FINANCIAL APPROACHES TO VALUING BRANDS
Jan Lindemann
The financial community seriously woke up to the importance of intangibles and brands in the 1980s when some large financial transactions were completed on the back of well-established brand portfolios. The leveraged buy out of RJR Nabisco, a US consumer goods business with a diverse portfolio of tobacco and food brands, by KKR, a leading US based leveraged buyout firm, for US$31 billion in 1989 was a landmark transaction based on the steady cash flows of the target company’s brand portfolio. It remained the largest leverage buy-out until November 2006 when the same group joined the US$33 billion buyout of US hospital chain HCA.1 Also, in the 1980s a number of significant M&A transactions emerged involving companies with strong brands such as Nestlé buying Rowntree for UK£2.8 billion (five times its book value) and Philip Morris acquiring Kraft General Foods for US$12.9 billion (six times its book value) with about 90 percent of the value represented by the company’s brand portfolio.2 These transactions did not only show that intangibles such as brands are valuable business assets they also highlighted the increasing value gap between companies’ book and market values. In the 1980s the price to tangible book value of the S&P500 started its long-term ascent. Within the decade the ratio more than doubled from 1.1 to 2.6. Even during 2008/9, one of the worst bear markets in history, that ratio did not drop below 2.7 meaning that investors assumed that intangible assets accounted for about 63 percent of shareholder value.3 This gap between book and stock market value showed that investors were paying little attention to the balance sheet and recognized the value of intangibles including brands, R&D, distribution rights, and management know-how. As long as this gap was relatively small the financial community did not regard it as a major issue. If a company acquired another company for a price that exceeded the book value of the business the difference between the purchase price and the book value was called goodwill and written off against reserves. This was not a big issue as long as the goodwill portion was minor and could comfortably be written off without a major impact on the balance sheet. However, in particular cases where the target company owned strong brands the goodwill portion increased dramatically to a level when a write-off was seriously damaging the balance sheet of the acquiring company. The accounting treatment of goodwill was clearly out of sync with economic reality. This sparked the accounting debate and subsequent changes in the accounting treatment of goodwill which are discussed in Chapter 8. The financial approaches to brand valuation can be grouped into three categories: cost; market; and income based approaches.
Cost-based approaches
Cost-based approaches value an asset according to the acquisition cost of the asset. There are two types of cost-based approaches. The first one is the original cost approach which values assets based on their original acquisition costs. In the case of a brand, the original cost value would be the sum of all directly identifiable investments that were made into the brand including brand development, design, trade mark registration and maintenance, advertising, and corporate identity management. The approach is simple and, if accurate documentation exits, easy to implement. While historic costs may be interesting for an ROI assessment they do not provide a suitable valuation approach for brands as there is no clear relationship between historic investments in a brand and the economic benefit they generate. For example, GM has invested a lot of money in brands such as Pontiac, Oldsmobile, and Saturn. Today these brands are defunct or in the process of being discontinued. On the other hand, the value of the Red Bull brand will exceed the value of its investments. The whole purpose of brands as assets is that they create much more value than the monetary investment they require. An important investment in the brand is the concept and overall brand idea which is independent of costs as it depends on the creativity of its development. In addition, it is for most established brands impossible to track all past investments that were made into the brand. For leading brands such as Coca-Cola, Kellogg’s, or GE it will be impossible to trace all the investments that were made into these brands. However, the main reason why the historic cost approach is not suitable for brands is the fact that there is little relationship between the money that is invested in a brand and its economic value creation.
Replacement cost approach
The other and more relevant cost approach is the replacement cost approach that values assets based on what it would cost to replace them if they were acquired or recreated today. Replacement costs may be determined either by finding current prices for assets, or by applying an inflation factor to the original cost. The replacement cost approach is economically more relevant as it represents the actual costs required to obtain a certain asset. The approach can be applicable for the valuation of assets for which current values are easily available and for which the application of replacement makes sense such as a building. The replacement cost is only suitable for valuing a brand if it has not been used in the market or its awareness level is negligible when its value equals its development and registration costs. For actively used brands this approach is unsuitable as there is no meaningful relationship between the cost of establishing a brand and its economic value. Established brands such as Coca-Cola, Nivea, or Sony would be impossible to replace due to their position in the market place.
