Using the asset value stated in the accounts has obvious appeal for those impressed by the apparent objectivity of published accounting data. The Balance Sheet shows the recorded value for the total of fixed assets (sometimes, but not invariably, including intan- gible assets) and current assets, namely stocks and work-in-progress, debtors, and other holdings of liquid assets such as cash and marketable securities. After deducting the debts of the company, both long- and short-term, from the total asset value (i.e. the value of the whole company) the residual figure is the net asset value (NAV), i.e. the value of net assets or the book value of the owners’ stake in the company or, simply, ‘owners’ equity’.
net asset value approach Calculation of the equity value in a firm by netting the liabili- ties against the assets
Table 4.1 Balance Sheet for DS Smith plc as at 30 April 2004
Assets employed £m £m
Fixed assets (net) 785.1
Current assets:
Stocks 154.9
Debtors 361.5
Cash and investments 61.6
Creditors falling due within one year (401.2)
Net current assets 176.8
Total assets less current liabilities 961.9
Creditors falling due after one year (inc. provisions) (394.1)
Minority interests (5.8)
Net assets (NAV) 562.0
Financed by:
Called-up share capital 38.7
Share premium account 254.6
Profit and loss account 260.2
Revaluation reserve 8.5
Shareholders’ funds (NAV) 562.0
Source: DS Smith plc, Annual Report 2004 (www.dssmith.uk.com)
the NAV is a very unreliable indicator of value in most circumstances. Most crucially, it derives from a valuation of the separate assets of the enterprise, although the accountant will assert that the valuation has been made on a ‘going concern basis’, i.e. as if the bundle of assets will continue to operate in their current use. Such a valuation often, but not invariably, understates the earning power of the assets, particularly for profitable companies.
In July 2004, the market value of DS Smith’s equity was £596 million (share price of 154p times number of 10p shares, i.e. 387 million). Hence, the net assets were apparently worth rather less than the firm as a going concern with its existing and expected strategies, man- agement and skills, all of which determine its ability to generate profits and cash flows. If the profit potential of a company is suspect, however, then break-up value assumes greater importance. The value of the assets in their best alternative use (e.g. selling them off) might then exceed the market value of the business, providing a signal to the owners to disband the enterprise and shift the resources into those alternative uses. Sometimes, then we may be able to adjust the NAV to take into account more up-to-date, or more relevant informa- tion, thus obtaining the Adjusted NAV.
Self-assessment activity 4.2
For DS Smith plc, identify:
(i) the value of the whole firm, i.e. enterprise value (ii) the value of its total liabilities
(iii)the value of the owners’ equity.
(Answer in Appendix A at the back of the book)
■ Problems with the NAV
The NAV, even as a measure of break-up value, may be defective for several reasons.
1 Fixed asset values are based on historical cost
Book values of fixed assets, e.g. £785.1 million for DS Smith, are expressed net of depreciation, the result of writing down asset values over their assumed useful lives.
Depreciating an asset, however, is not an attempt to arrive at a market-oriented assess- ment of value but an attempt to spread out the historical cost of an asset over its expected lifetime so as to reflect the annual cost of using it. It would be an amazing coincidence if the historical cost less accumulated depreciation were an accurate meas- ure of the value of an asset to the owners, especially at times of generally rising prices.
Some companies try to overcome this problem by periodic valuations of assets, espe- cially freehold property. However, few companies do this annually, and even when they do, the resulting estimate is valid only at the stated dates. Whichever way we look at it, fixed asset values are always out of date!
A more sophisticated approach (but thus far stoutly resisted by the accounting pro- fession) is to adopt current cost accounting (CCA). Under CCA, assets are valued at their replacement cost, i.e. what it would cost the firm now to obtain assets of similar vintage. For example, if a machine cost £1 million five years ago, and asset prices have inflated at 10 per cent p.a., the cost of a new asset would be about £1.6 million, i.e. £1 m (1.10)5. The historical cost less five years’ depreciation on a straight-line basis, and assuming a ten-year life, would be £0.5 million. However, the cost of acquiring an asset of similar vintage would be around £0.8 million.
There are obvious problems in applying CCA. For example, estimating current cost requires knowledge of the rate of inflation of identical assets, and of the impact of changing technology on replacement values. Nevertheless, the replacement cost meas- ure is often far closer to a market value than historical cost less depreciation. Ideally, companies should revalue assets annually, but the time and costs involved are gener- ally considered prohibitive.
Asset values may also fall. Directors are legally required to state in the annual report if the market value of assets is materially different from book value. It is better to ‘bite the bullet’ and actually reduce the value of poorly-performing assets in the accounts. This was done by BT in September 2001 when it announced a charge of £500 million in its first-half results to reflect the reduced value of its disastrous 9 per cent holding in AT&T Canada and its 20 per cent holding in Impsat of Argentina.
