Dreaming of Intangibles - December update

NEWS UPDATE

All of a sudden, Christmas is upon us. The year has flown and we are into yet another season of fantasy, myth and dreams. An ideal time, it seems, to talk about intangibles and subjectivity.

When Interbrand first introduced its valuation methodology in the 1980s, its creators emphasised the need for it to use the “true” earnings of the brand. These are the numbers taken from the audited accounts which are: “hard, proven data which are verifiable.” Discounted Cash Flow (DCF), which is based on projections into the future, “suffers from being sensitive to wide fluctuations from relatively minor shifts in inflation and interest rate assumptions ”. This was very much in line with the mood of the time, even though DCF has been a popular financial instrument for two decades or more. Interbrand has since changed to DCF.

The future is ahead not behind

What has always intrigued us is that the accounting definition of an asset implies DCF in that the core of the statement refers to “future economic benefits.” That does seem to be at odds with both the historic cost notion in which accounting has traditionally been grounded and with the resistance accountants have shown to providing forward looking advice to their clients.

Now the accountants have made the first move to shift away from their backward looking stance by employing the new measure of Fair Value. Fair Value is the price at which the asset could be exchanged between knowledgeable, unrelated willing parties. The definition goes further and suggests that this price would be based on the asset’s utility, its probable future cash flows and the risks associated with the those cash flows.

It seem clear from this that assets will in future be valued by the DCF method as opposed to their original cost depreciated over time. That means peering into the future. Armed with knowledge of what has happened historically and using the best intelligence available, businesses will increasingly be reliant on the crystal ball to satisfy the balance sheet requirements of the new accounting standards.

How bad is this?

Actually, not very bad at all, because that is precisely how most human’s run their lives. Think of the assets in which you personally invest: car, house, business, and kids’ education. The evaluation of each of those items entails a contemplation of the future. What will the housing market do? What will be the resale or trade-in value of the car I want to buy? Is there really a market for the product or service I plan to sell through my new business? Will my investments grow sufficiently to pay for the school and university fees that I will one day have to pay for my children’s education?

Nearly everything we do in business is geared to the future. Our plans and actions are generally designed to raise productivity, output, sales and profit. We plan today and hope to reap the future rewards for those plans. That is why strategy has assumed such importance. Strategy is the long-term plan we devise to attain a future goal. Without strategy or planning, business would be moribund.

Time value of money

I have always been mystified as to how the accounting profession thought its members would estimate “future economic benefits” without a little bit of guesswork and gazing out of the window. In fact they are given guidance in the text books because at some stage, most writers on accounting practice use the words the bean counters dread to hear: “the professional will have to use his or her judgement.”

Brands succeed due to judgement, visionary planning and forward thinking. They die when brand managers trade them and abuse them with short-term deals and price cuts. To plan for the future management has to have some measure of what the future will bring. To be able to judge what level of investment will support that forecast, we have the net present value (NPV) tool based on DCF. It’s worked as a corporate finance instrument for years now to aid the management decision process when buying assets that decline in value such as machines, motors vehicles and computers. It is even more applicable to brands because they are long lived and will generate earnings for the company for many years to come – if they are treated well.

Which of course gives the clue as to how brands are valued. They can be little else than the capitalised present value of these future earnings. Naturally things can go wrong; economic conditions will change and interest rate, inflation and growth assumptions will be missed or exceeded. But that is why risk is built in to the calculation. The risk factor is there to take account of these unknown forces.
An unsolicited email that I received the other day (which, by the way, described me as a subscriber – which I am not) offered me a template for calculating the Life Time Value (LTV) of customers. According to them, the equation for this is:
LTV = (Frequency of Purchase) X (Duration of Loyalty) X (Gross Profit)
That is a huge simplification. Apart from anything else, if you are able to show that your customers stay with you, on average, for six years, then you cannot count the present value of the projected earnings in the sixth year as you would the earnings in the first year. If you do you will overstate today’s value of that customer by a long shot. Try it and see. Since these people are trying to assist marketers in decided how much they can justify spending on a customer (normally, they suggest, one third of the LTV), they might be promoting purgatory rather than marketing sense.
Anyway, I am opposed to the whole notion of customers as assets. Customers by definition of being customers are associated with a brand. Frequency of purchase, duration of loyalty and gross profit, all denote a brand which is the anchor of the lifetime value. So the concept of a brand being the capitalised present value of customer generated profits, is the natural extension of the work conducted over the last ten years by the customer equity boffins. Now we can get back to the value of the brand asset.
So! What was all that about?
In an era of fair value, we will be living in a world of prediction. That alone should provide the academics with wonderful research projects. How close do the forecasts come to actuals? What devices are the best predictors of future economic benefits? Credible brand valuation, which already is placing a value on an intangible, will be fully committed to the forecasting ability of the valuer.
Is this a problem?
That is the point. It’s worked on the stock market; it works with prize bulls; and it works with property. All are related to how the asset will perform in the future. Sometimes the guess is right and sometimes it’s wrong. With something as important as a brand, the best the brand owner can do is use a technique that reduces subjectivity to the greatest possible degree. One that is conservative and one that uses risk adjustments to take account of the vagaries of forecasting.
On which note we wish you all a very happy and restful festive season and an extremely prosperous 2006.