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AGENDA ITEM 12

IVSC PROFESSIONAL BOARD MEETING 3 NOVEMBER 2011

The Board is invited to approve that attached for publication, subject to any final editorial changes.

The Board also needs to confirm that this proposed TIP does not need to go through the normal

process of issuing as an exposure draft for consultation. The reason for this is that this TIP is

mainly a minor updating and reformatting of the material that is in GN4 that was published in March

2010 following a 3 year consultation process. The updating and reformatting are to bring the

guidance in the TIP into line with the new IVS, in particular the new IVS 210 Intangible Assets,

which was also the subject of extensive consultation. 1

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Draft

Proposed Technical Information Paper 3

INTANGIBLE ASSETS

Technical Information Papers

An IVSC Technical Information Paper (TIP) provides guidance on different valuation topics and is

designed to be of assistance to valuation professionals and informed users of valuations alike. A

TIP may:

provide information that is helpful to valuation professionals in exercising the judgements

they are required to make during the valuation process,

give indications and examples of generally accepted best practice, including appropriate

valuation methods and criteria for their use and

provide additional information to assist in the application of an International Valuation

Standard (IVS).

A TIP does not:

provide valuation training or instruction or


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direct that a particular approach or method should or should not be used in any specific

situation.

The contents of a TIP are not intended to be mandatory. Responsibility for choosing the most

appropriate valuation methods is the responsibility of the valuer based on the facts of each

valuation task.

The guidance in this paper presumes that the reader is familiar with the International Valuation

Standards (IVS). Of particular relevance are the concepts and principles discussed the IVS

Framework and IVS 210 Intangible Assets. 2

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Contents

Paragraphs Page

1 Introduction #

2 Definitions #

3 Identifying the Asset #

4 Valuation Approaches and Methods #

5 The Market Approach #

6 The Income Approach #

Prospective Financial Information 6.2 6.11 #

Valuation Methods 6.12 - 15 #

Relief from Royalty Method 6.16 6.24 #

Premium Profits Method 6.25 6.31 #

Excess Earnings Method 6.32 6.44 #

Greenfield Method 6.45 6.46 #

7 The Cost Approach #

8 Other Considerations #


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Discount Rates 8.1 #

Remaining Useful Life 8.4 #

Illustrative Example # 3

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1 Introduction

1.1 The objective of this TIP is to provide guidance on the principal recognised approaches and

methods that are used for valuing intangible assets of different types of assets. The

guidance in this TIP should be read in conjunction with the International Valuation

Standards. IVS 210 Intangible Assets sets out:

matters that must be considered when developing a scope of work for a valuation of

intangible assets and

matters that are to be considered when reporting a valuation of intangible assets.

1.2 The Commentary to IVS 210 provides a high level overview of different types of intangible

assets and the principle valuation approaches and methods that are used. This TIP

examines the matters discussed in the Commentary in greater detail and gives examples of

how these are applied in practice.

1.3 Valuations of intangible assets are required for different purposes including, but not limited

to:

acquisitions, mergers and sales of businesses or parts of businesses;

purchases and sales of intangible assets;

reporting to tax authorities;

litigation and insolvency proceedings; and

financial reporting.

1.4 This TIP provides guidance on appropriate valuation procedures, approaches and methods

for the valuation of intangible assets generally. It does not examine any specific statutory or


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regulatory requirements that may apply to the valuation of intangible for particular purposes

in specific jurisdictions, eg for taxation or financial reporting. Where a valuation is required

for inclusion in a financial statement the provisions of IVS 300 Valuations for Financial

Reporting apply. IVS 300 also contains guidance on the principal valuation requirements

under the International Financial Reporting Standards (IFRS). 4

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2 Definitions

2.1 The following defined words and terms have particular relevance to the valuation of

intangible assets and appear in this TIP. Other words and terms that are also defined in the

IVS Glossary may be used but are not listed below in the interests of brevity.

Contributory Assets Any tangible or intangible assets used in the generation of the cash

flows associated with the intangible asset being valued

Contributory Asset

Charges

A charge to reflect a fair return on Contributory Assets used in the

generation of the cash flows associated with the intangible asset

being valued.

Cost approach A valuation approach based on the economic principle that a buyer

will pay no more for an asset than the cost to obtain an asset of equal

utility, whether by purchase or by construction.

Discounted Cash Flow

Method

A method within the income approach in which a discount rate is

applied to future expected income streams.

Excess Earnings That amount of anticipated economic benefits that exceeds an


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appropriate rate of return on the value of a selected asset base (often

net tangible assets) used to generate those anticipated economic

benefits

Excess Earnings Method A method of estimating the economic benefits of an intangible asset

by identifying the cash flows associated with the use of the asset and

deducting a charge reflecting a fair return for the use of contributory

assets.

Going Concern A business enterprise that is expected to continue operations for the

foreseeable future.