For fair-value determinations of intangible assets, using a costoriented method plays a subordinate role. It is typically used to value assets to which no cash flows can be assigned. The cost approach is often used to value internally developed software. Thereby the costs that would have to be incurred in order to produce an exact duplicate of the asset (reproduction costs) are considered. Alternatively, it is possible to base the valuation on the estimated costs required to produce an asset with an equivalent benefit (replacement costs). Cost-based approaches are not suitable for valuing brands as there is no clear relationship between the cost of establishing and maintaining the brand and its economic value creation. Investing a lot of money in a brand does not guarantee economic success as the majority of new product launches demonstrates. Positively, it is the nature of effective branding that the returns achieved are far higher than the investments made.
Market value approaches
The market value approach works on the premise that an asset can be valued by looking at the market price of comparable assets. In the case of company valuations this can be companies quoted on the stock market or companies that have been subject to an acquisition. The asset price is assessed on the basis of a multiple of annual revenue or profits (e.g. EBIT, EBITDA, net profit) of the purchase price or stock market value. This valuation technique is widely used in financial transactions. The relationship between the share price and company earnings, also called P/E ratios, is commonly used to assess and compare the value of companies. Despite all the sophistication in financial modeling value multiples are used in most M&A transactions. The market value approach benefits from the perceived factual objectivity of prices that have been paid for comparable assets. However, the key issue of this approach is comparability. In order for this approach to work there needs to be a significant number of comparable transactions or quoted companies to derive a meaningful value. While it is difficult for most companies to find truly comparable businesses it is in most cases impossible to establish for brands. The value of companies with strong brands always includes additional assets. Therefore, comparable values do not lend themselves to the valuation of brands. In addition, the number of pure brand transactions is very small and often involves cases where the underlying business has collapsed. An example would be Woolworth’s in the UK, when the business went into receivership the brand was sold on its own to an Internet retailer. In such cases the multiples tend to be useless. The market approach does not work for the brand as they are and should not be comparable. The whole purpose of brands is to be different and unique. Take the example of the Coca-Cola and Pepsi-Cola brands. The underlying businesses are probably as close as is possible to find. Their products are nearly identical, they target the same markets and audiences, they have similar distribution approaches and systems, and they charge similar prices for their products. Without the brands their products would be indistinguishable. Their brands however, are very different with respect to image and value creation. Coca-Cola is the original market leading cola brand and Pepsi is the eternal challenger. The Coca-Cola brand has a larger market share and Coca-Cola’s average operating margin over the last five years was about 8 percent greater than that of Pepsi-Cola’s. According to BusinessWeek’s Best Global Brands survey the Coca-Cola brand is valued as a multiple of annual brand sales of about 3.4 times versus the Pepsi-Cola brand that is valued at a sales multiple of 2.2.4 The Coca- Cola brand has a strong global footprint while the Pepsi brand is much more focused on the US market. The example of the Coca-Cola and
Pepsi-Cola brands demonstrates that even in very comparable businesses brands are not comparable. As a result, the market approach is not suitable for valuing brands due to the lack of comparable transactions and the unique nature of brands. If comparable transactions and brand values are available then they should be used as a cross-check, but as a main valuation approach market comparables are not suitable for valuing brands.
Most accounting standards recommend the market approach as the first option for valuing intangible assets. However, since there is neither a liquid market for most intangibles nor suitable comparables the market approach is not used frequently in accounting practice. The most recent fair value debate acknowledges that intangible assets tend to be unique and situation specific. This has led to accounting practice focusing on the income approach for the balance sheet recognition of intangible assets.
Income approach
The income approach values an asset as the net present value (NPV) of the cash flows it is estimated to accrue during its economic life. It is the most widely accepted approach and in line with current corporate finance theory. The income approach is therefore the most widely used method for valuing intangibles including brands. There are several versions of the income approach. The main difference is how the asset specific earnings and discount rate are identified and calculated. There are three income approach methods.
