Cost Approach In Property Valuation

Cost Approach Valuation Methods

The Cost Approach is based on the following economic principles:

Substitution – Affirms that a prudent buyer would pay no more for an intellectual property than the cost to construct or developed an asset of equal desirability and utility.

Supply and Demand – Shifts in supply and demand cause cost to increase and decrease and cause changes in the need for supply of different types of intellectual properties.

Externalities – Gains or losses from external factors may accrue to intellectual properties. External conditions may cause a newly constructed intellectual property to be worth more or less than its original cost.

Functional Obsolescence – The reduction in the value of an intellectual property due to its inability the perform the function or yield the utility for which is was originally designed.

Technological obsolescence – A decrease in the value of an intellectual property due to improvement in technology that make an intellectual property less than and ideal replacement for itself. Technological obsolescence occur when, due to improvements in design and engineering technology, a new replacement intellectual property is judged more productive than the intellectual property being appraised. Technological obsolescence of often considered a specific form of functional obsolescence.

Economic Obsolescence – A specific form of external obsolescence, economic obsolescence reflected in a reduction in the value of the subject intellectual property due to conditions external to and not controlled by the current use or condition of the intellectual property. The impact of economic obsolescence is usually beyond the control of the intellectual property owner and is, thus, generally considered incurable.

There are several related valuations methods within the cost approach. Each uses a similar definition of the type of cost that is relevant to the valuation analysis. The most common types of cost or definitions of cost, include reproduction cost and replacement cost.

There are subtle but important differences in the definitions of this type of cost. Reproductions cost contemplates the constructions of an exact replica of the subject intellectual property. Replacement costs contemplate the cost to recreate the functionality or utility of the subject intellectual property, but in a form or appearance that may by quite different from the actual intellectual property subject to appraisal.

The valuer must also consider the concepts of functionality and utility. Functionality is an engineering concept that means the ability of the subject intellectual property to perform the task for which it was designed. Utility is an economic concept that has to do whit the ability of the subject intellectual property to provide an equivalent amount of satisfaction. Although the replacement intellectual property perform the same task as the subject intellectual property, the replacement asset is often better in some way than the subject asset. If so, the replacement property may yield more satisfaction than the subject property. The valuer must be careful to adjust for this factor in his estimate of obsolescence.

The cost approach also encompasses several other definitions of cost. First is a measure of cost avoidance, whit quantifies either historical or prospective costs that are not incurrent by the intellectual property owner to due ownership of the subject intellectual property. Next is a trending historical cost where actual historical asset development costs are identified and quantified and than “trended” to the valuation data by an appropriate inflation – based index factor.

All cost approach method include a comprehensive and all – inclusive definition of cost. It is important to recognize that the cost (whether replacement cost or reproduction cost) includes not only hard cost (e.g. material) and soft costs (e.g. engineering, design, labor, and overhead), but also the intellectual property developer’s profit on both the hard and soft cost investment and sometimes an entrepreneurial incentive to economically motivate the intellectual property development process.

The replacement cost of an intellectual property is the total cost to create, at current prices, an asset having equal utility to the intellectual property subject to appraisal. However, the replacement intellectual property would be created whit modern methods and developed according to current standards, state – of – the – art design and layout, and the highest possible quality. Accordingly, the replacement intellectual property may have greater utility and the subject property.

In contrast, reproduction cost is the total cost, at current price, to develop and exact duplicate or replica of the subject intellectual property. This duplicate asset would be using the same materials, standards, design, layout, and quality used to create the original intellectual property.

A replacement cost typically establishes the maximum amount that a prudent investor would pay for an intellectual property. To the extent that an intellectual property is less useful than an ideal replacement asset. The value of the subject intellectual property must be adjusted accordingly.

The replacement cost for the subject intellectual property should be adjusted for losses in economic value due to:
Functional obsolescence
Technological obsolescence (often considered a specific form a functional obsolescence). And
Economic obsolescence (often considered a specific form a external obsolescence)

In estimating the amounts, if any, of functional obsolescence, technological, obsolescence and economic obsolescence related t the subject intellectual property, the consideration of: (1) the subject property’s actual age and, (2) its expected remaining useful life are essential to the proper application of the cost approach.

Under the cost approach, a common formula for quantifying an intellectual property’s replacement cost is:

RCN’ = RCN – Curable Function & Technological Obsolescence

Notes:
RCN’ = Replacement Cost New
RCN = Reproduction Cost New

An intellectual property’s deficiencies are considered incurable when the current cost of enhancing or modifying the asset (in term of materials, labor and time), exceed the expected future economic benefits of improving it.

