Actuarial brand valuation

This is the second and concluding part of the article on Brand Valuation. The first part appeared in these columns on February 16.

One can now see briefly the various methods adopted in arriving at the value of brands and the methodology suitable to Indian conditions.

The methodologies can be distilled into three broad strands: Cost-based; market-based and economics-based.

Any method chosen should necessarily satisfy the criteria of credibility, objectivity, reliability, cost effectiveness and consistency.

Cost-based methodologies: The two main methodologies here are the historical cost approach and the replacement cost approach. The first measures the actual cost incurred in creating the brand; the second, on the other hand, quantifies the estimated cost of replacing the brand or recreating an equivalent brand. Even assuming that historical cost data of the brand are available and/or the replacement cost can be estimated with a reasonable degree of reliability and confidence, these approaches are generally inappropriate. The reason is that cost is not relevant for determining the value of a brand, which is derived from future economic benefits. There is no direct correlation between expenditure on an asset and its value. Probably one of the few occasions where cost can be a relevant benchmark is one where the brand has been recently acquired.

Market-based methodology: The value of the brand here is determined by reference to the prices obtained for comparable brands in recent merger/acquisition transactions. Apparently the methodology sounds simple, attractive and objective. But it is frequently impractical due to lack of market information. Arm's length transactions involving similar brands in similar industries are infrequent, given the uniqueness of individual brands. In addition, for transactions that are comparable, market and financial information concerning the asset may not be publicly available. However, this method can be used as a counter check.

Economics-based methodologies: These consider the economic value of a brand to the current owner, that is, the return the owner actually achieves as a result of owning the brand - the brand's net contribution to the business both now and in the future. The two commonly used approaches under this category are discounted cash flow (DCF) approach and earnings multiple approach.

Both methods involve in the first instance identifying, separating and quantifying the cash flows attributable to the brand. Under the earnings multiple approach, the cash profit is multiplied by what is known as the earnings multiple which in turn is estimated on the basis of various attributes of brand such as leadership, stability, market position, internationality, support and protection.

Under the DCF approach, the brand related cash profit is projected over a period of next, say, five or ten years. Assuming a steady state scenario (stable growth phase) thereafter, the brand-related cash flow stream is discounted to the present value using an appropriate rate of discount.

Out of the above two approaches, the earnings multiple approach is easy to use, but it is not based on strong conceptual underpinning. Generally the DCF approach is considered a conceptually superior method.

While performing brand valuation in India one should appreciate the point that it is not done just based on the accounting data supplied by the company only, but is supplemented with relevant data available in the open market obtained through questionnaire based surveys and focus group interviews. In the calculations one is concerned with probabilities of occurrence of various events in future and discounting the same at an appropriate rate of interest. Also the user of the valuation report would like to know and is actually entitled to know the various assumptions made and the effect of the variations from these assumptions on the final value. This means a suitable sensitivity, simulation and scenario analysis should be built into the valuation report.

Appropriate techniques have been developed in actuarial science for estimating future values dependent on so many contingencies and discounting the same to current date along with suitable simulation techniques. This is in accordance with the dictum of the actuarial profession, namely, Certum ex Uncertis, that is, "Certainty out of Uncertainty". After making an intensive study of Indian conditions and realising the need for actuarial, econometric, financial and marketing inputs, the authors recommend the following a methodology for India which can aptly be described as actuarial brand valuation. This method in essence follows the international practices and conventions in respect of brand valuation, but fine tuned to Indian conditions.

In the first instance, information about the brand has to be collected from the company. This will include brand-related accounting data, budget forecast, strategic business and marketing plans, internal market/industry and inputs obtained from brand-related research and analysis. Also, the information on various market characteristics such as market share, consumer royalty, image, geographical coverage, extension potential and marketing mix have to be accessed. In addition, information may be needed on the industry in which the company operates. This will involve gathering of information relating to structure of the industry, nature of competitors, barriers to entry, availability of substitutes, major industry trends, social, regulatory and economic factors.

Step 2: The gross brand contribution for the year in question has to be evaluated then. For this, the earnings attributable to the brand are to be identified first. It is necessary to ensure that the earnings of other products or other unbranded goods that may be produced in parallel are not included. The next stage is to make a fair charge for the value of other tangible assets employed in the business such as fixed assets and working capital. Next, one has to adjust for the incidence of taxation. Accordingly, tax at the appropriate rate prevailing on the date of valuation has to be deducted. Thus one arrives at what is known as gross brand contribution.

Step 3: The next stage is to arrive at actual brand contribution (ABC). This will be a proportion of gross brand contribution. The difference arises because the entire contribution cannot relate to the brand name and a portion of it can be traced to the generic nature of the product. In other words, even if the product is manufactured without a brand name, it may still be able to make some contribution. This proportion is arrived at by carrying out what is known as brand contribution analysis. For this purpose, one has to identify specific brand characteristics that drive demand in the market, build brand loyalty and make people buy the brand, stay with it and if necessary pay more for it. Any consumer research conducted by the company or within the industry will be useful for this purpose. In addition, information relating to income streams of corresponding unbranded products, if available, will be useful.

