Valuing a Firm with Intangible Assets

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Valuing a firm with intangible assets

Introduction 

Over the last few years, there has been a significant shift from manufacturing to service based economies. Hence, there has been an increase in the number of organizations whose worth is largely based incorporeal properties as opposed to tangible properties. For instance, technology companies derive much of their worth from copyrights, patents, and other intangible assets. Other intangible assets include trademarks, brand names, excellent management, excellent workforce, and technological expertise (Arregui-Ayastuy, Rodríguez, & Vallejo, 2011). This presents a challenge in that most of the models used to value traditional manufacturing companies are not applicable in valuing these service based companies. 

Critical challenges associated with valuing a firm with significant intangible assets

There are several challenges that are associated with valuing a firm with significant intangible assets. One of the main challenges is that most companies do not record down the value of their intangible assets. This makes it harder to value them (Arregui-Ayastuy, Rodríguez, & Vallejo, 2011). While assigning value to a tangible asset is easy assigning value to an intangible asset is not as easy. For instance, brand value is not included in the balance sheet of companies. This is especially important for those companies that spend a significant amount of money in creating and growing their brand (Saunders, & Brynjolfsson, 2016). Valuing of intangible assets by companies is possible however the cost of doing so is prohibitive to most companies. 

Another major challenge associated with valuing a firm with significant intangible assets is deciding what the value of the intangibles should be based on. For instance, accountants are always confused on whether to base the value of an intangible asset on the amount of money that was used to create it or simply come up with an estimate value of the assets (Damodaran, 2009). Determining the true value of an intangible asset is a difficult task as its value is not readily known. Most companies assign value depending on the amount of income generated by the intangible asset. For instance, one can determine the value of a patent by looking at the amount of income generated from licensing the patent. Unfortunately, this does not account for the unlicensed patent yet even that is part of the company’s assets. 

Just like all other assets, the value of intangible assets appreciates or depreciates over time.  While it is easy to calculate the rate of appreciation or depreciation of tangible assets, it is not as easy with intangible assets. For instance, it is very difficult for a company to determine the value of appreciation for its patents, trademarks and so on. Hence updating the annual value of intangible assets is difficult (Damodaran, 2009). Valuing intangibles is a tedious process that takes a long time. The process involves, first identifying the company’s intangible assets and then assigning them a justifiable value. None of this is easy as both processes require careful consideration. While intangible assets such as registered trademarks and patents are easy to identify others such databases, pending patents, in-house software and so on are easily overlooked yet they too are intangible assets. Even after they have been identified assigning them a justifiable value is not easy (Sacui, & Szatmary, 2015). For instance, it is not easy to assign a justifiable value to a customer database owned by the company yet it is part of its intangible assets. 

Determining the fair value of an asset involves determining its value in use as used with other assets. One looks at its best use as viewed from a market perspective (Damodaran, 2006). However, determining the fair value of an intangible value in use is not that easy especially when it’s being used with other assets. For instance, it is difficult to determine the best use for a trademark even when it is being used in all the products of the organization. From above it is clear that there are several challenges that are associated with valuing a firm with significant intangible assets.

Adjusting valuation approaches 

Valuation approaches should be adjusted to accommodate the differences in valuing tangible and intangible assets. Transferability of intangible assets differs from that of tangible assets. Tangible assets are easily transferable as separate assets, which is not the case with intangible assets. Mostly, intangible assets are transferred as part of a group of assets (Damodaran, 2006). This makes it difficult to realize its true value leading wrong valuation and sometimes their value is not considered at all. However, some intangible assets are transferred separate from other assets making it easier to assign them a fair value.  The value of an intangible asset comes from its intangible nature. This is as opposed to tangible assets whose value comes from their tangible nature. Unfortunately, most valuation approaches were designed for tangible assets hence do not take cognizance of the intangible nature of the intangible assets (Digliani & Miller, 1998). For instance, a database that holds important information that keeps the company running is likely to be overlooked in valuing the company despite its importance in decision making at the company.  Valuation approaches should be adjusted to ensure that such important assets are not overlooked in valuation (Ipate & Pârvu, 2016). Many of the approaches used in valuation of traditional manufacturing companies may not be applicable to companies with significant intangible assets. When applied, these used, these metrics mostly produce results that are not reliable. Many intangible assets are uncertain in nature and this is difficult to capture using the traditional valuing approaches (Foster, Fletcher, & Stout, 2003). Hence most critics rightly argue that the traditional valuing approaches are insufficient when it comes to intangible assets (Vidrascu, 2015). Valuation approaches should be adjusted to accommodate the difference. 