Property Valuation Method

Market Approach Valuation Methods

The Intellectual Property Valuation process usually involves an attempt to apply the market (sometime called sales comparison) approach. This is because the market – that is, the economic environment where arm’s length transactions occur between unrelated parties – is usually the best indicator of the value of an intellectual property.
The valuer will analyze the market for both sales and license transaction.

The process used to apply the market approach to the appraisal of intellectual properties may be summarized as follows:

▪ Research the appropriate market for information on sales transactions, listings, and the offers to purchase or license comparable intellectual properties. Comparability is judged in relation to factors such as intellectual properties type, intellectual property use, industry in which the intellectual functions and the date of the sale and/or license.

▪ Verity the information by confirming that the market data obtained is factually accurate and that the sales or license transaction reflect arm’s length market consideration. The verification procedure may also elicit additional information about the current market conditions of the sales and/or license of the subject intellectual property.

▪ Select relevant units of comparison (e.g. income multipliers or dollar per unit) and develop a comparative valuation pricing analysis for each units of comparison.

▪ Compare guideline intellectual property sales and/or license transaction whit the subject intellectual property, using the elements of comparison, and adjust the price of the each guideline transaction appropriately to the subject property. If such an adjustment is not possible, eliminate the transaction as a guideline.

▪ Reconcile the various value indications into a single value indication or range of value.

There are ten basic elements of comparison generally considered in selecting and analyzing guideline intellectual property sales and/or license transactions. These element are summarized below whit a more details checklist provided in exhibit II:

The specific legal rights of intellectual property ownership conveyed in the guideline transactions;
The existence of any special financing terms or other arrangement;
Whether the element of arm’s length sale and/or license conditions existed;
The economic conditions that existed in the appropriate secondary market at the time of the sale and/or license transaction;
The industry in which the guideline in intellectual property was or will be used
the physical characteristic of the guideline properties, compared whit the subject intellectual property;
The functional characteristic of the guideline properties, compared whit the subject intellectual property;
The technological characteristics of the guideline properties, compared whit the subject intellectual property;
The economic characteristic of the guideline properties, compared whit the subject intellectual property;
The inclusion of other nonintellectual properties in the guideline; this may include the sale of a bundle or the portfolio of assets, whit could include tangible personal property and/or real estate, as well as intellectual properties.

The last phase of the market approach valuation analysis is the reconciliation. In this step, two or more value indications that have been derived from the guideline sales and/or license market data must be synthesized into an overall value estimate. In the reconciliation, the valuer summarizes and review the empirical data, the valuation analysis, and the result of each of the value indications. These value indications are the resolved into a range of value of a single value indications. The valuer consider the strength and weakness of each guideline value indication derived and examines the reliability and appropriateness of the market data compiled an of a analytical techniques applied.

Intellectual Property Valuation

Intellectual Property

Knowledge underlies the creation of value. Successfully utilizing that knowledge contributes to
the progress of society. Knowledge in business is manifested as intellectual capital, which includes human capital, structural capital, intellectual assets and intellectual property. Human capital is a collection of experience, skill and education of a company.

Structural capital, which includes intangible assets such as process documentation and theorganizational structure itself, is the supportive infrastructure provided to human capital, whichencourages human capital to create and leverage its knowledge. Intellectual assets are thecodified physical descriptions of specific knowledge that can be owned and readily traded. Intellectual assets receiving legal protection become intellectual property.

There are five formsof intellectual property: patents, copyrights, trademarks, trade secrets, and know-how.Companies often fail to capitalize on the opportunities offered by their intellectual propertiesbecause they have never identified all the intellectual properties they own. We have identifiedover 90 types of intellectual properties and intangible assets that a company may own. Anillustrative list has been included as Exhibit I, in order to assist companies to begin the process ofidentifying all of their intellectual properties.

Challenges in Valuing Intellectual Property One of the major difficulties in valuing intellectual property or negotiating licensing agreementsis determining the market royalty rates that should be used. Most consultants traditionallydevelop royalty rates based on three traditional sources: first, from the client, if the client has itsown negotiated licensing agreements; second, from surveys performed by various professionals, generally in cooperation with trade associations; and third, from judicial opinions (court cases) which vary greatly depending on individual fact patterns. The valuer should augment thesetraditional tools through a search of public documents for licensing agreements. The authorshave identified over 1,800 transactions listed in public documents that will allow the reader todocument royalty rates and terms actually used by companies. This direct market evidence is themost compelling evidence available. When analyzing an intellectual property to select an appropriate royalty rate for licensing, manyfactors must be considered. Exhibit II entitled, Checklist of Factors to be Considered inEstablishing Royalty Rates has been included to provide a basic guideline of factors to beconsidered.