Goodwill Any future economic benefit arising from a business, an interest in a

business or from the use of a group of assets which is not separable.

Greenfield Method A method of valuing an intangible asset that deducts the cost of

buying or creating contributory assets from the cash flows associated

with the use of that asset.

Income Approach A valuation approach that provides an indication of value by

converting future cash flows to a single current capital value.

Intangible Asset A non-monetary asset that manifests itself by its economic properties.

It does not have physical substance but grants rights and economic

benefits to its owner.

Market Approach A valuation approach which provides an indication of value by

comparing the subject asset with identical or similar assets for which

price information is available. 5

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Multi Period Excess

Earnings Method


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A method of estimating the economic benefits of an intangible asset

over multiple time periods by identifying the cash flows associated

with the use of the asset and deducting a periodic charge reflecting a

fair return for the use of contributory assets.

Premium Profits Method A method that indicates the value of an intangible asset by comparing

an estimate of the profits or cash flows that would be earned by a

business using the asset with those that would be earned by a

business that does not use the asset.

Prospective Financial

Information

Forecast financial data used to estimate cash flows in a discounted

cash flow model.

Relief from Royalty

Method

A method that estimates the value of an intangible asset by reference

to the value of the hypothetical royalty payments that are saved

through owning the asset, as compared with licensing it from a third

party.

Royalty A payment made for the use of an asset, especially an Intangible

Asset or a natural resource.

Tax Amortisation Benefit Tax relief available on amortisation of the capitalised asset.

Weighted Average Cost

of Capital

A discount rate determined by the weighted average, at market value,

of the cost of all financing sources in a business enterprises capital


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structure. 6

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3 Identifying the Asset

3.1 IVS 210 requires the intangible asset being valued to be identified by reference to its type

and the nature of the right or interest in that asset. The Commentary to IVS 210 explains

the distinction between intangible assets that are identifiable and goodwill, which is an

unidentifiable intangible asset. In summary, an intangible asset is identifiable if it is

separable from the entity or if it arises from a contractual or other legal right.

3.2 The Commentary to IVS 210 describes four principal classes of identifiable intangible asset

to assist in compliance with the requirement to clearly define the asset to be valued and the

nature of the right or interest being valued. These are

marketing related

customer or supplier related

technology related and

artistic related

A more comprehensive discussion of each of these classes of assets and the type of right

or interest typically found is provided below:

3.3 Marketing related intangible assets are used primarily in the marketing or promotion of

products or services. Examples include, but are not limited to:

trademarks, trade names, service marks, collective marks and certification marks;

trade dress (unique colour, shape or package design);

newspaper mastheads;

internet domain names; or

non-compete agreements.

The word brand is often used to describe marketing related assets. It is a generic


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description that typically refers to a group of complimentary assets that can be separately

identified and therefore distinguished from goodwill. The rights to marketing related assets

such as trademarks, trade names or trade dress often are protected by registration under

statute.

3.4 Customer or supplier-related intangible assets arise from relationships with or knowledge

of customers or suppliers. Examples include, but are not limited to:

advertising, construction, management, service or supply agreements,

licensing and royalty agreements,

servicing contracts,

order books,

employment contracts, 7

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use rights, such as drilling, water, air, timber cutting and airport landing slots,

franchise agreements,

customer relationships or

customer lists.

As can be seen from this list, the rights to assets arising from customer or supplier

relationships often arise from contracts, although considerable value can attach to non

contractual assets such as customer relationships and customer lists.

3.5 Technology-related intangible assets arise from contractual or non-contractual rights to

use a specific technology or formula, such as:

patents and design patents,

a distinct design of machine or tool used for a specific process,

a formula or recipe used in the making a product,

computer software or


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a design or distinct type of product.

The rights to technology related intangible assets are often legally protected, but may also

be granted by contract or be implicitly protected by proprietary know-how (trade secrets).

3.6 Artistic-related intangible assets arise from the right to benefits such as royalties from

artistic works such as:

plays and other performed works,

books, newspapers and other literary works,

films, television and other visual media

music, including lyrics, and either published or performed or

photographs, illustrations, drawings and paintings

Frequently the rights to artistic related intangible assets are the subject of statutory

protection (copyright laws) but can also be granted by contract.

3.7 Statutory protection of intangible assets through rights such as trademarks, copyright and

patents, collectively known as intellectual property, is primarily under the laws of the specific

country or state where the intellectual property has been protected. However, protection is

often extended by various international treaties in which participating states agree to

mutually recognise intellectual property rights. The foremost of these is the World Trade

Organisation (WTO) Agreement on Trade Related Property Rights which aims to harmonise

the intellectual property laws of member states. Compliance with this agreement is a

requirement for any state wishing to join the WTO. There are, however, other treaties that

are specific to certain types of asset that may differ from the WTO or involve different

states. 8

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3.8 There are also differences between states in the way in which the treaties are applied or

enforced. Where an intangible asset is international in its use, or potential use, and the


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rights are dependent upon statutory protection, expert legal advice may be required on the

effective geographic extent as well as on the fields of use of the rights in that asset.

