Valuation Methodologies


All valuations are based in part on one of the following traditional approaches:
Cost Approach
e.g., historical cost or replacement cost
Market Approach
e.g., comparable market value or comparable royalty value
Income Approach
e.g., net earnings/cash flow, brand contribution or royalty
Advanced methods or approaches are for the most part, derivations of the above that include additional or special considerations. The approaches must be examined in the context of the asset being valued and the manner in which the asset gains its value.
In evaluation methodologies, the following criteria must be considered:
Credibility
The methodology must be credible and respectable from theoretical and practical perspectives.
Objectivity
There may need to be a trade off between intellectual rigour of the methodology and the inherent degree of subjectivity. Consideration must be given to the quality and quantity of information available.
Versatility
More credibility is given to methodologies which can be applied across companies, industries and classifications of intangible assets.
Cost Effectiveness
The benefit arising from the valuation should be sufficient to justify the efforts to determine the valuation and to keep it updated.
Consistency
Methodologies should be applicable on a consistent basis year on year.
Reliability
Valuations should be verifiable, such that other valuers may replicate the process using similar measurement principles.
Relevance
The valuation basis and methodology must be relevant to the requirements of the user.
Practicability
Methods and underlying parameters must be clear and relatively easy to apply in practice.
The following table summarises for various assets the order in which the approaches are preferred. The primary methods are those expected to provide the most credible results, secondary methods are those that may work but probably have deficiencies and weak approaches are those expected to provide the least credible indications of value.

Patents and technology
Trademarks and brands
Copyrights
Assembled workforce
management Information Software
Product Software
Distribution Networks
Franchise Rights
Corporate Practices and Procedures
Primary
Income
Income
Income
Cost
Cost
Income
Cost
Income
Cost
Secondary
Market
Market
Market
Income
Market
Market
Income
Market
Income
Weak
Cost
Cost
Cost
Market
Income
Cost
Market
Cost
Market
(Source: "Valuation of Intellectual Property and Intangible Assets" by G.V. Smith and R. L. Parr, Page 298)

Valuation Approaches Incorporating Uncertainty

In an ideal world, there would be only one method of valuation leading to one answer independent of the valuer. however, by its very nature, valuation must deal with uncertainty associated with varying market perceptions, differing value propositions, different perceptions of time and money and differing perspectives of risk. As a result, there is a range of alternative approaches to valuation available depending on the degree of uncertinty associated with the asset being valued and as the degree of uncertinty increases, the judgement and experience of the valuer becomes paramount not only in the selection of the most appropriate approach, but also in how the methodology is applied.

GuessworkJudgement

The most commonly recognised valuation techniques include (1) Industry Standards, (2) Rating/Ranking, (3) Rule of Thumb, (4) Standard Discounted Cash Flow plus probability adjusted and risk adjusted discounting, (5) Monte Carlo Approach, (6) Probability and Decision Tree Approaches and (7) Options analysis. All of these approaches require critical analysis, but as the degree of uncertainty increases, the valuer is increasingly required to adopt some subjectivity based on experience to arrive at a valuation result. A brief description of each of the above methods is provided below.
The diagram below indicates the usefulness or applicability of these methods as uncertainty increases.

Judgemethod

The Industry Standard approach relies heavily on similarities - the existence of a market history such as a large available database of similar transactions which can be used as comparison to infer value on the basis of likenesses. As a result, this approach is usually used for the valuation of mature and commonplace technologies or other intangible assets where there is no or very limited uncertainty about applications of the asset.
The Rating/Ranking approach relies on contrast in which the subject asset is distinguished from reference assets or arrangements to identify differences. These differences can then be appraised through the application of scoring criteria and the resulting scoring scale and associated wighting factors can be used to construct a decision table which enables the generation of a valuation range. This method can be used with the Industry Standard Method with the result from one method providing a reality check on the result from the other method.
The Rule of Thumb approach has been used for some time because of its simplicity, convenience and ease of use in non-litigation settings for example in licensing arrangements. The approach is also known as the 25% rule or the 25-33% rule and is based on practical experience that a quarter to a third of the total value created by or from a deal or earnings before interest and tax which the buyer or licensee of the asset realises with the lesser amount going to the licence fee or royalty. This approach should aways be viewed as an approximation or guide and, as a result, development or investment required or due to the degree of risk, the opportunity for exception increases and the less suitable the Rule of Thumb approach becomes.
The Discounted Cash Flow approach has come out of financial policy and management practice and is based around the formula PV=FV(a+k)t, where PV is the present value of money, FY is the future value of miney, k is therate of return and t is the time period for which an investment lasts. This method is a means of converting future cash flows into a present day equivalent. The very basis of this method is uncertainty: uncertainty about future cash flows, about the selection of a suitable discount rate or rate of return and uncertainty about the period over which future cash flows take place.