Intangible Assets - Valuation and Economic Benefit - JEFFREY A. COHEN (178 pages) This book is for all of my family, who provide the most important intangible asset unconditionally. Contents Preface xi Acknowledgments xiii CHAPTER 1 Introducing Intangibles 1 How This Book Is Organized 1 What Is Valuation Anyway? 2 CHAPTER 2 History and Taxonomy 9 Types of Intangible Assets 9 Identifiable Intangibles 11 Unidentifiable Intangible Assets 23 Liabilities 26 What Is Not an Intangible Asset 27 Summary 28 Additional Resources 28 CHAPTER 3 Theory of and Research on Intangible Assets 29 Some Economic Characteristics of Intangibles 29 Growth in Intangible Assets 33 Researching the Value of Intangible Assets 38 Summary 45 CHAPTER 4 Accounting for Intangibles 47 Identifiable and Unidentifiable Intangible Assets 48 To Expense or Capitalize 55 Goodwill Paradox: Why Ever Pay More than Fair Value? 59 Summary 60 CHAPTER 5 Portfolio of Intangible Economic Benefits (PIE-B) 61 Proto-Assets 62 Introducing the PIE-B 63 Perspectives on the PIE-B 67 Summary 71 CHAPTER 6 Income Approach and Intangibles 73 Steps to the Income Approach 74 Present Value Formula 75 Estimating the Discounted Cash Flows 77 Soda Machine as Proto-Asset? 80 Discussion 81 Income Approach and Intangibles 82 Options Model 84 Summary 88 Appendix to Chapter 6 89 CHAPTER 7 Market Approach and Intangibles 91 Introduction to the Market Approach 91 Some Features of the Market Approach 91 Elasticity: A Useful Economic Concept 95 Comparable Firms 99 Unidentifiable Intangibles and Comparables 105 Summary 106 Appendix: Sources for Comparables 107 CHAPTER 8 Cost Approach and Intangibles 109 Original Cost 109 Book Cost 110 Replacement Cost 110 Summary 114 viii CONTENTS CHAPTER 9 Intangible Assets and Litigation 115 Panduit Test 115 Market Definition 116 Georgia Pacific Factors 119 Trade Secret Framework 122 Famous Dilution 122 Summary 124 CHAPTER 10 Intangible Assets: Strategy and Securitization 125 Bowie Bonds 126 Identification 127 Dynamic Securitization 127 Extension 129 Off–Balance Sheet Intangibles 130 Insecurity—The Case of the Recording Industry 131 Summary 134 CHAPTER 11 Conclusion 135 Toward a Theory of Ephemeral Assets 135 Summary 137 Additional Resources 139 Notes 141 References 147 Index 151 About the Author 162 Contents ix Preface Valuing things we cannot touch is both an esoteric endeavor and a commonplace act. It occurs in almost every area of daily economic life. For example, would a couple going into a restaurant rather have a quiet table now in the smoking section, or would they prefer to wait for one near the kitchen door? The answer will be different depending on their preferences. Are they in a hurry? Are they smokers? Do they mind the noise near the kitchen? The chief executive officer (CEO) of a pharmaceutical corporation may want to know how much a particular portfolio of drug patents is worth because a competitor is interested in buying the patents. Should he sell? At what price? Under what circumstances? The CEO needs to know the value of these intangible assets. At the same time, a family might be thinking of sending their daughter off to college. The parents might ask whether it is worth spending $30,000 a year for a private university, or whether the local public college at $7,000 per year is good enough. In this context, what does “worth” even mean? And “good enough” to what end? It is the value of her education the parents wish to measure, and that is certainly an intangible asset. So how can we talk about things as different as a portfolio of pharmaceutical patents and a student’s college education in the same breath? The answer is that in each instance, the decision requires an analysis of the costs and benefits, and that process is at the root of economic reasoning. We choose the path that we hope will produce more return, earn more benefits, make more money, and give greater satisfaction than the other path. What further links these assets together is that neither one—the patents or the eventual bachelor’s degree—are physical assets. To be sure, both possess some tangible characteristics, but the paper on which they are written is not what makes them valuable. Ownership of the property rights associated with each asset—the right to manufacture a particular drug, or the right to claim graduating from a particular school, or the knowledge acquired, or the networking opportunities created—is what is important. That ownership right is valuable when the drug is successful, or when the student succeeds because of the schooling. This book presents a comprehensive framework for thinking about all intangible assets, from patents to education, from brands to goodwill. It is not confined to assets that can be bought or sold, although that is sometimes a useful distinction to make. The scope is wide: Many things are intangibles, and at least a reasonable attempt should be made to capture the important ones in a valuation. This book presents the concept of a firm’s portfolio of intangible economic benefits—PIE-B, for short—a basket that includes items not listed in the firm’s accounting records and often overlooked by valuation analysts. What goes into the basket are a little like proto-assets—nebulous to a degree, but still based on some positive ownership and economic benefit. The identification of intangibles is a central theme in this book. Sometimes identifying a firm’s intangible assets is hard, but valuing them is easy. Other times just the opposite is the case. Identification is largely what makes valuing intangible assets different from valuing tangible or physical assets. For analysts or managers, finding and quantifying the intangible assets of a firm improves the valuation, whether that valuation supports a transaction, litigation, or strategic improvement of the firm’s operations. Despite the broad discussion of different types of intangibles, this book is not a treatise on intangible asset valuation. There are good books and academic work in economics, accounting, finance, and valuation that go into greater detail of analysis; many of these works are cited as references. This book is intended for business students, management professionals, and attorneys who want a comprehensive introduction to valuing intangible assets. It will help readers find intangibles, especially those not on a company’s balance sheet, and it will help readers value those intangibles. Most important, readers of this book will learn that even when intangibles are hard to spot, and even if they are harder to value, the endeavor should not be abandoned. As the old saying goes, getting there is half the fun. Jeffrey A. Cohen Chicago 2004 Acknowledgments This book could not have been written without the influence and help of numerous friends and colleagues. Though their views were indispensable, all errors or omissions remain solely my own. My colleagues at Chicago Partners, especially Bob Topel and Jonathan Arnold, have helped form the bedrock of my own economic thinking. Steve Basileo, Stuart McCrary (who got me into this), Ricardo Cossa, and John Szoboscan provided many helpful comments on earlier drafts. Special thanks goes to Robert Riley and Claire Anderson, who contributed exceptional research assistance.