Intangible assets: what are they worth and how should that value be communicated?
Nick Rea and Adrian Davis
Despite widespread acceptance that intangible assets such as brands are critical to the future prospects of a business, they have traditionally been put in the too-difficult box – in terms of both their ongoing management and communicating their value. The fact that it can be difficult to obtain the information needed to manage and enhance the value of brands or patents, together with the sensitivity of that information, has held many companies back. That investors, analysts and other stakeholders are now alert to the importance of intangible assets – and increasingly keen to bridge the information gap that has existed until recently – is no surprise. If it is to arrive at accurate representations of investee companies’ value, the investment community needs to understand how companies create and manage their intangible assets. And that means that the competition for capital will inevitably push companies towards improved intellectual asset management – and improved systems and processes for communicating these initiatives to stakeholders.
Not only is there a compelling financial reason for more rigorous intangible asset management processes, the tax and accounting regimes are demanding that numbers are allocated to intangible assets as part of accounting for acquisitions. And it doesn’t end there, the value of these intangible assets is required to be monitored on an ongoing basis.
This chapter discusses how intangible assets, and in particular brands, are emerging as key business assets for both commercial and accounting reasons. This may well be a pivotal moment in terms of the way that intangibles are managed and communicated in the future, and is the first step towards all intangible assets being managed and reported to internal and external audiences.
How important are intangibles anyway?
With profit warnings announced by a number of well-known companies in recent months, some commentators have suggested that the days of the strong brand are numbered. However, recent PricewaterhouseCoopers’ research supports the view that a significant proportion of a company’s value (potentially over 60 per cent) relates to intangible assets. For many of these companies, the brand forms the majority of this value. These are, of course, not currently recorded or valued in the vast majority of financial records.
So why are intangible assets so important? Strong brands influence customers’ decision-making processes, as well as ensuring that premium prices can be charged. This is particularly true in many consumer businesses. At their best, they represent a guarantee of quality and sometimes, in the case of luxury brands, consumers even derive social status from the brand. This can also support the rapid development of new markets. For example, Tesco, one of the UK’s leading retailers, has had recent success in penetrating financial services. Certainly, in view of the above, a real (but not easily quantifiable) financial benefit arises from intangible assets such as brands and customer relationships.
Intangible assets, therefore, provide potential competitive advantage, but as assets they clearly demand specialist management and communication skills. Management’s ability to deliver its strategy is highly reliant on its customer relationships, brands and performance of key employees – all of which are typical intangible assets for accounting purposes. The relevance of these factors is clearly vital to a company’s profitability and to the sustainability of its future performance. So the question should be more about how to improve the management of such assets – rather than why.
Are intangibles really manageable?
So how do companies actively manage their intangibles in today’s market? Significant management focus is placed on brands to ensure that the brand is exemplified in all aspects of the company’s external and internal behaviours. Brands are constantly adapted and refreshed to respond to shifting customer trends and to keep ahead of the competition, thereby increasing their value. But it is often difficult to see information about the financial aspects of the brand being monitored and managed. For example, the amount that has been invested in a brand is not always accessible.
Customer relationships constitute another critical intangible asset for many companies. And, just as with brands, there is a scarcity of information about key customers – including the length of the relationship, the margins and the cost of supporting key relationships. This is especially pertinent to retailers and the proliferation of customer loyalty card schemes underlines the importance these companies attach to this asset. Retailers now have a much better understanding of what their customers want and why – and all of this information could be translated into value which could then be monitored and managed on an ongoing basis. The financial effect of changes to the way in which customers are managed could then be regularly reported to the board and ultimately to external parties.
This in turn would be likely to result in lower customer acquisition costs because successful brands would appeal to new customers without expensive targeting being required. A virtuous circle would be created, whereby suppliers would increasingly want to become associated with the added volumes that come with a fast-growing business and a strong brand, thereby lowering supplier and distribution results. And this in turn would reinforce the brand’s value.