Step 4: Now the actual brand contribution over the next five or ten years has to be projected. This will be based on past experience and future plans. A discussion with marketing personnel will be essential in this regard. After estimating the projected income streams for the next 10 years, say, a residual which one may call 'horizon value' has to be estimated as at the end of 10 years. Generally, it will be possible to fit an adjusted exponential function to this projected income stream.

Step 5: The next stage is to discount to the valuation date the projected streams of actual brand contribution over the next 10 years and also its horizon value. For this purpose one has to determine the appropriate discount rate which takes into account the economic, market and brand risks. This is done by scoring the brand against the following traits.

* Degree of brand leadership in the defined market (score: 0-20).

* Market position and financial strength of competition (score: 0-20).

* Stability of the revenue and cash flow stream over previous years (score: 0-20).

* Maturity of the brand and market in which it operates (score: 0-20).

* Marketing spend/support for the brand (score: 0-20).

Based on the weighted average score of the brand (which will be out of 100) which is termed as the brand safety score, the brand will be placed in one the following brand rating categories, as mentioned in the accompanying table.Step 6: Using the bond yield plus equity risk premium approach, one can choose an appropriate discount rate based on the brand rating. For example, a brand rated as AAA will have a discount rate based on the yield applicable to AAA rated bond plus an appropriate equity risk premium. In the Indian context, the equity risk premium (over and above the relevant bond yield) tends to vary between 2 and 6 per cent - the lower end of the range being applicable to bonds with higher quality ratings and the upper end being applicable to bonds with lower quality ratings. So a brand rated as AAA can be evaluated using a discount rate of, say, 11 per cent (AAA-rated bond yield) plus 2 per cent (risk premium) = 13 per cent.

Step 7: One can discount the ABC stream and horizon value determined in Step 4 using the discount rate determined in Step 6. The resulting value is the financial (intrinsic) value of the brand.

Step 8: One has thus arrived at the financial value of the brand as a single point estimate. While making these estimates one has made a series of assumptions and estimates. No doubt we have done our best to make these assumptions and estimates as realistic as possible. Still the user of the valuation report would like to have an idea as to what will be the effect on the value arrived at if these assumptions vary from actuals. For this purpose, one has to carry out a sensitivity analysis by changing critical assumptions regarding projected cash flows/capitalisation factor. Thus one may arrive at a range of values which makes more financial sense.

One can also carry out a scenario analysis which involves identification of possible scenarios and assessment of the probability of their occurrence. The scenario analysis has an additional advantage over sensitivity analysis in that it enables the valuer to vary more than one variable at a time and thus to explore inter-relationships between variables.

There is a still more sophisticated technique known as the Monte Carlo simulation method which involves the estimation of a range of values for each variable and the probability of occurrence of each value occurring. This caters to the wide range of risks and inter-dependencies involved. With the aid of resultant distribution pattern, one may be able to assess the likelihood of achieving certain results. A large number of simulation runs will help derive a realistic distribution of brand values which in turn can be used for determining the "mean" brand value and the associated variability in terms of standard deviation.

Step 9: It may become necessary in the case of certain brands to do valuations separately for different market places. This necessity will arise because in one market a brand may have a great deal of value and in another it may have very little. This way brand valuation can be segmented by discrete markets and then aggregated to total value. Such segmentation is a good aid for better business management.

It will be clear from the foregoing that the actuarial brand valuation methodology involves a multi-disciplinary approach involving skills such as actuarial, econometric, financial and marketing. Accordingly, the valuation team should possess all these skills. Since the valuation is done not in isolation but with the economic scenario in the background, the team should have access to all relevant data available in the open market and should continuously monitor the progress of various brands in different industries. Since a large number of subjective elements are involved, it is necessary that the valuation team is completely independent of the company. This way there will be more objectivity and credibility to the valuation report.

The next question is, how frequently is the brand valuation to be done. Since quite a good number of assumptions are made, it is necessary to review the value of the brand as on March 31 every year. This way any actual deviation of actuals from the assumptions during the year will automatically get corrected and the earlier assumptions revised, if necessary, at the time of next valuation. This will lead to a better estimate as on March 31 of every year.

It is clear that the brand has a value and it can be quantified. The actuarial brand valuation advocated above is ideally suitable for Indian conditions. It will be also be clear from the above that this valuation is going to be of immense help to companies in so many areas. It brings out the value of a real asset which has remained hidden so far.

Reporting of the value of this invisible asset will immensely enhance the company's image and push up its stock market value leading to more sales which in turn will lead to economies of scale which in turn again will bring down the cost of production.

IT is also useful in cases of acquisition /merger/ takeover/ licensing/ franchising/ joint venture. Particularly for banks which lend money to a company against its assets, the brand valuation is a boon as the bank can now be more aware of the additional security that is available.

Also, in the software industry there has been a lot of acquisitions not only of companies and brand but also of "intellectual property" traits such as trade marks, patents, copyrights and designs, knowhow, technology, software and databases.

These intangible assets also have the same valuation issues as brands and can be valued by the methodology described above.

It is no exaggeration to say that a brand revolution is now on and its importance is next only to IT revolution.

(Concluded.........The first part of the article was published on February 16.)

R. Krishnaswamy,
Consulting Actuary, & K. Sriram,
Professor of Finance, Bharathidasan Institute of Management.

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