Fundamental Principles in the Valuation of Intangible Assets (Research Paper Sample)

Fundamental Principles in the Valuation of Intangible Assets
The valuation of intangible assets is playing an ever greater role in valuation practice nowadays. One of the main reasons for this are the fundamental changes that have occurred in important accounting standards, particularly those concerning the treatment of business combinations (especially IFRS 3) and the impairment of assets
(especially IAS 36).
Intangible assets can be divided into various categories. In this context – in addition to other assets, such as trade marks and the customer relationship – patented technologies in particular are also of great importance.
In this study, we shall be discussing both the theoretical principles involved in the valuation of patents and also the way in which they are implemented in a specific valuation case. First of all, we shall briefly consider some of the basic principles of valuation – independently of the valuation of patents – in so far as they are relevant for the purposes of this study.
The comments will not, however, be restricted a priori to a consideration of the valuation of patents for accounting purposes. The only special feature of that case is the fact that the valuation model is characterised by specific assumptions which are laid down by the Accounting Standards or their interpretation. This will only be discussed in passing in the study.
Valuation Principles
Outline
A precondition for any valuation – in addition to a thorough understanding of the valuation methodology to be applied – is a clear and unambiguous delimitation of the object to be valued and a knowledge of the reason for the valuation. In the following, we shall present the aspects involved here in so far as they are relevant to the valuation of patents.
Basic Valuation Approaches
1 Initial Considerations
The value of an object, e.g. a patent or even an entire company, is derived from the benefit which it brings its owner. In order to measure this benefit, it is in principle possible to refer to three categories:
• the income which the asset to be valued is likely to generate in future
• the existing market prices for the object concerned or for comparable objects
• the cost of obtaining a comparable object.
Accordingly, a distinction is made between three fundamental valuation Approaches
* Income approach,
* Market approach or
* Cost approach.
In the practice of valuation, especially the valuation of intellectual assets, these approaches have taken on different forms. In this context, the “hybrid approaches” deserve particular emphasis since they combine elements of two of the basic valuation approaches, specifically the market and the income approaches.
In addition, a number of articles can be found in the literature which claim to have developed further valuation methods in addition to the three basic concepts.
An analysis of these approaches, however, reveals that they are only adaptations of the basic concepts, especially of the income approach, and accordingly do not have any individual significance.
In the following, the three basic valuation approaches will be explained briefly.
2 Income Approach
As already mentioned, the income approach takes as its point of departure the income which can probably be expected in future from the asset to be valued. In the case of a patent to which licences have been granted, for example, this is derived from the future royalty payments to its proprietor, and in the case of a company it is the future dividends paid to the shareholders, or the payments to all investors. The point of departure for the valuation approach is therefore the ability of the asset to be valued to generate future income. “Income” for the purposes of the income approach also includes savings of notional royalties which the patent proprietor would have to pay to a third party if the patent concerned, which is in fact exploited economically by the patent proprietor, were the property not of the patent proprietor, but of a third party. The value of the asset to be valued then corresponds to the amount that would have to be invested in order to obtain the alternative investment.
This comparison of alternatives is performed by discounting the future flows of income from the asset to be valued. In this case, the discount rate embodies the alternative investment. The resulting value of the asset to be valued can accordingly be defined as the present value of the future income payments that can be expected. The valuation methods used in the income approach are the discounted cash flow methods.
3 Market Approach
The market approach, which, according to IFRS 3 is to be preferred in the valuation of intangible assets, works on the premise that the valuation of an object should be based on an estimation of the benefits to the market participants. The approach is based on the idea that, in competitive markets – provided other conditions are met – market prices will develop as a matter of principle for the objects traded there.11
If the asset to be valued is itself traded on an active market,12 its market price provide the most reliable estimate of the value of the asset. If this is not the case, comparable assets should be used as a guide, and their market prices transferred to the asset to be valued (guideline method).
When the guideline method is used, the first step is to calculate a multiple for the relationship between the market price of the comparable asset and a reference parameter. In order to determine the value of the asset to be valued, this multiple must then be applied to the reference parameter of the asset to be valued. In the case of the valuation of a patent for example, the known market price of a comparable patent can be based on the current annual sales (reference parameter) of the product protected by the comparable patent. Applying the multiple determined in this way to the current annual sales of the product protected by the patent to be valued leads to the patent value sought.
When the asset to be valued is not traded on an active market but the market approach is still to be applied, it is necessary for there to be an asset available which is comparable to the asset to be valued and whose market price is known. If a comparable asset is not traded on an active market, comparable transactions must be referred to in order to calculate market prices. If corresponding transactions can be identified, a precise analysis is needed, especially of the detailed terms of the transactions and the circumstances under which they came about (e.g. changes in the market conditions that might have occurred in the meantime, influence of motives specific to that particular buyer).
In view of these preconditions for applying this method, it is immediately apparent that the scope of application of the market approach for valuing intellectual assets, especially patents, is very limited.
54 Cost Approach
With the cost approach, the value of the asset to be valued is determined by the amount needed in order to acquire an asset that enables the owner to obtain the benefit which the asset to be valued gives him. It is therefore the amount which the owner must spend in order to substitute the asset to be valued with an equivalent.
The principle on which the approach is based is that of substitution.
One consequence of the principle of substitution is that the cost approach establishes an upper limit for the value: an investor acting rationally will pay no more for an asset – even if its value would be higher when adopting the income approach – than the amount which he would have to spend in order to acquire another object from which he could obtain the corresponding benefit.
The cost approach exists in various forms:
One basic form proceeds from the identical reproduction of the asset to be valued – an “exact duplicate”, which is the reproduction cost. The other main variant is based on the procurement or production of an object with an equivalent benefit; this is the replacement cost.16
Unlike the reproduction cost, the replacement cost disregards elements which the asset to be valued possesses but which do not provide any benefit at the time of the valuation. The converse applies to technological advances, which are only reflected in the replacement cost. The asset on which the calculation of the replacement cost is based can accordingly differ significantly from the asset to be valued.
When calculating the value according to the cost approach, it may be necessary, where appropriate, also to take physical deterioration and technical and economic obsolescence into account.
The scope of application of the cost approach is, however, limited, because the fact that costs have been incurred in producing an object does not necessarily make it possible to draw conclusions about any future benefit that may result from it.
One can think of the development of new technologies, for example, in which vast amounts may be invested, but whose benefit may be very minor in a specific case.17
The cost approach is used above all if – as has already been explained – it establishes the upper limit of the value.
The cost approach also includes the asset-based approach.
Dependencies Between Income, Market and Cost Approaches
The income and cost approaches are based on the amount needed in order to obtain an asset that provides the same benefit. With the income approach, the measurement of this benefit is specified by the income associated with the asset to be valued. The connection with the market approach exists whenever market prices are referrd to in order to calculate the “costs”.
Asset to Be Valued
The asset to be valued may consist of individual assets, e.g. machin...