Intangible assets are often the primary driver of value for a company, especially when your company is technology-based or provides services instead of producing or manufacturing physical goods.
Examples of intangible assets include the following:
- Intellectual property, such as patents, trademarks, and copyrights
- Branding, including the value associated with a company’s name and reputation
- Customer relationships and databases, including customer lists, contacts, and data on customer behavior
- Marketing-related intangibles, such as advertising and promotional assets
- Business processes, including manufacturing processes and distribution systems
- Software and technology, whether developed in-house or purchased, and software licenses
- Artistic assets, such as music, film, and literature
In today’s service and technology-driven environment, intangible assets often comprise a significant amount of a company’s value. So, the question we often receive is, “How do I value my intangible assets?”
What Is the MPEEM?
There are several methods that you can use to value intangible assets. The multi-period excess earnings method (MPEEM), a form of the income approach, is one such method often used to value intangible assets. It is commonly used as part of an exercise when allocating the purchase price of a business to all the acquired assets and liabilities under Accounting Standard Codification Topic 805, Business Combinations. The MPEEM focuses on the cash flows associated with a single intangible asset (typically the company’s primary asset).
Specifically, as the name implies, the MPEEM quantifies the residual (or excess) cash flows generated by the primary intangible asset and discounts those cash flows to their present value. If the estimated earnings for your company’s primary intangible asset rely on using some of your company’s other assets (sometimes called “contributory assets”), then the projections for the primary asset should include charges (sometimes called “economic rents”) to use those contributory assets. These charges represent the return on all contributory assets and are applied to estimate the “excess” earnings generated by the primary intangible asset. Contributory asset charges typically include payments for using working capital, tangible assets, and other intangible assets.
The MPEEM can be complex because, although you are valuing your company’s primary intangible asset, you must value all your company’s other assets to determine their contributory charge.
The Importance of Understanding the MPEEM
Understanding the MPEEM and other methods for valuing intangible assets is important for a few reasons:
Business Strategy: Understanding the value of your company’s intangible assets can help you make strategic decisions, such as deciding whether to enter a particular market or how to price products.
Financing: When raising capital, you might need not only to prove your business’s value to investors, but also to show your intangible assets’ value to persuade them to invest. Whether those intangible assets are internally created or gained through acquisitions, understanding how to value them and prove to investors that they can create profits is crucial when trying to raise the capital you need.
Mergers and Acquisitions (M&A): Understanding how to value intangible assets can help you negotiate a fair price in an M&A transaction. Following your acquisition of another company, that understanding can help you assess and capitalize the assets obtained.
Accounting and Reporting: Because you must report the fair value of intangible assets on financial statements, understanding the MPEEM, as well as other valuation methods, can help you determine the proper values to report.
Competitive Analysis: Understanding the value of competitors’ intangible assets can help you understand their market position and identify opportunities for differentiation.
The upshot is that understanding the MPEEM and how this method compares with other methods for valuing intangible assets can help you make informed decisions about your business’s management and growth.
Using the MPEEM
The first step in using the MPEEM to value your company’s primary intangible asset is identifying the asset and its potential uses. As part of this step, you will want to consider expectations and estimate future cash flows the asset will likely generate. This process typically involves assuming the market size for the asset, the asset’s penetration rate in that market, and the expected margin on sales of the asset.
Once you estimate the future cash flows, you can use a discounted cash flow (DCF) model to estimate those cash flows’ present values. The discount rate used in the DCF model should reflect the risk of that asset’s cash flows and be consistent with the risk of other investments with similar features.
When using the MPEEM to value your company’s primary intangible asset, remember some important things. One is that the method relies heavily on assumptions about future cash flows and market conditions, which can be difficult to predict. Another is that the method might not account for all the asset’s possible uses, so the value estimate might be low.
Finally, like other valuation methods, the MPEEM will be more accurate when combined with other methods and after critical analysis. Intangible asset valuation is not an exact science, and you must be transparent about the assumptions and methodologies used when presenting the value estimate.
A valuation professional held detailed discussions with the management of Company X, the target of an acquisition, to identify Company X’s tangible and intangible assets. Based on these discussions, these assets were identified: net working capital, fixed assets, customer relationships, intellectual properties, trademarks, and assembled workforce. These discussions determined that customer relationships were Company X’s primary asset.The following reflects the valuation analysis of Company X’s customer relationships:
- If the intellectual properties were found to be Company X’s primary asset, then a similar MPEEM analysis would have been performed for the intellectual properties with a contributory return taken for customer relationships. Under this scenario, the customer relationships would have to be valued using a method other than the MPEEM.
- Customer attrition is incorporated to account for an existing customer base’s typical decline over time. Although new customers might sign up for or buy your company’s products and services, valuation of an existing customer base ignores those new customers and attempts to value only the number of customers as of a particular date. Customer attrition can be somewhat subjective, but most often you determine it through analysis of historical customer attrition patterns. In the example above, it was determined that customer attrition was about 25% per year.
- In this example, the actual market value of inventory was found to be $852,000 higher than the book value of inventory. Consequently, the cost of revenue was understated by the higher inventory cost of $852,000, and an adjustment was necessary.
- Operating expenses reflect expenses as a percentage of revenue from management’s projections applied to revenue for existing customer relationships.
- Contributory charges are based on the supporting assets’ market values and include an appropriate return expected for each asset class. For example, if you placed $1,000 in a savings account at your local bank, you expect a return on that investment or savings as an interest payment. Similarly, if you own a business and buy assets to produce goods and services for your customers, you expect a return on that investment.
- The discount period is based on a midyear convention, which assumes that net cash flow occurs evenly throughout the year.
- The discount rate or present value factor is based on the perceived risk of the subject asset itself and is often based on your company’s overall discount rate. A specific intangible asset typically includes a premium because the intangible asset would have a risk higher than that for the combined group of assets for your overall business.
- The final part of the valuation typically incorporates a Section 197 tax amortization benefit. This item is commonly added when valuing intangible assets and reflects a buyer’s benefit from amortizing the purchase price over a 15-year statutory tax life.
Why Hire a Valuation Professional?
As this article demonstrates, using the MPEEM to value an intangible asset can be complex. Further, a purchase price allocation that uses the MPEEM to determine a particular intangible asset’s value adds complexities. As illustrated above, there are several factors and assumptions must be considered when using the MPEEM.
When selecting which methodologies to use to value individual intangible assets, consider the facts and circumstances unique to your company and its assets. Much research, thought, and experience are required when using the MPEEM, especially when performing a purchase price allocation. If you are considering how to value your intangible assets or need to perform a purchase price allocation, we highly recommend hiring a qualified valuation analyst — the benefits of doing so far outweigh the costs.