3.9 Contractual ownership rights may be recorded in a formal legal agreement or recorded by

an exchange of correspondence. Where rights are granted by a contract or agreement the

terms of the agreement are essential to the definition of the rights to be valued. Some

agreements may be of limited life contain a restriction on transfer which could have a

fundamental effect on the value.

3.10 Some intangible assets grant privileges without the existence of actual ownership rights, eg

customer relationships or trade secrets. These intangibles do not necessarily have an

underlying contract, yet a company or individual can be the owner of such intangibles and

derive economic benefit from them.

3.11 Although it may at times be appropriate and possible to value an identifiable intangible

asset on a stand-alone basis, it may be either impossible or impractical in other cases to

value an intangible asset other than assessing it in conjunction with other tangible or

intangible assets. The valuer should document clearly in the valuation report whether an

intangible asset has been valued on a stand-alone basis or in conjunction with other assets.

If the latter is the case, the valuer should explain why it is necessary to aggregate the

subject asset with other asset(s) for valuation purposes and describe clearly the asset(s)

with which the subject asset has been aggregated.

3.12 Goodwill is an unidentifiable intangible asset because it is not separable from the business

to which it relates. Although goodwill is not separable and is therefore unidentifiable in its

entirety, some elements that contribute to goodwill can be identified. These include but are

not limited to:

company specific synergies arising from a combination of two or more businesses, eg

reductions in operating costs, economies of scale or product mix dynamics,


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opportunities to expand the business into different markets,

the benefit of an assembled workforce, as distinct from any intellectual property

developed by members of that workforce

the benefit to be derived from future customers or

the benefit of an established network.

3.13 In general terms, the value of goodwill is any residual amount remaining after the value of

all identifiable tangible, intangible and monetary assets less liabilities and potential liabilities

have been deducted from the total value of a business. 9

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4 Valuation Approaches and Methods

4.1 All three of the principal valuation approaches described in the IVS Framework, the market

approach, the income approach and the cost approach, can be applied to the valuation of

intangible assets. The main methods within each approach are discussed in this section.

There are additional valuation methods such as real option theory, which are not discussed

in this TIP as they are not widely used, although they may be appropriate for the valuation

of certain types of intangible asset under certain circumstances.

4.2 Understanding the nature and attributes of the subject intangible asset and the nature and

characteristics of the market for that asset is generally critical to determining the most

appropriate valuation approach. Sufficient data may be available so that the required

parameters to apply a secondary method can be deduced from the value for the intangible

asset calculated under the primary method. This is sometimes called reverse engineering.

For instance:

if an intangible asset is valued using relief-from-royalty or premium profits as the

primary method, the implied multiples of, say, revenues and contribution after

marketing charges could be deduced and compared with those from identified


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comparable market transactions; or

if an intangible asset is valued using multi-period excess earnings or replacement cost

as the primary method, implied royalty rates could be deduced that would have applied

if relief-from-royalty were used; such rates could then be considered for

reasonableness.

4.3 The Commentary to IVS 210 observes that the heterogeneous nature of many intangible

assets means that there is often a greater need to consider the use of multiple methods and

approaches than for other asset classes.

4.4 Regardless of the valuation method applied, a sensitivity analysis can be an important part

of performing cross-checks or reasonableness checks on the value of the asset and its

application should be considered if appropriate.

5 Market Approach

5.1 The market approach provides an indication of value by comparing the subject asset with

identical or similar assets for which price information is available.

5.2 The required inputs for applying the market approach to intangible assets are:

prices and/or valuation multiples in respect of identical or similar intangible assets; and

adjustments as required to such transaction prices or valuation multiples, to reflect the

differentiating characteristics or attributes of the subject asset and the assets involved

in the transactions. 10

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5.3 A valuation multiple is often determined by dividing the transaction price of an asset by a

financial parameter, such as historic or prospective revenue or profit at a given level.

Valuation multiples may also be calculated by reference to a key non-financial operating

parameter eg to establish a price per unit of sale

5.4 Because most intangible assets are heterogeneous it is rarely possible to find transactional


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data for an identical asset that can be used as a benchmark for the value of the subject

asset. It is more likely that any market evidence will be in respect of similar rather than

identical assets. Where transactional evidence is available an exercise should be

undertaken to identify any differences between the subject asset and the asset that is being

used as a benchmark and how these affect the relative values. Differences can include:

geographical coverage,

functionality,

market share,

markets accessed (for example one asset may be in the business-to-business market

and the other in the business-to-consumer market) or

the date of the benchmark transaction and the valuation date.

5.5 The objective of this exercise should be to determine whether the identified factors would

result in the price in the benchmark transaction being higher or lower than the price in a

hypothetical transaction involving the subject asset. If possible, any increase or decrease

should be quantified if this is not possible, as much qualitative information as available

should be documented, such as whether the factor is likely to significantly or slightly

increase value as compared with the asset transacted.