Approaches that should be taken

One way to accommodate the difference when using traditional valuation approaches on a firm with significant intangible assets is by first carrying out an audit of all intangible assets. This can be done for instance by looking at the periodic payments required to keep intellectual property rights in force (King, 2005). The audit can also include an evaluation of the procedures the company uses to prevent other companies from utilizing their intellectual property rights. The annual intangible assets audit, as opposed to doing it once in a long period of time, will ensure that they are not overlooked in valuation exercises. Once the assets have been identified it becomes easier to monitor their appreciation and depreciation. Once identified, the company can then use the market, income, cost, or the 25% rule approach to assign value to the intangible assets (Kimouche, & Rouabhi, 2016). The 25% rule is especially popular for valuing patents and technology. Conducting audit before employing one of the above approaches ensures that the organization assigns the closes fair value to an intangible asset, hence making it easier to value a firm with significant amount of intangible assets. 

Question 2

Amazon’s Underlying business model

Amazon.com is the largest online retailer in the world. The company sells products at a markup but also provides a platform for other retailers to sell their products. Its three main products are the online retail, internet services and kindle.  The company has a large selection of retail products sold through it websites. It prides itself as one that sells its products at the lowest price for a low profit. Initially the company started as online book selling company before venturing into selling other products such as music movies, electronics and household goods. It also provides a market place for other sellers and makes some money for every sale made.  Through Amazon web services the company provides server space to other companies in addition to providing other internet services.  Although it is not the core part of the company it makes significant profits for the company.  Amazon is also involved in the production and distribution of kindle tablets. The tablets are widely popular and are a major aspect of the company. Initially the tablets were designed as book readers but have since been converted into a media device. The devices are sold at a very low price with the real target being the selling of books, games and videos. 

Amazon’s Balanced Scorecard 

The balanced scorecard provides a very good way of understanding the business strategy of a company.  The scorecard looks at the financial perspective customer perspective, process perspective and learning and growth perspective (Arregui-Ayastuy, Rodríguez, & Vallejo, 2011).  In the early years of Amazon, the company insisted too much on the customer perspective and the learning and growth perspective. The financial and process perspectives were to a large extent ignored. Hence, back then, the score card was unbalanced. 

The financial perspective, involves looking at factors relevant to the valuation of the company by shareholders. For Amazon, between 1998 and 2000 the return on equity was reducing. Net income was actually negative in 2000 (Amazon, 2001). Due to the customer obsession strategy introduced at the time, its asset turnover ratio was very unstable. However, all that has since changed and the company has posted profit 4 quarters in a row. 

The process perspective looks at the internal processes carried out by a company with a keen interest on what the company needs to do to post better results. It looks at how business efficiency can be improved. In 1999, it took about 59 days to sell goods at Amazon. As of now the average inventory period is 45 day. The inventory ratio has since improved to about 8.1 (Amazon, 2016). In its early days the company had warehouse expansion plans which resulted in having more goods in the warehouse. This meant it took more time to pay creditors. However, with time this has increased significantly. 

Amazon engages in a lot of activities that require information, innovation and continuous improvement.  During its early dates sales were declining but that has changed. Cost of sales reduced by about 3% in the first quarter of 2016 (Amazon, 2015). The sales are in line with the company’s business strategy. Considering that the company has expanded significantly over the last ten years, one can conclude that it is doing well from a learning and growth perspective. 

From a customer perspective, Amazon has been very successful in meeting customer expectations. It is widely believed to have the best customer service among online retailers. It also has high customer retention rates. This can be attributed to its strategy of obsessing over the customer.  The strategy involved company employees going out of their way to ensure that customer needs were met. While employee morale is not very high, their competence is enviable (Amazon, 2015). In the early days, Amazon’s score card was unbalanced. That has however changed. One can conclude that the company’s scored card is now balanced. 