Managing the Millennium Intellectual capital is the value generator of the future. To sustain growth, companies in thefuture will have to:. Identify the intellectual capital available to them;. Measure the value of the intellectual capital components;. Structure the means of delivery and potential leverage with otherpotential intellectual capital within the company;. Manage the cash flow and the distribution channels of theintellectual capital;. Protect the intellectual capital by converting it to intellectualproperty;. Manage the intellectual property registrations on a world widebasis;. License intellectual property to and from third parties; and. Assure compliance with all agreements.

Distinction Between Intellectual Property and Intangible Assets Intellectual property is a subset of intangible assets. Intellectual properties, specifically patents,copyrights, trademarks and identifiable know-how, satisfy the definitional requirements ofintangible assets. As will be seen later, valuation methodologies applicable to intangible assetsalso apply to intellectual property. Intangible assets are long - lived assets used in the production of goods and services that, unlikefixed or tangible assets, lack physical properties. Intangible assets represent certain long- livedlegal rights or competitive advantages developed or acquired by a business enterprise. Intangibleassets differ considerably in their characteristics and useful lives and are classified in theFinancial Accounting Standards Board as follows: Identifiability - Patents, copyrights, franchises, trademarks, and other similarintangible assets that can be specifically identified with reasonably descriptivenames.Manner of Acquisition - Intangible assets that may be purchased or developedinternally. Determinate or Indeterminate Life - Many intangible assets that have adeterminate life established by law or by contract or economic behavior.Transferability - The right to a patent, copyright or franchise that can beidentified separately and bought or sold.For valuation purposes, the intangible assets must be readily identifiable and capable of beingseparated from the other assets employed in the business. An intangible asset can be defined byreferring to practical considerations such as whether it is supported by a contract, or by referringto whether it can be economically measured objectively with a determinate life. Intangible assetsthat exist but cannot be specifically identified are included in goodwill.

Attributes of Identifiable Intangible Assets For an identifiable intangible asset to exist from a valuation or economic perspective, it shouldpossess certain attributes. Some of the more common attributes include the following:

• It should be subject to specific identification and a recognizable description.

• It should be subject to the right of private ownership.

ere should be some tangible evidence or manifestation of the existence of theintangible asset (e.g., a contract, a license, a registration document, a computerdiskette, a set of procedural documentation, a listing of customers, recorded on aset of financial statements, etc.)

• It should have been created or have come into existence at an identifiable time (ortime period) or as the result of an identifiable event.

• It should be subject to being destroyed or to a termination of existence at anidentifiable time (or time period) or as the result of an identifiable event.In other words, there should be a specific bundle of rights (legal and otherwise) associated withthe existence of any intangible asset.For an identifiable intangible asset to have a quantifiable value from an economic analysis orappraisal perspective, it should possess certain additional attributes. Some of the more commonadditional attributes include the following:

• The intangible asset should generate some measurable amount of economicbenefit to its owner; this economic benefit could be in the form of an incomeincrement or of a cost savings; this economic benefit is sometimes measured bycomparison to the amount of income otherwise available to the intangible assetowner (e.g., the business) if the subject intangible asset did not exist.

• This economic benefit may be measured in a number of ways, such as net income,net operating income or net cash flow.

• The intangible asset should be able to enhance the value of the other assets withwhich it is associated; the other assets may encompass all other assets of thebusiness, including: tangible personal property, tangible real estate, or otherintangible assets.Some of the more common categories of intangible assets most commonly valued are as follows (see Exhibit 1 for a more detailed list):

• Patents - product or process;

• Brands - consumer goods. brands, trademarks, corporate names;

• Publishing Rights - magazines, books, mastheads, film and music rights;

• Intellectual Property

Unidentifiable Intangible AssetsEconomic phenomena that do not meet these specific attribute tests typically do not qualify asidentifiable intangible assets. Some economic phenomena are merely descriptive in nature. They may describe conditions that contribute to the existence of - and value of - identifiableintangible assets. But these phenomena do not possess the requisite elements to distinguishthemselves as intangible assets. For a typical business, descriptive economic phenomena that do not qualify as identifiableintangible assets may include:

• High market share

• High profitability

• General positive reputation

• Monopoly position

• Market potential and

• Other economic phenomena.

However, while these descriptive conditions do not qualify as identifiable intangible assetsthemselves, they may indicate the existence of identifiable intangible assets that do havesubstantial economic value. They are most often referred to collectively as goodwill..