5.6 Care should also be taken to establish the circumstances of the transaction that is being

considered as a benchmark. The price paid may have been with a related party, the seller

may have been under pressure to sell or the buyer motivated to pay a high price because of

synergies that only it could exploit.

5.7 It is often the case that full information on a transaction may not be in the public domain, is

difficult or impossible to obtain or may be subject to confidentiality. The valuer may not

know the detailed terms, for example whether warranties and indemnities were given by the

seller, whether incentives were involved, or the impact of tax planning on the transaction.


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Caution is required before relying on transactions where full information is not available.

5.8 Even where transactions can be identified and information regarding prices paid is

available, it can be difficult to determine the appropriate adjustments to the prices or the

valuation multiples necessary to reflect the differentiating characteristics or attributes of the

subject intangible asset as compared to those of the assets involved in the transactions.

Because the difficulties described may restrict the appropriateness of the market approach

this method is often only used as a cross check. 11

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6 Income Approach

6.1 Valuation methods under the income approach determine the value of an intangible asset,

by reference to the present value of future income, cash flows or cost savings that could be

reasonably expected to be achieved by a market participant owning the asset.

Prospective Financial Information

6.2 All the intangible asset valuation methods under the income approach require prospective

financial information (PFI) for some of their inputs. The income stream will relate to

financial parameters such as revenues, operating profit, cash flow or some other measure.

Estimates of these financial parameters are critical to derive a credible valuation.

6.3 PFI should be estimated with respect to factors, such as:

revenues anticipated through use of the asset or asset group and the forecast share of

the market;

historic profit margins achieved and any variations from those margins anticipated

taking account of market expectations;

tax charges on income derived from the asset or asset group;

working capital, capital expenditure requirements or replenishment costs of the

business using the asset; and


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growth rates after the explicit forecast period appropriate to the assets expected life

reflecting the industry involved, the economies involved and market expectations.

6.4 The assumptions behind these inputs should be documented in the valuation report

together with their source.

6.5 The forecast period needs to be assessed consistently with the expected remaining useful

life of the subject intangible asset. As the life of an intangible asset may be finite or

assumed to be indefinite or even infinite, forecast cash flows may be for a finite period or

may run into perpetuity.

6.6 PFI obtained from different sources should be benchmarked to assess its appropriateness

for use in the valuation. Benchmarking is the process of performing consistency checks on

the PFI assumptions. When performing valuations to establish market value this will

include comparing the inputs with data derived from the market to assess and improve their

accuracy and reliability.

6.7 For PFI being used to determine the market value of intangible assets, growth rates,

margins, tax rates, working capital and capital expenditure, benchmarking should include a

comparison with the corresponding data from market participants, where possible. 12

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6.8 Other factors affecting PFI inputs may include the economic and political outlook and

related government policy. Matters such as currency exchange rates, inflation and interest

rates may affect intangible assets that operate in different economic environments quite

differently. Consideration should be given to how such factors affect the specific market

and industry in which the subject asset is being valued.

6.9 When cash flows are forecast into perpetuity, specific consideration should be given to the

growth rates used. These should not exceed the long-term average growth rates for the

products, industries, country or countries involved, unless a higher growth rate can be


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justified.

6.10 When using PFI to determine the value of an intangible asset, a sensitivity analysis of the

resulting asset value should be performed to assess the impact of possible variations in the

underlying assumptions. Those elements of PFI to which the resulting asset value is most

sensitive, should be reviewed to ensure that the assumptions underlying them are as robust

as possible with all available relevant factors being reflected.

6.11 Where the PFI is to be used as an input into a valuation method that uses discounting

techniques, regard should be had as to whether a discount rate adjustment technique or an

expected cash flow adjustment technique is being used, and to select a discount rate that is

consistent with the cash flow forecasts.1

Valuation Methods

6.12 There are various methods used for valuing intangible asset that fall under the income

approach. The most common are discussed in this paper, ie:

relief-from-royalty method, sometimes known as royalty savings method,

premium profits method, sometimes known as the incremental income method,

excess earnings method and

greenfield method.

6.13 Each of these methods involve the discounting of forecast cash flows attributable to the

subject asset based on PFI using either discounted cash flow techniques or, in certain

limited cases, the application of a valuation multiple.

6.14 In addition to capitalising the future expected income flows, or alternatively cost savings that

may be derived from use of the asset, it may be appropriate to take account of any tax relief

that would be available on amortisation of the capitalised asset in a transaction. Such an

adjustment, known as the tax amortisation benefit (TAB), reflects the fact that the income

derivable from an asset includes not only the income directly achievable from its use but


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also the reduction in tax payable by purchaser of the asset. The benefit is highly dependent

on the ability to amortize the intangible asset in the relevant tax jurisdiction, thereby

1

See IVSC TIP No 1 Discounted Cash Flow 13

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providing a tax shield, as well as the assumptions for relevant tax rates and amortization

conventions.