The first, the multi-period excess earnings method, is based on the assumption that cash flows can only be generated from an intangible asset in conjunction with other tangible or intangible assets. In order to separate the intangible asset to be valued, payments for the supporting assets are considered as contributory asset charges. The approach identifies returns for all the other assets which are subtracted in addition to the operating costs from the overall revenue stream. The unidentified returns are then assumed to accrue to the intangible asset to be valued. Accounting firms often use this approach to value technologies and customer relations. The difficulty with this approach lies in the assumed returns and charges for the other assets. While it is relatively easy to find returns for tangible assets such as office and factory buildings, it is much harder to identify the return of specific intangibles such as customer lists and brands. Accounting firms have derived lists of fictitious charges for such assets. However, the validity of some these returns can be questioned. This approach is mainly driven by the need to find values for a wide range of intangibles to be recognized on the balance sheet in the course of a purchase price allocation.
The second income approach for valuing an intangible asset is the incremental cash flow method. This method determines the difference between the cash flows of the company with the relevant intangible asset and a fictitious company without this asset. The difference represents the additional cash flow related to the intangible asset, and discounting this as the asset specific capitalization leads to its fair value. This approach is a simpler version of the previous one as it only makes assumptions about the cash flow of the intangible asset to be valued and not the other intangibles in the business. It works on the principle of exclusion by assuming all earnings that are not attributable to the specific intangible asset valued represent the return of the other business assets. This approach is mostly applied in the form of a profitsplit approach, where after remunerating the capital employed in the business the remainder is split between the intangible asset valued and the other intangible assets. This approach is used by many consulting firms, such as Interbrand and Millward Brown Optimor that specialize in valuing brands. The validity of this approach very much depends on the quality of the method used for identifying the earnings attributable to all intangibles as well as to the specific intangible, i.e. the brand. This approach will be discussed in more detail later.
Another version of the incremental cash flow method is the price premium approach. It is based on the premise that brands can command a price premium over and above non-branded or generic offers. The approach compares the revenues of the branded offer with a generic product and calculates the NPV of the future cash flows stemming from this price differential. As previously noted, there are also market research models that base their brand assessment mainly on the willingness of consumers to purchase at a premium. The price-premium approach has been used by many consulting firms such as McKinsey and PricewaterhouseCoopers. The approach is flawed as it focuses on the price premium as the only source of brand value and the assumption that there are comparable branded products and services sold in the market. In reality there are only a very small number of categories in which generic and branding products are sold in competition, for example, petrol, lubricants, and pharmaceuticals. The pharmaceutical industry and some commodity based industries such as lubricants are probably the only sectors where generic products have some significance. Otherwise unbranded generic offers do not exist as all products and services are branded. Even “own label” products offered by supermarkets have become brands in their own rights. Some supermarkets have applied very sophisticated branding around their products. In the UK, some supermarkets offer premium ranges of their own label products at a price premium over some established brands. Creating a difference between a brand and a generic offer has become irrelevant – the generic simply does not exist. This makes the assessment of price premium very difficult. At best one can compare premium brands with the cheapest brands in the market. Even that approach will be very difficult as in most cases brands do not provide the same offer. The price premium of a Rolls-Royce Phantom or an S Class Mercedes depends on the benchmark. It will be huge in comparison to a Tata Nano or a Nissan Micra but not very meaningful for assessing the value of these brands. In fact many mass-market brands create more value than premium brands. The value of the Toyota brand is more than seven times that of the Porsche brand. In many categories the price differential between brands is minor. For example, consider televisions where there are several brands with very similar price points in different product and price categories. In telecommunication and financial services, pricing differentials are hard to identify and often meaningless as they change with different bundled offers. As a result a brand may have a price premium in one offer but not in another. Premium pricing is an important value driver for certain brands in particular in the luxury goods category. It is, however, not the only value driver for the majority of brands as volume, frequency of purchase, and supporting cost structures tend to be equally relevant for their value creation. The premium price approach ignores key value drivers and places too much emphasis on one value driver. While a price premium is an important indicator of the strength of a brand it does not provide a sufficient basis for a valuation of the brand. Price premium is one of several assessment criteria but not a valid brand valuation approach.