Amazon is considered one of the most successful online businesses. Some even consider it to be the pioneer online retailer. From above, one can conclude that it understands well its business model and implements it well.  Its main source of success over the years has been its ability to cultivate and maintain customer loyalty.  Considering that Amazon did not have any other such model to use as a guide, one can conclude that the model it invented has been fairly successful.  Over time it has managed to make its processes so efficient that it has attracted other companies such as Toys R Us and Circuit city among others.  

Amazon’s Valuation

Assumptions
1. The firm is expected to grow at a higher growth rate in the first period.
2. The growth rate will drop at the end of the first period to the stable growth rate.
3. The free cashflow to equity is the correct measure of expected cashflows to stockholders.

	Output from the program
	Cost of Equity =	14.90%
	Equity/(Debt+Equity ) =	100.00%
	After-tax Cost of debt =	5.12%
	Debt/(Debt +Equity) =
	Cost of Capital =	14.90%
		1	2	3	4	5	6	7	8	9	10	Terminal Year
	Revenues	$1,667.50	$3,335.00	$5,836.25	$8,754.38	$11,380.69	$14,248.62	#########	#########	#########	#########	$24,689.29
	– COGS	$1,834.25	$3,501.75	$5,836.25	$8,579.29	$11,153.07	$13,792.66	#########	#########	#########	#########	$22,714.15
	– Depreciation	$30.00	$52.50	$78.75	$102.38	$128.17	$154.32	$178.39	$197.66	$209.52	$222.09	$235.42
	EBIT	($196.75)	($219.25)	($78.75)	$72.71	$99.44	$301.63	$576.44	$674.93	$1,020.99	$1,361.75	$1,739.73
	– EBIT*t							$156.77	$242.97	$367.56	$490.23	$626.30
	EBIT (1-t)	($196.75)	($219.25)	($78.75)	$72.71	$99.44	$301.63	$419.67	$431.95	$653.43	$871.52	$1,113.42
	+ Depreciation	$30.00	$52.50	$78.75	$102.38	$128.17	$154.32	$178.39	$197.66	$209.52	$222.09	$235.42
	– Capital Spending	$52.50	$78.75	$102.38	$128.17	$154.32	$178.39	$197.66	$209.52	$222.09	$235.42	$258.96
	–  Chg. Working Capital	$50.03	$83.38	$125.06	$145.91	$131.32	$143.40	$145.34	$133.81	$107.09	$65.92	$69.88
	Free CF to Firm	($269.28)	($328.88)	($227.44)	($98.99)	($58.02)	$134.16	$255.07	$286.28	$533.77	$792.27	$1,020.01
	Present Value	($234.36)	($249.11)	($149.93)	($56.80)	($28.97)	$58.89	$99.39	$99.94	$168.43	$227.91
	NOL	$316.75	$536.00	$614.75	$542.04	$442.60	$140.96
	Index										1
	Cost of Capital Computation
	Beta	1.80	1.80	1.80	1.80	1.80	1.64	1.48	1.32	1.16	1.00	1.00
	Cost of Equity	14.90%	14.90%	14.90%	14.90%	14.90%	14.02%	13.14%	12.26%	11.38%	10.50%	10.50%
	Cost of Debt	5.12%	5.12%	5.12%	5.12%	5.12%	5.12%	5.12%	5.12%	5.12%	5.12%	5.12%
	Debt Ratio						3.00%	6.00%	9.00%	12.00%	15.00%	15.00%
	Cost of Capital	14.90%	14.90%	14.90%	14.90%	14.90%	13.75%	12.66%	11.62%	10.63%	9.69%	9.69%
	Cum. WACC	1.14900	1.32020	1.51691	1.74293	2.00263	2.27805	2.56642	2.86457	3.16904	3.47622
	Growth Rate in Stable Phase =	6.00%
	FCFF in Stable Phase =		$1,020.01
	Cost of Equity in Stable Phase =	10.50%
	Equity/ (Equity + Debt) =		85.00%
	AT Cost of Debt in Stable Phase =	5.12%
	Debt/ (Equity + Debt)  =		15.00%
	Cost of Capital in Stable Phase =	9.69%
	Value at the end of growth phase =	$27,620.01
	Present Value of FCFF in high growth phase =	($64.61)
	Present Value of Terminal Value of Firm =	$7,945.42
	Value of the firm =			$7,880.81
	Market Value of Debt =
	Market Value of Equity =		$7,880.81
	Value of Options Outstanding (See option worksheet) =	$1,721.09
	Value of Equity in Common Stock =	$6,159.72
	Value of Equity per Share =		$116.75

