Ever heard of Benjamin Graham’s “Intelligent Investor?” The 640-page piece has been revolutionary in shaping the way we approach investing today. Warren Buffett, one of the world’s most famous investors has even referred to this book as his investing “bible”. If you haven’t gotten the chance to read the novel yourself, Graham mentions of the “enterprising investor”, who works to identify undervalued companies relative to its book value. While many may think that calculating a company’s book value is as simple as taking their total assets, less intangibles, and liabilities, it can become much more complex than that when looking deeper into a company. When analyzing these components, the value of a company’s assets and liabilities are quite discrete, but when it comes to the dollar value of a company’s intangible assets, valuation can become more abstract.
Just look at items such as the Mona Lisa, Apple’s IOS software, and the patent holding rights to CRISPR-Cas 9 technology. All these items’ “physical” value is minuscule, although their purchase prices are in the hundreds of millions. From an investors perspective, how can one arrive at such a number that they feel reasonably expresses the monetary value of a company’s intangible assets?
In valuing intangible assets, three main categories can be formed to categorize each asset by its properties: distinct intangible assets that have existing cash flows, non-distinct intangibles that have existing cash flows, and non-existent intangibles that may generate future cash flows. This article will focus on these three segments of intangible assets and will discuss the best valuation approach according to NYU Stern finance professor, Aswath Damodaran. It should also be noted that the method of valuing non-existent intangibles will be discussed at a high level due to the complexity of valuation.
Beginning with distinct intangibles that have existing cash-flows, this category contains items such as copyrights, trademarks, licenses, and franchises. When looking at these assets, the “distinct” term comes from the fact that these assets are not corporate-wide and often only affect single business segments and/or products. In terms of valuation techniques, it is best to analyze the specific products that are tied to the intangible and project any future cash flows that the product may generate and then discount these numbers back to present value. In these scenarios, one does not have to worry about any competitor in a relative sense, as these types of intangible assets often differentiate a business’s goods or services to the point where they are the only offering to the market of its kind. It is important to note that these intangibles often hold a finite life so terminal values of these items can be expected to be fairly small. A good example to depict this type of intangible is the book publishing industry. Once an author obtains the rights of publication to a piece of work, they are the only one that can create and sell their work to the public. If another publisher desires to sell this book, they must purchase the rights from the author. At the time of offering, the author would attempt to project the amount of earnings the book will create over the number of years the purchaser will have rights to the book’s publication and then discount back to present value using an appropriate discount rate (which can be assessed based on the riskiness tied to the earnings). This ending sum would then be the price at which the author would attempt to achieve, although the purchaser is not receiving any physical items other than a contract.
When it comes to valuing intangible assets that are non-distinct but are currently generating cash flows, investors must take an alternate approach as opposed to using the methods mentioned above. The main difference between distinct and non-distinct intangibles has to do with the broader spectrum that non-distinct intangibles have across a business’s activities. Items such as brand names, reputation, strong workforce, or superior skills are some examples of non-distinct intangible assets. This classification of intangible assets brings a more complex valuation approach, as they’re are not as clear to the investor the impact they have on a business. Considering that some of these intangibles can’t be broken down into specific segments, the difficulty of valuing these asset types increases. Seeing these facts, relative valuation becomes a crucial component when trying to arrive at a monetary value for a company with intangible assets that has similar competitors. It is recommended that one creates a comparable universe for the given company holding intangible assets and compare DCF valuations and relative valuation multiples across the companies in the universe you have created. If companies that are very similar to the business being analyzed exist, then it can be assumed that the excess revenues at which it’s DCF valuation expresses are close to the overall sum of the companies’ intangible components. In the case where the company also holds distinct, cash flow generating intangibles, one can simply subtract this value from the total intangible value to arrive at the value of the company’s non-distinct intangible portion. To further this explanation, let’s look at Pfizer Consumer Products. One of their subsidiaries, Advil (which generated $484 million of revenue in 2017), is one of the top selling over the counter drugs in the United States. Advil charges a 600% markup compared to generic brands. The main reason for their ability to do this comes from the intangible value they hold in their brand image. This image isn’t mutually exclusive to one segment of Advil’s sales either. In fact, it has affected all types of products that Advil offers, including pain relief, sleep aid, and cold and sinus medications. In valuing Advil’s brand image, one could either look at the business segment and assess the difference in trading multiples and DCF valuations based on this stream in a comparable universe. Please note that accurately segmenting a business line can become extremely complex. It is difficult to build models on specific sub-segments because a significant amount of information is required and companies sometimes are more opaque in regards to releasing segmented financial statements that would ease the process.
