In this second of a three part blog-post series on intangible assets and intellectual property valuation, we focus on how we value intangible assets. We cover the cost and market approach, before turning to the income approach in our next blog post.
How do we value intangible assets?
Once we have identified the intangible assets as well as the reason we are conducting our valuation, we need to select the appropriate methodology. Typically, valuation experts and appraisers employ a variety of methods and compare the final results to ensure that they are reasonable and accurate. It is beneficial to determine the value of an intangible asset using multiple methods and in fact, many tax regulations require the use of multiple methods. All too often there is a range of values for the intangible asset, depending on which method is employed. Ideally, the methods will give similar results, although there are cases where a particular method may result in an outlier. The reason for utilizing multiple valuation methods is to ensure corroboration in the value conclusion.
Valuation methods are typically derived from one of three universal approaches used in the valuation theory: the Cost Approach, the Market Approach or the Income Approach. Each approach comprises a large subset of methods, but there is also a significant amount of overlap between the various approaches. For example, many income approaches consider or include some component of the market approach and vice versa.
Cost Approach
The Cost Approach is based on the premise that a willing buyer would pay no more for an intangible asset than the cost to produce such asset. In other words, why pay more for an already created software program if it would cost you less to develop it yourself (forgetting about copyrights for the time being). Alternatively, when considering market conditions and the time value of money, it may be more prudent to purchase the asset “as is,” if in the long run the cost to develop it yourself proves higher than the purchase price. So how does the Cost Approach relate to intangible asset valuation? To gain insight into the value of the intangible asset under investigation, valuation experts often look to the Cost Approach to tell them how much it would take to “re-create” the asset, thereby giving an indication of the value.
As an example, let us consider the value of a workforce-in-place. A typical cost approach might look at the cost to effectively replace the existing workforce. Namely, we might estimate the cost to recruit, hire and train a replacement workforce. We would begin by looking at the compensation level of each employee, including the level of education and tenure. We can sum up the current compensation level and apply recruitment and training factors as our initial replacement cost. However, we must consider obsolescence, which appears in the form of functional obsolescence (would a replacement workforce necessitate the same number of workers or might we have excess capacity?), as well as economic obsolescence (where we could higher younger, more educated workers to replace older, less productive employees). Once we compile the data and introduce our adjustment factors, we can effectively compute the cost to replace our existing workforce.
Market Approach
Another approach to valuing intangibles that is usually investigated is the Market Approach. Here, we look toward comparable industry events to give us an indication of the value of an intangible asset (or assets). The market approach is based on examination of similar intangible assets that have been transacted in the marketplace. Unfortunately this method depends heavily on the availability and comparability of data. If there are not enough publicly available transactions, or if the comparability of the transactions is suspect, then we are better off looking to another approach.
If there are a reasonable number of transactions available for comparison, the first step in the market approach is to collect data on the transactions. For example, suppose we are concerned with the value of the FCC license of a given radio station. We would begin by collecting data on publicly available transactions where comparable licenses have been bought or sold. After considering market factors, we could decide to compare the transactions to our own intangible asset on a common unit, such as price per watt, or price per listener. Again the decision of what comparable unit is left to the discretion of the valuation expert, and often hinges on the reliability of the data. Finally we apply the pricing multiple derived from our transaction and market analysis to our own subject intangible, thereby deriving a value for our intangible asset.
In our next blog post, we will discuss the income approach. Until then, have a happy holiday season!