In above analysis, the discounted cash flow analysis model was used. It was used as it is a good model for determining how attractive an investment opportunity is. The model was chosen as since the principal aim of the analysis was to project cash flow for a short period of time as opposed to infinity. The model gives a good picture of expected growth, capital efficiency cost of debt and so on hence is appropriate for this valuation. 

References

Arregui-Ayastuy, G, Rodríguez Castellanos, A, & Vallejo Alonso, B 2011, Identifying, Measuring, And Valuing Knowledge-Based Intangible Assets : New Perspectives, Hershey, PA: IGI Global, Discovery eBooks, EBSCOhost, viewed 25 August 2016.

Amazon, 2015, ‘Amazon annual report 2015,’ available at http://www.annualreports.com/HostedData/AnnualReports/PDF/2015%20Annual%20Report.pdf

Damodaran, A. 2009, ‘Invisible Value? Valuing Companies with Intangible Assets’ .  http://ssrn.com/abstract=1609799  

Damodaran, A., 2006,’The value of intangibles’
http://pages.stern.nyu.edu/~adamodar/pdfiles/ovhds/dam2ed/intangibles.pdf

Damodaran, A., 2006, ‘The basics of discounted cash flow valuation’
http://people.stern.nyu.edu/adamodar/pdfiles/basics.pdf

Digliani, F. & Miller, M. 1998 ‘The Cost of Capital, Corporation Finance and the Theory  of Investment’. American Economic Review 48 (3): 261–297

Foster, B., Fletcher, R., and Stout, W., 2003, ‘Valuing Intangible Assets, CPA Journal’
http://www.nysscpa.org/cpajournal/2003/1003/features/f105003.htm

King, K., 2005, ‘The Value of Intellectual Property, Intangible Assets and Goodwill’
http://www.wipo.int/sme/en/documents/value_ip_intangible_assets.htm

Kimouche, B, & Rouabhi, A 2016, ‘The impact of intangibles on the value relevance of accounting information: Evidence from French companies’, Intangible Capital, 12, 2, pp. 506-529, Business Source Complete, EBSCOhost, viewed 25 August 2016.

Saunders, A, & Brynjolfsson, E 2016, ‘VALUING INFORMATION TECHNOLOGY RELATED INTANGIBLE ASSETS’, MIS Quarterly, 40, 1, pp. 83-110, Business Source Complete, EBSCOhost, viewed 25 August 2016.

SACUI, V, & SZATMARY, M 2015, ‘Intangible Assets in Business Combinations’, Review Of International Comparative Management / Revista De Management Comparat International, 16, 3, pp. 385-397, Business Source Complete, EBSCOhost, viewed 25 August 2016.

IPATE, D, & PÂRVU, I 2016, ‘THE IMPACT OF INTANGIBLE ASSETS ON COMPANIES IN EMERGING MARKETS’, Economics, Management & Financial Markets, 11, 1, pp. 94-99, Business Source Complete, EBSCOhost, viewed 25 August 2016.

Savickaitė, Ž 2014, ‘The Evaluation of Company’s Intangible Assets’ influence for Business Value’, International Journal Of Economic Sciences & Applied Research, 7, 3, pp. 133-155, Business Source Complete, EBSCOhost, viewed 25 August 2016.

VIDRASCU, PA 2015, ‘INTANGIBLE ASSETS – SUSTAINABLE ECONOMIC FACTORS AND NEW CREATORS OF VALUE’, Internal Auditing & Risk Management, 10, 1, pp. 65-75, Business Source Complete, EBSCOhost, viewed 25 August 2016.