Another way to verify the accuracy of the former method is to take the approach of determining the value of the intangible based on the intangible asset CAPEX. For example, if a company invests a portion of capital into its advertising branch, we can try and determine the proportion of expenditures that were allocated to building up its brand name. Once determining this and summing these expenses over time, these costs can be adjusted for inflation. Investors can then use this value and use the unamortized balance to determine the value of the brand name. This approach can be challenging as it is quite difficult to accurately determine proportionalities in a company’s CAPEX segments. To adjust for this, it is recommended that investors take multiple approaches to determining these values to verify the validity of each technique.
Finally, when looking at intangibles that aren’t currently in use but have the possibility to be in the future, the valuation of these assets can become quite complex. One unique characteristic of intangible assets that are currently non-existent is that the likelihood of them becoming of value to a company is a probability (most of the time either success or failure). To properly value these types of assets, one can value the asset as if it were an option. For example, when holding a call option, the buyer has a strike price, which they hope the stock price appreciates above to allow them to make a profit. If the price of the stock falls below the strike price, the only remaining value within the option’s value is the time until expiration. If the price fails to rise above the strike price before expiration, then the buyer will incur losses on 100% of the premium. Applying this concept to intangibles, if the outcome of the intangible being used in production (patents in development, possible expansion opportunities) is successful, then the value of the intangible will be determined by the degree of the competitive advantage that the intangible provides the company (market monopoly, oligopoly, regional monopoly) and can be valued based on whether it is a distinct or non-distinct intangible. If the outcome of the intangible development deems not an additional benefit to the company, then the value of the asset will be zero and the company will be valued based on the loss in CAPEX it expensed to take on the project. Essentially, investors try to calculate the expected value of the company succeeding in development and use this number as a proxy for what the company is worth today. To show this numerically, if a company has a 1% chance of becoming a $1,000,000,000 company, the value of that company today is $10,000,000 (0.01x$1,000,000,000). Often times, this method of valuation is required when assessing the value of a company in the pharmaceutical sector. A real-world application to this concept can be used in Abbvie Inc.’s patent pipeline. Currently, Abbvie Inc. has a product patent in development (ABBV-323) and is currently in phase 1 of its product development. Considering this, Abbvie has a potential product that may be able to generate future income, given that it enters clinical testing. For an investor to incorporate the value of this non-existent intangible into their company valuation, they may utilize option pricing techniques to come to a value of the intangible.
Although these valuation methods may be very helpful in assessing a company’s intangible portion, it is crucial that investors are not fooled by false intangible value. In other words, popular brands do not imply intangible value. Some companies may charge more for their products not because of their brand value, but because they simply provide higher quality products. Mercedes-Benz is a good example as the auto-manufacturer provides high-quality products, ultimately forcing them to charge a higher price in order to meet margin requirements.
When it comes to company valuation, future performance can be subjective to personal opinion, so it is advised that these approaches to intangible valuation be used as tools opposed to guidelines. When assessing a company’s future performance given the many factors that may affect this, sentiment begins to shift from a “black and white” outlook and into a more abstract view. It is important for each scenario to be evaluated independently to each case in order to maintain accuracy in assumptions and valuations techniques that have not been mentioned in this article may be more appropriate.