So what should management be doing differently? Taking our brand example further, we would advocate the following steps:
(1) Develop key performance indicators to monitor the performance of the intangible;
(2) Conduct a yearly assessment of the brand value.
Develop appropriate key performance indicators
Regular appraisal of the various financial and non-financial key performance indicators (KPIs) that measure the competitiveness of the brand is an essential management process for today’s brand owner. KPIs allow management to assess performance against targets and competitive brands and, in our experience, measuring a brand results in better management of the brand asset.
Financial KPIs represent the drivers of value that we would typically analyse when performing a full-scale brand valuation.
The suite of measures that we would advocate tracking depend on the industry and the business model. Broadly speaking, however, they should include price premium paid, relative market share/volumes and customer value, in addition to traditional measures relating to brand positioning and purchasing preference. These KPIs need to be conceived by both the marketing and financial department, and should be presented as part of the board reporting pack.
For customer relationships, KPIs will be average revenue per customer, churn rate, frequency of purchase etc. When monitoring patent value, appropriate KPIs would be expiry date, revenue derived from the innovation, number of licences granted and royalty revenues.
Assessing the value of intangibles
The final step is allocating a value to the brand or other intangible assets on a regular basis and tracking this over time. One of the key features is establishing the incremental earnings from the brand as this will play a key role in the ongoing valuation. The key value drivers for the brand need to be established and then used as inputs into the modelling process. These value drivers include the following:
• Trading history: margin and sales trends.
• Competitive positioning relative to other brands.
• Role within value chain.
• Level and effectiveness of marketing investment.
• Existing market footprint.
A small number of companies have taken a proactive approach to their brands and even publicised their ongoing valuations in their financial statements. An example of this is the Infosys brand valuation which is shown in figure 1.
Fitting in with the new accounting rules
A major reason why intangible assets have not previously been managed like other assets is a lingering suspicion that intellectual property cannot be properly valued (given the number of assumptions which need to be made). However, there are well-established valuation techniques that are gradually being accepted by market practitioners and regulators. This uniformity of approach should lead to greater acceptance and confidence in the numbers that are produced. Certainly, if values are to be recorded in companies’ financial statements, then a high degree of rigour will need to be applied before arriving at supportable results for external analysis. The natural next step will be for such analysis to be put to good use for internal purposes.
The main stumbling point is the fact that it is only acquired intangible assets (and not self-generated ones) that are currently required to be recorded in companies’ financial records. So which intangible assets will need to be identified and valued as part of acquisitions?
Intangible assets under IFRS are defined as “an identifiable non-monetary asset without physical substance”. The intangible assets that are included by the accounting standards in effect cover the majority of the intellectual property and intellectual capital that are generally considered under the definition of intellectual assets, including assets under legal ownership, as well as intellectual capital such as know-how, unpatented knowledge or technology.
As a result of the new accounting standards, there will be a significant increase in the amount of intangible assets arising from acquisitions. Research conducted by PricewaterhouseCoopers on acquisitions under similar regulations in the US for the period 2001 to 2003 has revealed that approximately 22 per cent of consideration on deals was represented by intangible assets. Based on an estimate of M&A volumes for the UK in 2004 of £100 billion, we might expect to see (as a high-level estimate) approximately £22 billion of intangibles in the financial statements of acquiring companies in the UK in 2004.
Given the significance of the acquired intangible assets that will be attracting an expense in the P&L account, there is bound to be much greater scrutiny by management of their companies’ intangible assets. There will also, inevitably, be an increasing level of attention paid to the proper communication to the market of whatever value these assets represent. Analysts and investors will demand this information - and companies will have to make sure that they are providing it in an acceptable, resilient format, clearly showing the market what decisions they are taking about the management and development of both their tangible and intangible assets.
The ongoing management of intangible assets will be critical, as will having a clear strategy in relation to these assets post-acquisition.
