Valuation Methods

The three main approaches described and defined here encompass all the significant methods used in valuation. They all are based on the economic principles of price equilibrium, anticipation of benefits or substitution. The methods used to apply the principles of these three valuation approaches to different asset types are discussed briefly below.

These main approaches can be further subdivided in several valuation methods. Besides the valuation methods mentioned below more sophisticated methods are available such as valuation using real option theory.

Cost Based Approach

The cost approach measures the values of the intangible assets by assessing the expenditures necessary to replace the assets. The cost approach is based on the economic concept ofsubstitution, that is, people will pay no more for an asset than it would cost to develop or obtain another asset with similar functionality. Cost items that should be included when valuing the assets include the legal costs, registrations costs, personnel costs, development costs, production costs and marketing and advertising costs.

With the cost method, people usually use two bases to value the intangible assets;

1. Historical cost: Value an asset at its historical cost such as the purchase price and depreciate it appropriately based on a reasonable useful life estimate;

2. Replacement or Reproduction cost: Value the intangible asset by using its current price to calculate the cost of duplicating the asset today.

The difference between these two bases is the historical cost and current prices due to market efficiencies, technology developments or competition. Although the cost method is an easy to use and understand method, it fails to incorporate the economic benefits derived from ownership and utilization of the asset. This method usually underestimates the value of the intangible assets. Considering the disadvantages of this method, the cost approach is generally used for the valuation of periphery technologies or other assets that have little application or can generate little economic benefits for the owner.

Market Based Approach

Intangible assets are valued by comparing recent sales or similar transactions with similar assets involved in similar markets. This method is applicable when similar markets and similar transactions exist; however, more than often, comparable assets can’t be found due to the uniqueness of most intangibles which limits the application of this method.

Sometimes when there are arm’s length transactions, the market approach is the preferred method. Comparing with other approaches, the market approach relies on markets prices and royalties that can reflect the fair value of the intangible asset.

Income Based Approach

The income approach measures the value of an intangible asset based on the future income streams that are expected to be generated by the asset.

With the income approach, the value of the intangible assets is the present value of the future incomes that will attribute to the owners. In order to calculate the present value of the asset, the analysts will need to project the future cash flows that will be generated by the assets, estimate the useful life of the intellectual property and the discount rate of return based on the risk associated with the utilization of the assets.

Some income approach methods:

-          Relief from royalty method

-          Multi Period Excess Earnings method

-          Incremental cash flow method