Business Valuation

SMALL BUSINESS VALUATION METHODS

BOOK VALUE : Is simply the small business valuation based upon the accounting books of the business. Assets less liabilities equals the owners equity, which is the "Book Value" of the business. The problem with book value small business valuation methods is that the accounting records may not accurately reflect the true value of the assets in the small business valuation.
ADJUSTED BOOK VALUE VALUATION METHODS: Your MBA performs two types of adjusted book value small business valuation: Tangible Book Value and Economic Book Value (also known as book value at market).

Tangible Book Value small business valuation is different than book value in that it deducts from asset value intangible assets, which are assets that are not hard (e.g., goodwill, patents, capitalized start-up expenses and deferred financing costs).
Economic Book Value small business valuation allows for a value analysis that adjusts the assets to their market value. This small business valuation allows valuation of goodwill, real estate, inventories and other assets at their market value.

INCOME CAPITALIZATION VALUATION METHODS: First you must determine the capitalization rate - a rate of return required to take on the risk of operating the business (the riskier the business, the higher the required return). Earnings are then divided by that capitalization rate. The earnings figure to be capitalized should be one that reflects the true nature of the business, such as the last three years average, current year or projected year. When determining a capitalization rate you should compare with rates available to similarly risky investments.

DISCOUNTED EARNINGS: This determines the value of a small business based upon the present value of projected future earnings, discounted by the required rate of return (capitalization rate). Usually, the question is how well earnings are projected.
DISCOUNTED CASH FLOW VALUATION METHODS: Are the small business valuation methods best used to conduct a business valuation on an entity established for the purpose of fulfilling a specific project, in certain startup and other companies where cash flow is more important than net income, and when a certain time frame is set where an investor wishes to see his investment returned over a specific period of time. In discounted cash flow, the present value of liabilities is subtracted from the combined present value of cash flow and tangible assets, which determines the value of the business.

PRICE EARNINGS MULTIPLE: The price-earnings ratio (P/E) is simply the price of a company's share of common stock in the public market divided by its earnings per share. Multiply this multiple by the net income and you will have a value for the business. If the business has no income, there is no business valuation. If the common stock in not publicly traded, business valuation of the stock is purely subjective. This may not be the best choice of business valuation methods, but can provide a benchmark business valuation.
DIVIDEND CAPITALIZATION: Since most closely held companies do not pay dividends, when using dividend capitalization valuators must first determine dividend paying capacity of a business. Dividend paying capacity based on average net income and on average cash flow are used. To determine dividend paying capacity, near term capital needs, expansion plans, debt repayment, operation cushion, contractual requirements, past dividend paying history of a business and dividends of a comparable company should be investigated. After analyzing these factors, percent of average net income and of average cash flow that can be used for the payment of dividends can be estimated. What also must be determined is the dividend yield, which can best be determined by analyzing comparable companies. As with the price earnings ratio method, this usually produces a subjective result.

SALES MULTIPLE SMALL BUSINESS VALUATION METHODS: Sales and profit multiples are the most widely used business valuation methods benchmark used in valuing a business. The information needed are annual sales and an industry multiplier, which is usually a range of .25 to 1 or higher. The industry multiplier can be found in various financial publications, as well as analyzing sales of comparable businesses. This method is easy to understand and use. The sales multiple is often used as the business valuation benchmark.

PROFIT MULTIPLE SMALL BUSINESS VALUATION: Profit and sales multiples are the most widely used small business valuation benchmarks used in valuing a business. The information needed are pretax profits and a market multiplier, which may be 1, 2, 3, or 4 and usually a ceiling of 5. The market multiplier can be found in various financial publications, as well as analyzing the sale of comparable businesses. These small business valuation methods are easy to understand and use. The profit multiple is often used as the small business valuation ceiling benchmark.

LIQUIDATION VALUE: This type of small business valuation is similar to an adjusted book value analysis. Liquidation value is different than a book valuation in that it uses the value of the assets at liquidation, which is often less than market and sometimes book. Liabilities are deducted from the liquidation value of the assets to determine the liquidation value of the small business. Liquidation value can be used to determine the bare bottom benchmark value of a business, since this should be the funds the business may bring upon small business valuation.
REPLACEMENT VALUE: This type of small business valuation is similar to an adjusted book value analysis. Replacement value is different than liquidation value in that is uses the value of the replacement value of assets, which is usually higher than a book valuation. Liabilities are deducted from the replacement value of the assets to determine the replacement value of the small business.

TRUE VALUE SMALL BUSINESS VALUATION: Is the amount that a buyer is finally willing to pay. This is the "real world" in small business valuation methods.