In this final part of our series, we take a very brief look at the income approach.
Often, the most relied upon approach in valuing intangible assets is the income approach. In this approach, we determine intangible asset value by examining the future or expected economic benefit (i.e., income or cash flows) attributable to the intangible asset. There are a number of variations of the income approach, including direct capitalization models that rely on a single period of forecasted economic benefit and discounted cash flow models that explore longer forecast horizons. Both of these methods are loosely premised on four steps: (1) the determination of an appropriate income measure, (2) the estimation of a time period, (3) the projection of the income, and (4) the appropriate determination of a capitalization or discount rate that captures the risk associated with the expectation of receiving the economic benefit from the intangible asset.
A discounted cash flow method results in an intangible asset value derived from the sum of the present value of a stream of income attributable to the intangible asset over its life (or the economic useful life if subject to limitations such as patent term or licensing agreement). One could argue that this method is preferable to a single period capitalization method (which is based on the assumption of constant-growth income), as it allows for changes in the income stream at discrete periods of time in the future. Nevertheless, there are times when data availability and limitations restrict practitioners to using a single period capitalization approach.
In addition to these two general income approaches there are numerous other approaches that can be labeled “Income” or “Market” approaches; these include incremental income or excess earnings approaches, the profit split method, and royalty analyses. The incremental income approaches, which can include capitalized and discounted cash flow methods, are based on examination of the additional income accrued by the existence of the intangible asset. The profit split method looks to split the income between the intangible asset and other tangible and intangible assets associated with it. The key to this method is the determination of the appropriate split of the profit, where one often looks to market transactions regarding royalty or transfer agreements. Finally, royalty analyses examine the payment a licensee pays a licensor for use of a discrete intangible asset. These methods can be based on the actual royalty income or hypothetical royalty income.
The “royalty cost savings” or “relief from royalty” approach is one method based on the premise of hypothetical royalty income. Here, we are concerned with the economic benefit obtained by not having to license the intangible asset from another party. The value of the intangible asset can be examined by looking at the present value of the income saved by not having to pay the royalty. For example, suppose we are interested in determining the value of a particular brand name. Through our research we have determined that 2016 sales will be $100 million, the long-term growth rate is 3 percent, the income tax rate is 37 percent, and our appropriate discount rate is 15 percent. In addition, after extensive review of market data we can determine that a market-derived royalty rate of 20 percent of sales is accurate.
To determine the intangible value of our brand, we capitalize the after-tax brand royalty sales using our discount rate and long-term growth rate. Thus, our after-tax brand royalty sales are $12.6 million ($100 million times 20 percent times one minus the tax rate of 37 percent). The value of the intangible asset is $105 million, which is the $12.6 million divided by a capitalization rate of 12 percent (our 15 percent discount rate less our 3 percent long-term growth rate). Although this is a very simplified example, it illustrates the conceptual methodology of the relief from royalty method.
Regardless of the method, of which there are many, it is essential to fully understand the specific intangible asset in question, to determine the purpose of the valuation, and, of course, to consider a variety of valuation methods. Each method has its pros and cons, given the often subjective and data-intensive nature of valuation. The one key to remember is to never forget the ultimate goal: to reach a final conclusion of the value that best represents the intangible asset.
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