A third and frequently used method for valuing intangible assets is the relief from royalty method. This method is typically employed for the valuation of brands and patents. It is based on the fundamental premise that an external third party would be prepared to pay a license fee for the use of a brand or a patent that it does not own. The value of the intangible asset is then calculated as the present value of the saved license payments. The approach is popular with accounting firms and some specialized brand valuation consultancies due to its simplicity and perceived objectivity. However, the approach is really another version of valuing intangible assets by comparison. This is a significant drawback of this approach as it relies on the comparability of royalty rates. However, relative to other comparables, such as transactions, there is much more data available on royalty rates. The difficulty arises when applying comparable royalties due to comparability and clarity of what the royalty rate encompasses. Most royalty agreements are not publicly disclosed and often bundle several intangibles into one royalty rate. Also, many licensing rates that are part of franchise agreements are linked to other charges such as the requirement to purchase certain raw materials at fixed prices exclusively from the licensor. In such situations the pure license fee does not represent the total return the licensor receives for licensing the intangible asset. These hidden returns can only be identified by analyzing the entire agreement. Most of these agreements are secretive and not publicly available. Brand licensing rates can range from less than 1 percent to more than 20 percent of revenues. Even in the same category, licensing rates can vary dramatically by geography and application. For example, the royalty rate for a fashion brand will differ between its use in sunglasses and perfumes. It will also vary by geography. The same brand will command a different royalty in the US than in China. In telecommunications, for example, royalty rates can range from 2 to 8 percent.5 The diversity of rates according to different markets makes the royalty relief method difficult to apply. The royalties approach only works if a significant number of comparable rates can be identified. This is not often the case in particular when dealing with brand licenses. The approach faces the same comparability issue as the market approach. The uniqueness of brands makes comparability difficult. The royalty relief method can also lead to brands being undervalued as the royalty represents only the brand value to the licensor but not the licencee. The approach also fails to deliver insight into the value creation of the specific brand as it relies on the rate from another brand. Therefore it does not deliver reliable brand valuations and should not be used as the primary valuation approach for valuing brands. The royalty relief approach can be useful to cross-check for other more brand-specific valuation approaches as it provides a third party view on the value of a brand license in the same industry.
Most of the traditional income approaches have been developed by financial professionals and are mainly focused on the financial component of valuing intangible assets and brands. It has been predominantly the accounting profession that has been active in this field as it has to deal with intangible assets on balance sheets which emerged from the purchase price allocations and subsequent impairment tests stipulated by all the relevant accounting rules around the world. In developing valuation techniques for intangibles, they have extended and adjusted their established valuation methods. As the majority of valuations of intangible assets performed by accounting firms focus on establishing a financial value, mainly for balance sheet recognition, the valuation approaches are more concerned with the mechanics of the calculation than a deep understanding of the underlying assets. The objective of the purchase price allocation valuations is to split and allocate a given goodwill value that has emerged from a transaction into fair values for the individual intangible assets. The valuations are therefore performed top down from an already determined financial value. The focus is on the relative value of each intangible asset. The purpose of the valuation is therefore not to understand the value of each of the intangibles to derive an overall value for these assets, but to allocate a given overall asset value to different intangible asset classes as required by the accounting standards. This explains why accounting valuations are more concerned with the financial and numeric mechanics of intangible asset valuations. From an accounting perspective this is perfectly fine and practical. It may also work for some technical intangibles such as software licenses but it is certainly not suitable for the valuation of brands. This has to a certain extent been acknowledged by the accounting profession. The current fair value debate about intangible assets suggests that due to the unique nature of many intangible assets such as brands the conventional comparables focused approaches are insufficient and asset specific techniques need to be used to assess a fair value of these assets. In a discussion paper of fair value the IVSC, an international accounting standards body, acknowledges the existence of different assets, i.e. non-comparable intangible assets such as brands, that they suggest should be valued according to the specific earnings stream they create.6
NOTES
- Bloomberg, 2007.
- See Chapter 2.
- See Chapter 2.
- See Reuters.com; Best Global Brands, 2008; author’s calculations.
- See royaltysource.com
- IVSC Discussion, 2007.
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