6.15 If estimating the market value, an adjustment to the cash flows for tax amortisation should

be made only if this benefit would be available to a purchaser of the asset in the market

under the relevant tax regime. When performing a valuation of an asset on a basis other

than market value, a TAB adjustment should be made if amortisation would be consistent

with the basis of valuation and the approach adopted. Thus, if an entity-specific valuation is

being performed, a TAB adjustment should be included only if tax amortisation is available

to the specific entity concerned under the application of an income approach.

Relief-from-royalty

6.16 The relief-from-royalty, or royalty savings, method estimates the value of an intangible asset

by reference to the value of the hypothetical royalty payments that would be saved through

owning the asset, as compared with licensing the asset from a third party. It involves

estimating the total royalty payments that would need to be made over the assets useful

life, by a hypothetical licensee to a hypothetical licensor. Where appropriate, the royalty

payments over the life of the asset are adjusted for tax and discounted to present value.

6.17 Some or all of the following valuation inputs are required in the relief-from-royalty method:

an estimate of the hypothetical royalty rate that would be paid if the asset were

licenced from a third party,

projections for the financial parameter, eg revenues that the royalty rate would be


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applied to over the life of the intangible asset together with an estimate of the life of the

intangible asset,

rate at which tax relief would be obtainable on hypothetical royalty payments,

the cost of marketing and any other costs that would be borne by a licensee in utilising

the asset and

an appropriate discount rate or capitalisation rate to convert the assets hypothetical

royalty payments to a present value.

6.18 Royalty rates are typically applied as a percentage of the revenues expected to be

generated when using the asset. In some cases, royalty payments may include an upfront

lump sum in addition to periodic amounts based on revenues or some other financial

parameter.

6.19 Two methods can be used to derive the hypothetical royalty rate. The first is based on

market royalty rates for identical or similar assets. Royalty rates may be obtained by

reference to any existing or previous arrangements in which the subject asset was licensed

or by reference to licensing arrangements for other identical or similar assets. A

prerequisite for this method is the existence of comparable intangible assets that are

licensed at arms length on a regular basis. 14

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6.20 The second method used in the absence of market royalty rates for identical or similar

assets is based on a split of profits that would hypothetically be paid in an arms length

transaction by a willing licensee to a willing licensor for the rights to use the subject

intangible asset. A reasonable percentage split is determined having regard to the facts of

the case, eg the respective investment that would be required by the licensor and licensee

in order for the asset to generate the anticipated profit. A cross check can be made by

reference to royalty rates for any broadly analogous asset.


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6.21 Any royalty information obtained should be adjusted to reflect the differences between the

comparable royalty arrangement and the subject asset. Factors to benchmark when

comparing the subject asset and other royalty agreements include:

specific licensor or licensee factors that might impact the royalty rate such as their

being related parties;

exclusivity terms;

whether the licensor or licensee has responsibility for certain costs, such as marketing

and advertising;

licence inception date and period of effect;

duration of licence; or

differentiating characteristics such as market position, geographical coverage,

functionality, whether they are used in connection with B2B or B2C products etc.

6.22 When performing royalty cash flow calculations, maintenance and other support

expenditure must be treated consistently. Thus, if the licensor would be responsible for

maintenance expenditure, for example advertising or maintenance research and

development, the royalty rate should reflect this as should the royalty cash flows.

Alternatively, if maintenance expenditure is not included in the royalty rate, it should also be

excluded from the royalty cash flows. Similarly, taxes must be treated consistently in the

royalty cash flows.

6.23 Reasonableness checks should also be performed in respect of the selected royalty rate.

One such check compares the total profit at a particular level, such as gross or operating

profit, and how much of that profit would accrue to each of licensee and licensor if a

selected royalty rate were used in determination of the licence fee. The reasonableness of

such a profit split can then be reviewed.

6.24 If the resulting profit splits are significantly different from the ranges indicated by market


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observation then:

this may be explicable by reference to specific factors for instance, the subject asset

may be especially complex and, hence, expected to earn a higher than normal return

for the licensor,

it may be necessary to reconsider whether the selected royalty rate is appropriate or 15

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depending on the basis of valuation being adopted, a royalty rate might be appropriate

that is different from that adopted by market participants.

The above are indications of potential shortcomings. There may be other reasons for

deviations and respective adjustments require professional judgement.

Premium profits method

6.25 The premium profits, or incremental income, method indicates the value of an intangible

asset by comparing an estimate of the profits or cash flows that would be earned by a

business using the asset with those that would be earned by a business that does not use

the asset. The forecast incremental profits or cash flows achievable through use of the

asset are then computed. Forecast periodic amounts are brought to a present value

through use of either a suitable discount factor or suitable capitalisation multiple.

