.