Intangible assets are assets that are not physical but have legal rights attached to them and create value for the owner. They sometimes make up a very large component of a business but are not factored into intrinsic valuation of the business. A lot of value is created out of the accounting system and intangibles assets could account to as much as 80% of the intrinsic value of a business in some cases. As important as intangible assets are, business owners usually do not have a clear understanding of these assets. While rule of thumb valuation techniques factor in some of these benefits, valuing intangible assets and then adding it to the intrinsic valuation should be the preferred approach to valuing a business.
The time spent in planning, marketing, human capital, building relationships and developing a corporate culture are expensed on the income statement to calculate net income or net profit. While this is appropriate and required from an accounting point of view, cumulative investment in areas like developing an agile and customer focused corporate culture must be identified recognized as intangible assets.
Intangible capital of a business usually falls in the following areas:
- Brand value which is the Net Present Value (NPV) of the estimated future cash flows attributable to the Brand. A strong brand is a distinct asset owned by a business and can be easily monetized by keeping prices higher than the competition.
- Systems of differentiation developed by the business to compete in its marketplace.
- Customer relationships which includes a loyal customer base and loyalty systems. Businesses should leverage concepts such as customer acquisition cost (CAC) and life time value (LTV) of a customer to value its customer base.
- Business Processes related to customers acquisition including paid and unpaid activities.
- Internal Business Processes and technical expertise.
- Favorable location for the business.
- Patents, Copyrights, Trademarks, Trade names, Non-compete agreements and R&D.
- Relationships with partners including supply chain related business processes.
- Supply agreements, Licensing agreements, Service contracts and Franchise agreements.
- Unique corporate culture and corporate reputation.
When a buyer, seller or investor is conducting due-diligence on a company, he/ she must value at intangible assets in addition to calculating the intrinsic value of the business. All parties must be aware of all intangibles and know if the company has low intrinsic valuation with high intangible assets or vice versa. That said there may be an arbitrage opportunity if one party recognizes an intangible asset that the other party has discounted or not identified. Understanding intangibles also provides a view into the health of an organization.
The process of valuing intangible assets starts with first identifying and listing all intangible assets, which requires thorough understanding of the business. The next step is to attach a fair value to each intangible asset and to estimate the economic life of each intangible asset. Finally, businesses can get a value by using the company’s discount rate to calculate the present value of all intangible assets listed.
Other approaches to factor intangibles into the value of a business are to add a premium to the intrinsic value of the business. The magnitude of the premium will depend on the industry and the sector. Alternatively, a few intangible assets like patents can be added as assets to the balance sheet as long as it allowed by the accounting standards.