Brand valuation and the global credit crisis

In the standards issued by the accounting authorities that guide preparers of financial reports in how their assets should be valued, there is a three-stage hierarchy. It is needed to differentiate between the main ways of establishing a value. If you want to know the value of an asset, such as a share, that is regularly traded on a stock market, you simply look at what price investors are willing to pay for that asset. Price to earnings ratio (p/e) is used as a multiple to establish the value of companies that have similar firms reported in the stock exchange listings.

For these instruments to be used, the markets must be liquid, or actively traded. When identical assets can be used as a reference the approach is called level l. If the assets are not identical but similar, the method is level ll.

No markets in brands

There is virtually no market in brands. Even though they might be the target of a merger or acquisition, brands tend to come with the corporate entity being bought. The market for brands is therefore thinly traded or illiquid: level lll. In the absence of any suitable reference, valuers have developed a variety of methodologies, primarily based on the discounting of future cash flows.

When the financial markets dried up a few months ago the banks had no reference point against which to set the value of their investment assets: the markets were illiquid. They shifted down the hierarchy and used the latest observable transaction, which in some cases (because these were fire-sale amounts) were as little as 20% of the original value (Level ll).

Among other serious problems that made some of them technically insolvent; others literally ran out of cash. It was, incidentally, the wrong approach, because they should have used their judgement too to acknowledge that not all assets are distressed (Level lll). But that is how the standard had been interpreted.

If, as I have done recently, you have read the literature reporting on and discussing the crash, you too will conclude that it is an unholy mess. There are ill-advised, hastily taken decisions, bull-headedness, poor administration, sheer ineptitude and, of course, capitalism's curse: greed.

The power of brands

I doubt that brands could bring down an economic system, but they are important assets. The current situation is that when the finance people in a company that has just bought another do the accounting that follows a takeover, they are guided by accounting standard IFRS 3 Business Combination (in the US, SFAS 141).

This makes it abundantly clear that brands will be among the costs they must identify that contributed to any premium paid that exceeds the net asset value (NAV). That used to be called goodwill. Now, as much as possible of that margin must be explained by listing, along with their values, such intangibles as can be identified and which meet the criteria laid down in the standard. Any residual that cannot be reliably explained, remains goodwill: now a much smaller amount.

What brings brand valuation closer to the troublesome investment assets is that the guidelines for measuring intangibles have been dumped in the melting pot. Just when it seemed that a standard approach was emerging, the crisis occurred resulting in valuation concepts such as fair value being questioned. My bet is that the approach will survive, but all eyes are on the standard setters and other authorities.

Conversations in Germany

Earlier this month I was a speaker in Frankfurt, Germany at the annual conference of the German chapter of the International Association of Chartered Valuers and Analysts (IACVA). Naturally my subject was brand valuation.

Other speakers referred to brands in their talks and as usual there was valuable corridor chat. Here are three of the many interesting topics that arose:

• Impairment. This is an accounting term that is used to test the value of an acquired intangible asset over time. The original, or carrying amount, is tested each year to see if the value (described as the replacement costs) has fallen below the amount at which the asset is being carried. If it does drop, the amount is credited to the income statement as an impairment loss. I have argued for some time that brands tend not to lose value; they grow. What happens to the gain if the value is higher than the carrying amount? This apparently is an issue being considered (I thought it was my original idea). I asked the audience what they thought and they agreed that a gain should also be recognised and that the amount should go to the balance sheet not the income statement. Strong balance sheets are valuable management tools.

• Strategic buying. In 2005 Barclays plc bought South African bank Absa. It paid R30 billion (±£2.2 billion) for a company that was earning R4.5 billion (±£0.3 billion) in after tax profits. The value of the brand on the balance sheet in the 2006 accounts was £0.172 (R2.5 billion). This is a very low value which results from a royalty rate of 1.5% (it used the dreaded Relief from Royalty method). There is no explanation why the value of the brand should be set at this level, but a highly regarded speaker in Frankfurt suggested that buyers might make a strategic or financial purchase with plans to replace the brand in the short term. To avoid taking a serious hit to the income statement when the change took place, they would register a low value to ensure a limited impairment loss. Doesn't that resonate a little with the cause of the meltdown mentioned above? That low value that seemed right in one set of market conditions might become a liability in others.

• Consumer based risk adjustment. The BrandMetrics method uses consumer perception of the brand compared with the competitors in the category as a risk adjuster for the DCF forecast. The notion is that a strong brand has customers who buy more regularly; are often willing to pay a premium price; buy broadly from the range; and recommend the brand to others. All of this enhances the cash flows. The stronger the brand, the greater the number of years in the forecast; the weaker the brand, the fewer the number of years. This is where marketing meets finance. The more successful the marketing programme, the stronger the brand, resulting in increased value. Risk is a vital part of any valuation approach and this is a very sensitive and real measurement. My audience of professional valuers and analysts in Frankfurt thought so too.

I attended the talk given by a very dynamic young PhD valuer who had recently set up her own consultancy. She was introduced as one of Germany's top experts in the valuation of trademarks or brands, so I was intrigued to hear what she had to say.

I followed her talk by way of two excellent translators who were instantaneous and somehow injected a smile into the delivery that livened up what could have been a tedious talk. I can't comment on the original, but I enjoyed what I heard.

I also enjoyed hearing her say how hard it is to value brands using the conventional tools. She was very much in favour of brands as assets, but was critical of the approaches commonly used. Relief from Royalty suffers from finding an appropriate rate. The only sources are American and they provide a mix of examples which make it difficult to choose the right one. The 25% rule (or profit split) that I have written about is good but imprecise. She favours what she called the “value by analogy” approach. I think this means looking for analogous industries and using that as a basis to devise a royalty rate.

The future of valuation

If you think from this that the world of the valuer is confusing, it probably is. But this is because the accounting standards that ushered in the measurement procedures for intangible assets are new and, in a very painful way, are being shaken out.

Two things are clear: when the dust settles the need to value intangibles will be as strong as ever. We will not return to the days when any premium over net assets was conveniently called goodwill. Second, the need for brand valuation will increase. Brands are assets in that they conform to the accounting definition of what an asset is, and it is brands that drive many a merger and acquisition. The buyer wants to own the brands and the body of consumers who prefer the brand to the alternative choices.

Moreover, the standards (SFS 142 and IAS 38) which deal with intangible assets that have not been subject to a sale, are being developed and, given a few years, will cause ALL brands to be valued for the balance sheet.

And, finally, let us not forget the boards of directors who demand that their marketers become more accountable. More than ever now, they will want to see what their marketing investment is contributing to the company's hammered worth. For this they need a balance sheet ready number; like brand value.