Some positive trends in the communication of intangibles
As identified in the PricewaterhouseCoopers’ publication Trends In Corporate Reporting 2004 – Towards VALUEREPORTING, much of the information that relates to value drivers and key intangible assets, and which is critical to a business’s success and sustainability (eg, customers, people, brands and innovation), is not currently being reported in a sufficiently credible and consistent fashion by many companies.
Does that mean that companies are managing these intangibles but not reporting the outcome of their management processes? This may not be the case. The age-old belief that assets only get managed when they are properly measured - and then reported - is probably also true of intangible assets.
The world’s accounting standard setters are considering how best to address this issue. In the interests of greater transparency and comparability in financial records, companies are encouraged to disclose information about all the assets that are used in the business, but not shown on the balance sheet.
To their credit, some forward-thinking companies have published ongoing information on critical intangible assets, including their brands and customer relationships. Interestingly, it has tended to be companies in the consumer goods and industrial products and services sectors who have raised the bar in terms of effectively communicating those areas where companies can and do create value. At its best this has included an actual ongoing brand valuation and information on customers (including sales by customer and satisfaction levels). An example of brand association measurement is shown in Figure 2.
And there may be other KPIs that would be of significant interest for internal purposes but may not be suitable for public consumption. These may include price premium, customer value and relative satisfaction (against competitors).
Debate is set to intensify around the issue of best practice in the management and valuation of core intangible assets, including brands. And, at the same time, finance teams will be required to understand, with much greater clarity, which techniques are most appropriate and how different methodologies should be reconciled. Practitioners generally try to use more than one approach when it comes to arriving at a value that can withstand the scrutiny of users of financial statements.
Some practitioners may have sufficient information and be sophisticated enough to monitor external data on a regular basis, thereby giving senior management an opportunity to understand, in value terms, the effects of decisions taken on brand and customer relationships. The results of their investment in marketing may also be easier to track than has been the case in the past.
Despite the size and importance of company brands, many organisations are still lacking the appropriate information needed to manage these critical assets properly. This is largely because the marketing function may not be responsible for monitoring and measuring the financial success of the brand. However, there are some companies that are able to translate information about customers and their preferences and satisfaction with a company into a genuinely useful tool for increasing the value of their brand (and the company). This enables the impact of decisions to be explained to both internal and external stakeholders with more credibility and supporting information.
This may lead us into a brave new world where the financial power of a company’s intangible assets is properly recognised and rigorously managed, where the contribution made by these assets to the bottom line is understood and communicated, and where specific intangible assets can be monitored and their success (or failure) accurately assessed. This in turn will provide management with a far closer understanding of the external market – and how their company is perceived within it.
Are the commercial implications significant enough?
It is clear that the introduction of accounting requirements for acquired intangible assets will have significant business implications for companies. They will need to understand and be able to communicate how acquisitions will now be accounted for under the new standards and explain what precisely has been acquired and its financial impact for the market and the wider investment community.
Management teams should be considering the intangible assets within potential targets and the financial impact of proposed acquisitions thoroughly during due diligence, so that they are able to answer any probing questions from analysts and shareholders effectively.
It is clear that the ongoing changes to financial reporting are increasing the usefulness of financial accounts in areas such as intangible assets. We believe that this will be of great use to the market when understanding what companies have acquired. However, while this is clearly an extremely positive step, there is still a major gap in the reporting of intangible assets. While reporting of acquired intangibles will occur, those intangibles generated by a company internally (often representing very significant value) do not have to be reported for financial reporting purposes.
It is unknown when, or if, the move to increased reliance on fair values in accounts will require companies to value and record these self-generated intangible assets. Companies will therefore need to be persuaded of the commercial benefits flowing from the investment of time and energy in the management and communication of all their intangible assets, particularly those with mostly internally generated brands.
Management would then be in a much better position to answer the following key questions:
• What are my key intangible assets?
• How do I create and maintain competitive advantage using my intangible assets?
• What are the drivers of value for my intangible assets?
• Which KPIs should I use to manage my intangibles?• How do I mitigate risks to my intangibles?