6.26 The key inputs in the premium profits method of valuation are:

forecast periodic profit, cost savings or cash flows expected to be generated by a

market participant using the intangible asset,

forecast periodic profit, cost savings or cash flows expected to be generated by a

market participant not using the intangible asset and

an appropriate capitalisation multiple or discount rate to capitalise forecast periodic

profit or cash flows.

6.27 Forecasts of the cash flows achievable both with and without the subject intangible asset


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should be made by reference to:

activities of the owning entity,

any entities using similar or identical intangible assets for which information is available

publicly,

any proprietary databases of the valuer and

other research as available.

6.28 Where the PFI is obtained from the owning entity it should be tested or benchmarked

against other data in the market. Depending on the basis of valuation required,

adjustments may be required in respect of entity-specific factors in the forecasts.

6.29 The method can be used to value both intangible assets whose use will save costs and

those whose use will generate additional profit. Examples of where different profits may

be generated with or without an asset include:

a beverage being sold by the same entity under both a branded and non-branded label

and

a non-compete agreement creating different projected cash flows. 16

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6.30 The application of this approach should reflect the extent to which the profit or cash flow

forecast excluding the use of the intangible asset is unrepresentative because of its reliance

on another intangible asset. This could happen, for instance, through the comparable

profits being reliant on an own-name brand rather than no brand. In such cases, the

identified premium profit and resulting value attributable to the intangible subject asset

would be understated.

6.31 Account also needs to be taken of any differences in the level of investment that may exist

between an apparently comparable brand and the subject. A branded product may produce

higher gross profits than an unbranded product due to higher selling price. However, sales


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of the branded product may require advertising and marketing expenses that the unbranded

product does not. Similarly, a new manufacturing technology may reduce manufacturing

costs, but require the purchase of additional machinery. The return on and of the additional

machinery needs to be considered in the valuation of the technology.

Excess earnings method

6.32 The excess earnings method determines the value of an intangible asset as the present

value of the cash flows attributable to the subject intangible asset after excluding the

proportion of the cash flows that are attributable to other assets. It is a method that is often

used for valuations used in financial reporting when there is a requirement for the acquirer

to allocate the overall price paid for a business between tangible assets, identifiable

intangible assets and goodwill.

6.33 The excess earnings method can either be applied using several periods of forecast cash

flowsthe multi-period excess earnings method or using a single period of forecast cash

flowsthe single-period excess earnings method. In practice, because an intangible

asset will normally bring monetary benefits over an extended period, the multi-period

excess earnings method is more commonly used.

6.34 The inputs that should be considered when applying the excess earnings method include,

but are not limited to:

forecast cash flows obtainable from the business to which the subject intangible asset

contributes to cash flows this will involve allocating both income and expenses

appropriately to the pertinent business or group of assets of the entity that includes all

the income derivable from the subject intangible asset,

contributory asset charges in respect of all other assets in such business(es), including

other intangible assets,

an appropriate discount rate to enable expected cash flows attributable to the subject


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intangible asset alone to be brought to a present value and

if appropriate and applicable,TAB. 17

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6.35 The method is frequently used in practice to value in-process research and development, or

IPR&D, projects which are difficult to value by other methods. As each IPR&D project is

likely to be unique, it is unlikely that there will be data available from market transactions of

similar assets so a comparison approach is unlikely to be possible. The nature of an

IPR&D project is that additional development time and costs are anticipated prior to the

asset generating cash flows (or cost savings). A discounted cash flow exercise, such as

multi-period excess earnings, can be adapted to reflect these costs prior to the asset

generating cash flows (or cost savings), whereas such adaptation is difficult with either the

relief-from-royalty or premium profits methods.

6.36 The method is also frequently used in practice to value customer relationships or customer

contracts. Again, there are rarely market transactions in similar assets for which price

information is available so a comparison valuation method is unlikely to be possible. Also, it

is difficult to apply relief-from-royalty to such assets as these assets are not leased in the

market and so there is no data available on which to base royalty rates. Similarly, it is not

possible to apply the premium profits method as it would be difficult to find a comparable

business that did not have customer relationships.

6.37 Typically, the types of intangible assets that are valued using the excess earnings method

are those that contribute to cash flows in combination with other assets in a group. While it

is important to assess the cash flows in the context of the business, the excess earnings

method is generally applied at a level of cash flows below that of the business. The method

first involves forecasting the total cash flows expected to arise from the business or group of

assets that use the subject intangible asset. From this forecast of cash flows, a deduction


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is made in respect of the contributions to the cash flows that are made by assets, tangible,

intangible and financial, other than the subject intangible asset. This is referred to as the

application of contributory asset charges (CACs) or economic rent.

6.38 When calculating the intangible asset value it is important to ensure that the forecast cash

flows are reflected in the projection only to the extent that it is expected to arise from the

asset being valued in existence at the valuation date.

6.39 The forecast cash flows are brought to a present value by application of a suitable discount

rate or, in simple case with infinite or indefinite RUL, a capitalisation rate.

