How do we evaluate the brand in practice using the discounted cashflow method? During a company acquisition, as soon as the target company has been taken over by its buyer, it becomes necessary to record its assets at their true value in the consolidated accounts of the buyer company or group. These assets include tangible and intangible assets; the brand falls into the latter category.
Given that the purchase price for the company is generally well above its nett accounting value, the difference (or gap) is known as the first consolidation difference, or goodwill in the wider sense of the term. It must be allocated to its various components, the company assets, evaluated at their ‘fair value’. The non-allocated residual balance will be referred to as goodwill in the strict sense. How then do we determine the value of each asset and, in particular, the value of a brand? This takes the form of a nine-stage procedure:The first key stage is to segment the brand into strategic units. In order to be able to isolate the share of added value imputable to the brand, we need to work from the bottom up, starting with the factors that produce the sales and profits: the ‘cashgenerating units’ and ‘reporting units’. We must identify the excess profit of each of these strategic units, which then allows us to establish what share of this excess profit is imputable to the brand, remembering that this share can vary from one unit to another. Furthermore, the individual profitability structures and growth potential for each unit may be very different.
Thus, for a hygiene and beauty brand, the relevant unit would operate at product level for each distribution channel. Each product has its own individual profitability structure; and furthermore, the relative weight of the brand in the consumer’s decision-making process varies from product to product. Lastly, sales and growth potential also vary from product to product and from channel to channel.The second stage will be to build the forecasted profit accounts using the business plan. Like any asset, the brand has no value apart from the potential for future profit derived from its use. What will this use be? What sales do we expect? At what price? With what sales and marketing expenditure?
This second stage aims to define the overall share imputable to intangible assets in the financial results forecasted for each of these units, and is known as the EVA (economic value added). This is obtained by taking the product or business’s trading profit and subtracting company tax (which gives nett EBIT), then allowing for permanent invested capital and working capital requirement (which gives the EVA). Invested capital is entered at a ‘normal’ rate (t), the average cost of the capital. This produces the following sequence of residual balances:
EBIT – Taxes = t (Tangible Assets + WCR) + t’ (Intangible Assets) Nett EBIT – t (Tangible Assets +WCR) = EVA = t’ (Intangible Assets)
Remember that these calculations are based on a business plan: they are forecasts for future profits under a specific growth hypothesis.The third stage is where we deduct from this EVA the contributions of other intangible assets once they become directly evaluable: for example, assigning a value to patents based on the usual rates applied in this area, or the virtual allowance made for a portfolio of customers or subscribers, a function of market practices. We should add that if the brand operated exclusively through licences (as is the case with certain luxury brands), its contribution could then be evaluated directly. This deduction, made in order to account for other intangible assets required for business, reminds us that the brand is indeed a conditional asset.So is this residual balance the share of the profit attributable to the brand? Not necessarily: this is where the allocations to the brand and to other potential candidates stage comes in. Here, we should ask ourselves what weight the brand carries in the customer’s purchasing decision for each analysis unit (that is, each product in its distribution channel). This is a question for an expert jury to answer. Other methods exist. The customers themselves could be interviewed.
A typical study consists first of identifying all the product choice criteria, then measuring the influence each one has in the customer’s decision, and lastly evaluating the brand’s share in the perception associated with each criterion. For example, we know that the brand has a strong influence on the perception of taste: in blind testings, consumers preferred Pepsi to Coca-Cola, but as soon as the brand is identified, they claim to have preferred the glass of Coca-Cola. Conversely, recognition of the brand has no influence on the perception of its presence in stores. By adding together the respective influence of each of these criteria and balancing these against the role played by the brand in evaluating each of them, we obtain an overall percentage which measures the brand’s total influence in the purchase. A typical service station brand will score a 30 per cent rating, whereas a soft drink brand will be of the order of 70 per cent.Once armed with this percentage, we can then calculate year by year, in the business plan, the share of excess profit attributable to the brand for each cashgenerating unit or reporting unit.Given that the ultimate goal is to produce a discounted sum of these revenues specifically attributable to the brand, we must first fix on the discount rate to be used. It will depend on our understanding of risks: in other words, are the brand’s levers of added value durable in the long term? How is the market growing? Is it open to competition? Is it becoming commoditised? Is it becoming sensitive to price, and thus to distributor’s brands? What is its state of innovation? What is its R&D potential, and so on?The purpose of this seventh stage is to conduct a strategic audit of the brand and a ‘risks and opportunities’ audit, by examining (see Table below):the risks associated with the market;the risks associated with the brand and the long-term status of its differentiating features;the risks associated with the product itself;the risks associated with the company, its staff and its finances for developing the brand;the opportunities for geographical expansion;the opportunities for brand extension into other product categories.
This strategic analysis produces a risk evaluation, and thus a discounting rate for future use.
Assessing brand strength: strategic diagnosis
This stage is that of the discounted sum of profits attributable to the brand, based on the discount rate identified above, after the strategic audit of the brand. It produces the brand’s value, which will in theory be taken as a deduction from goodwill and recorded on the balance sheet as such. It is a good idea at this stage to check whether the value obtained is especially sensitive to the discount rate used.Finally, an evaluation should not be confined to one single method. The goal of reliable accounts and fair value evaluation demands cross-checking against other evaluation sources. It is true that only the discounted cashflow method is economically valid and accepted by official accounting and auditing bodies. But it is also true that other methods exist; these may not be accepted to the same degree, but they can be used for crosschecking results. Fair value has to be obtained through a narrowing-down process; it cannot be calculated directly.
For this reason, it is common to crosscheck results obtained from the discounted sum of revenues imputable to the brand with an evaluation based on the royalties method. To do this, we calculate which royalty rate would, when applied to forecasted turnover, give the same overall current royalty value after discounting. It is reassuring if this rate matches standard figures for the sector.
For example, in the haircare products sector, l’Oréal would pay Jacques Dessange 3 per cent of its turnover for products sold under its licence name. If the gap between the results produced by these two approaches is too wide, a complete rethink is necessary in order to identify the sources of the discrepancy and, if appropriate, to correct them. For example, in an evaluation, the value of non-directly-calculated intangibles works out at a royalty rate of nearly 30 per cent. This is impossible. After analysis, it is decided to impute one-third of the value to the brand and two-thirds to the market share (an asset that can be recorded on the balance sheet in some countries).
An alternative version of the above procedure exists. It consists of taking (during Stage 4) the discounted sum of the combined value of all intangible assets; that is to say, the EVA taken as a whole – after having used the strategic audit matrix to establish the discount rate to be used, of course. This overall intangible asset value is thus distributed between each of them afterwards. As we can see, this variation assumes that the basis for distribution remains more or less the same regardless of which cash-generating units and products are involved.