How to Value an Intangible Asset

Appraisal methods that value the entire enterprise will yield a value that includes all of the assets of the business, both tangible and intangible. When this is the case, there may be no need to separately value individual intangible assets. But in two cases, valuation of a specific intangible asset may be merited:

• A specific intangible asset is being bought or sold separately and apart from the sale of an entire enterprise.

• The seller of an enterprise wishes to make a case for a higher value of the entire company by highlighting the value of a specific intangible asset that will be sold as part of the entire enterprise.

When the decision is made to isolate and value a particular intangible asset, many methods can be used. Every method falls into one of three approaches to value: cost, market or income. This article introduces two of the easier methods to apply:

• Cost approach: replacement value method

• Income approach: direct capitalization method

Let's first review the definition of intangible asset.  Valuation experts know that defining intangible assets can be difficult. But for our purposes, an intangible asset is something of value that does not have a physical presence. Examples are royalty rights, customer lists, expertise, recipes, processes, brand awareness and reputation. Some of these have a physical representation, such as a customer list, but the information, not the paper it is printed on, has the value.

Cost approach: replacement value method

When we apply the cost approach, we answer the question:

What would it cost to create or construct, at current prices, an intangible asset with equivalent utility? The methodology used is represented by the equation:

Value = replacement cost new - functional obsolescence

Calculating replacement cost new (RCN) requires identification of all costs that might be incurred in re-creating an intangible asset that is functionally identical to what is being valued. All costs fall into one of the following categories:

Material: expenditures related to tangible elements of the intangible asset development process

Labor: expenditures related to human capital efforts necessary to develop the intangible asset

Overhead: expenditures necessary to oversee the project, including management, supervision, support and clerical labor, necessary payroll taxes, perquisites and benefits, utilities, and operating expenses

Developer's profit: required by the person charged with creating or developing the intangible asset

If the intangible asset that is being valued is not new, it is possible that the newly created asset is of greater utility than the one being duplicated (the "old" one). If this is the case, then the old may have functional obsolescence, which is defined as the reduction in value of an intangible asset due to its inability to perform the function it was originally designed for. An adjustment must be made to the RCN value, as the formula above represents.

Income approach: direct capitalization method

All income approaches estimate value by calculating the present value of future income streams expected to be generated by the asset. The direct capitalization method (DCM) is an income approach to valuation and thus uses the same methodology. DCM is easier than other income methods to apply, but the annual future income stream to be generated by the asset must have the following characteristics:

• Constant future income, or income growing at a constant rate (i.e., same dollar value each year or constant growth rate)

• Perpetuity (i.e., income stream to be received each year, indefinitely)

If the intangible asset being valued generates (or will generate) for the buyer an income stream that has the above two characteristics, then the DCM method can be used. The next task is to determine the following:

• Income to be received beginning in Year 1

• Growth rate annually for the income stream

• Discount rate or required rate of return

Identifying a discount rate can be tricky and confusing to the untrained. There isn't sufficient room here for a complete description of how discount rates are calculated. To summarize, the discount rate is referred to as the required rate of return. In other words, it is the return an investor would require to make the investment and forego alternative investments. Once a discount rate is selected, the capitalization rate can be computed as follows:

Capitalization rate = discount rate - growth rate

Once the capitalization rate is calculated, the following formula can be applied to determine the value conclusion:

Value = income / capitalization rate

Example: XYZ Company wants to buy the royalty rights to a book titled Making Money in America. It is estimated that this book will generate $95,000 in after-tax royalty income per year in the first year, and this income stream should increase 10% per year for a very long time. A discount rate of 18% was determined after considering the expected rate of inflation, lack of marketability (liquidity) of the investment and the risk characteristics. By simply plugging our inputs into the formula, we calculate the value as follows:

Value = income/(discount rate - growth rate)

= $95,000 / (.18 - .10)

= $95,000 / .08

= $1,187,500

The above discussion is meant to provide the business owner, investor, executive or advisor a general understanding of the subject. A working knowledge will help you make better decisions. When material dollars are at stake, skilled professionals should be considered before any conclusions are drawn or investments made.