6.40 The underlying principles of the CAC calculation are that:

CACs should be made for all the tangible, intangible and financial assets that

contribute to the generation of the cash flow and

if an asset for which a CAC is required is involved in more than one line of business, its

CAC should be allocated to the different lines of business involved.

6.41 CACs are generally computed as a fair return on and of the value of the contributory asset. 18

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The appropriate return on a contributory asset is the investment return a typical

prudent investor would require on the asset. This return that an investor would require

is computed with respect to the Market Value of the asset.

The return of a contributory asset is a recovery of the original investment in respect of

assets that deteriorate over time. Thus, in the case of a tangible fixed asset, the return

of such asset could be represented by its depreciation charge.

6.42 If cash flows are forecast on a post-tax basis, CACs should be determined on a post-tax

basis. if cash flows are forecast on a pre-tax basis, CACs should be determined on a pretax basis. In

practice, it is more common to value intangible assets on a post-tax basis.

6.43 Assets for which CACs are typically assessed include working capital, fixed assets,

intangible assets other than the subject intangible asset, and any workforce in place.


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Precautions should be taken to ensure that there is no double counting between charges in

the profit and loss account and the CACs, and similarly that no CACs are omitted.

6.44 For more guidance on CACs specifically for valuations for financial reporting see the

Exposure Draft TIP## The Calculation of Contributory Assets and Economic Rents.

Greenfield method

6.45 The greenfield method is conceptually similar to the excess earnings method in that it

identifies the incremental or excess cash flow associated with the subject asset. However

instead of subtracting a CAC from the cash flow to reflect the contribution of contributory

assets, the greenfield method assumes that the owner of the subject asset would have to

build or buy the contributory assets. An amount representing that initial investment is

therefore deducted from the cash flow.

6.46 Because the cash flows used in the greenfield method can be used to explicitly model the

initial start-up costs of buying or creating the contributory assets, it can it can be a useful

indicator of the value of the going concern in cases where the PFI reflects an established

business. A greenfield approach is most commonly used as one of the methods to estimate

the value of licence based intangible assets.

7 Cost approach

7.1 The cost approach is based on the economic principle that a buyer will pay no more for an

asset than the cost to obtain an asset of equal utility, whether by purchase or by

construction. Due to most intangible assets being heterogeneous there will rarely be any

transactions involving identical or even similar assets (see para 4.8) and therefore the cost

approach considers the cost that a buyer would incur in constructing or creating an

equivalent asset. 19

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7.2 The cost approach, determines the value of an intangible asset by comparing it with the


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cost of creating an asset of equal utility or service capacity. Often a newly created

intangible asset will have a greater utility than the subject asset. Where this is the case an

adjustment is required to the cost of creating the new asset to reflect the inferior utility of the

subject asset. This adjustment is generally known as an obsolescence or depreciation

adjustment.

7.3 The cost approach can only be applied to the valuation of intangible assets when it is

possible to reasonably estimate either the reproduction or replacement cost of the subject

asset. In this context;

The reproduction cost is the cost that would be incurred in replicating the asset. It

would reflect the time, investment and processes involved in creating the subject

asset, at costs prevailing at the valuation date. It is most appropriate for recently

created intangible assets.

The replacement cost is the cost of creating an modern equivalent asset that offers

the same utility or functionality as the subject asset. Due to changes that have

occurred in the market, eg because of changing consumer tastes or technological

changes, the processes involved in creating the subject asset may no longer be

appropriate. Replacement cost is most appropriate for well established assets where a

potential buyer may have options for creating an equivalent alternative that do not

involve replicating the processes involved in creating the subject asset.

7.4 The cost approach is mainly used for those intangible assets that have no identifiable

income streams or other economic benefits. Examples of intangible asset the cost

approach is applied include:

self-developed (proprietary) software,

web sites, and

the benefit of an assembled workforce (see 6.43) .


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7.5 The costs that should be considered in applying the cost approach to value an intangible

asset include:

the labour costs and any material costs involved in creating the asset,

the cost of any advertising or other promotion required to create an asset of equivalent

utility,

the cost of any management time involved in project oversight,

legal, licensing and patent registration fees and

the opportunity cost, ie the cost of any opportunities for alternative investment that

would be foregone in order to develop an equivalent asset. 20

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7.6 It may also be appropriate to consider the impact of tax deductibility for the costs incurred in

researching or developing an intangible asset

7.7 Obsolescence adjustments may be needed to the costs of replacing an intangible asset if

the subject asset would be less valuable than its replacement. This could arise where:

the a new equivalent would be developed using technology or know how that was not

available when the subject asset was created or

if the subject asset would have a shorter remaining useful life than a new equivalent

8 Other Considerations

Discount rates

8.1 The various methods that fall under the Income Approach described in Section 6 of this TIP

involve the use of discounting techniques. The heterogeneous character of most intangible

assets means that it will seldom be possible to obtain reliable market data on discount rates

for comparable individual assets. However, it may be possible to use rates from the market

as reasonableness cross-checks of results from application of the build-up method.

8.2 If the subject intangible asset is the principal asset of the business it is common practice to


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estimate the discount rate for an intangible asset by reference to to the weighted average

cost of capital (WACC ) applicable to that business. However, the WACC rate may not be

appropriate if the subject intangible asset has a distinct risk profile from the rest of the

assets and liabilities utilised in the business or if there is other evidence that indicates an

alternative discount rate.

8.3 Because of the limitations on deriving an appropriate discount rate from market data the

build-up technique described in TIP1 Discounted Cash Flow is commonly used for valuing

intangible assets.

Remaining Useful Life

8.4 An important consideration in the valuation of an intangible asset is the remaining useful life

of the asset. This may be a finite period limited by either contract or typical life cycles in the

sector; other assets may effectively have an indefinite or even infinite life. Estimating the

remaining useful life of an asset will include consideration of legal, technological or

functional and economic factors. For example, an asset comprising a drug patent may

have a remaining legal life of five years before expiry of the patent, but a competitor drug

with improved efficacy may be expected to reach the market in three years. This might

cause the remaining useful life of the patent to be assessed as only three years, although

consideration should be given as to whether the know how would have value beyond that

date for production of a generic drug. 21

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ILLUSTRATIVE EXAMPLE

The following example illustrates how various methods referred to in this TIP can be applied.

The valuer has been engaged to perform a purchase price allocation under IFRS 3 for the clients

acquisition of a company that distributes food products. The required valuation basis is therefore

fair value as defined in IFRS. Revenue is forecast to grow at 4% per annum for 4 years. The


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company expects revenue of CU200m in the first year and to maintain a constant EBITDA margin of

20% each year. Depreciation is estimated at 2.5% of revenue. A long term tax rate assumption of

23% has been assumed over the forecast period. As at the valuation date, the valuer determines

an appropriate post-tax discount rate to be 8.5%.

The valuer has identified the following intangible assets in the company as at the Valuation Date:

1. A registered patent applied on all food products the company distributes which will generate

economic benefits for 4 years.

2. A non-compete agreement with the founder of the company which disallows his establishment

of a rival company after the sale of the company to the acquirer.

3. A four year distribution agreement with a key customer representing 10% of the companys

annual turnover at the same overall margin.

The valuer uses different methods to value the above intangible assets based on the nature of the

intangible assets:

1. Relief from royalty method is used to value the registered patent.

2. Premium profits method is used to value the non-compete agreement.

3. Multi-period excess earning method (MPEEM) is used to value the distribution agreement.

The valuer has added risk premia on top of the base discount rate to the company as appropriate

for the respective intangible asset.

A total pre-tax contributory asset charge of 11% is applied to the pre-tax earnings in using the

MPEEM on the distribution agreement. 22

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Method 1 - Relief from royalty

m

Year 1 2 3 4

Revenue 200.0 208.0 216.3 225.0


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Pre-tax royalty payment 10.0 10.4 10.8 11.2

Tax -2.3 -2.4 -2.5 -2.6

Relief from royalty 7.7 8.0 8.3 8.7

Discount period 1.0 2.0 3.0 4.0

Discount factor 0.913 0.834 0.762 0.695

Present value 7.0 6.7 6.3 6.0

Fair value before TAB 26.1

Key assumptions

WACC 8.5%

Risk premia 1.0%

Discount rate 9.5%

Comparable royalty rate (pre-tax) 5.0%

Tax 23.0%

Method 2 - Premium profits

m

Year 1 2 3 4

EBIT with non-compete agreement 35.0 36.4 37.9 39.4

EBIT without non-compete agreement 28.0 30.9 34.1 37.4

Premium pre-tax profit 7.0 5.5 3.8 2.0


Discount factor 0.905 0.819 0.741 0.671


Sum of present value before TAB 14.9

Probability of competition and success 75.0%



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Key assumptions

WACC 8.5%

Risk premia 2.0%

Discount rate 10.5% 23

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Method 3 - Multi-period excess earning method

m

Year 1 2 3 4

EBIT 3.5 3.6 3.8 3.9

Pre-tax CAC -0.4 -0.4 -0.4 -0.4

Pre-tax profit after CAC 3.1 3.2 3.4 3.5

Tax -0.7 -0.7 -0.8 -0.8

Excess earnings 2.4 2.5 2.6 2.7


Discount factor 0.913 0.834 0.762 0.695



Key assumptions

WACC 8.5%

Risk premia 1.0%

Discount rate 9.5%

% of total sale and EBIT attributed 10.0%

Pre-tax contributory asset charges (CAC) 11.0%

Tax 23.0%

( Additional text required to reconcile different methods and confirm valuation conclusion )

Agenda Item 12

Documents

Transcript of Agenda Item 12