The highest write-off to date was the $50 billion write-down in 2003 by Worldcom (later renamed MCI) of assets acquired during an acquisition spree, following which several executives saw the inside of jails after convictions for false accounting. Write-offs are, in effect, an admission that profits have been overstated in the past, (i.e.) deprecia- tion has been too low. Firms tend to increase write-offs during difficult trading times on the principle of unloading all the bad news in one go. In the USA, Goldman Sachs, the merchant bank, reckoned that write-offs in 2002 rose to 140% of corporate earnings.
replacement cost The cost of replacing the exist- ing assets of a firm with assets of similar vintage capable of performing similar functions
Under the new International Reporting Standards (IFRSs), UK firms will no longer have to depreciate goodwill (the difference between the price paid for an acquisition and the book value of the assets acquired), but to carry out an annual ‘impairment review’, which is already the US practice. The results of the switch to IFRSs can be remarkable. In January 2005, Vodafone, which has grown rapidly by acquisition, revealed that its loss of £1.88 billion for the six months ending September 2004 would have been shown as a profit of £4.5 billion under IFRSs.
2 Stock values are often unreliable
Under Generally Accepted Accounting Practice (GAAP), stocks are valued at the lower
of cost or net realisable value. Such a conservative figure may hide appreciation in the value of stocks, e.g. when raw material and fuel prices are rising. Conversely, in some activities, fashions and tastes change rapidly, and although the recorded stock value might have been reasonably accurate at the Balance Sheet date, it may look inflated some time later.
3 The debtors figure may be suspect
Similar comments may apply to the recorded figure for debtors. Not all debtors can be easily converted into cash, since debtors may include an element of dubious or bad debts, although some degree of provision is normally made for these.
The debtor collection period, supplemented by an ageing profile of outstanding debts, should provide clues to the reliability of the debtors position.
4 A further problem: valuation of intangible assets
Even if these problems can be overcome, the resulting asset valuation is often less than the market value of the firm. ‘People businesses’ typically have few fixed assets and low stock levels. Based on the accounts, several leading quoted advertising agencies and consultancies have tiny or even negative NAVs.
However, they often have substantial market values because the people they employ are ‘assets’ whose interactions confer earning power – the quality that ultimately deter- mines value. This may be seen most clearly in the case of professional football clubs, few of which place a value for players on their Balance Sheets. Manchester United led the way in this respect when it valued its players prior to flotation on the market in 1991. There are 17 quoted football companies in the Financial Times listings, fifteen English and two Scottish. Is your club shown in Table 4.2?
Vanishing stock values (USA: stock=inventory)
In March 2000, shares in New Economy powerhouse Cisco Systems Inc. peaked at $80. Cisco, whose remarkable growth was founded on making gear to power the internet, was now planning to re-focus on selling equipment to new-world telecoms companies planning to supplant
‘dinosaurs’ like AT&T.
Yet its customers were beginning to complain about long lead times for products. So Cisco entered into long-term supply contracts with suppliers and manufacturers to ensure the avail- ability of customised components. But, already, the US economy was slowing down, reducing demand for Cisco’s products. In April 2001, Cisco announced that sales for the current quarter were set to drop by 30 per cent, driving the share price down to a 52-week low of $13.63.
In May 2001, Cisco announced a third quarter loss of $2.7 billion, a loss struck after a write- down of excess stock by $2.2 billion, 70 per cent of this involving telecom gear and parts. The amount and the timing of the write-down surprised many. Cisco’s inventory, valued at $4.1 bil- lion for the quarter ending April 2001, was 65 per cent higher than the previous quarter’s $2.5 billion, itself up from $1.3 billion a year earlier. Over the whole year, Cisco was clearly adding inventory that it knew it could not sell, given weak demand and rapid technological change. This raised the issue of why it had not disclosed any similar write-downs in previous quarters. The Cisco case clearly illustrates the folly of rapid stock-building of high-tech products based on sus- pect demand forecasts.
Valuation of brands
However, some other companies have attempted to close the gap between economic value and NAV by valuing certain intangible assets under their control, such as brand names.
The brand valuation issue came to the fore in 1988 when the Swiss confectionery and food giant Nestlé offered to buy Rowntree, the UK chocolate manufacturer, for more than double its then market value. This generated considerable discussion about whether and why the market had undervalued Rowntree and perhaps other companies that had invested heavily in brands, either via internal product development or by acquisition.
Later that year, Grand Metropolitan Hotels (now Diageo) decided to capitalise acquired brands in their accounts, and were followed by several other owners of ‘household name’
brands, such as Rank-Hovis-McDougall, which capitalised ‘home-grown’ brands.
Decisions to enter the value of brands in Balance Sheets were partly a consequence of the prevailing official accounting guidelines, relating to the treatment of assets acquired at prices above book value, often termed ‘goodwill’. These guidelines enabled firms to write off goodwill directly to reserves, thus reducing capital, rather than carrying it as an asset to be depreciated against income in the Profit and Loss Account, as in the USA and most European economies. UK regulations allowed companies to report higher earnings per share, but with reduced shareholder funds, thus raising the reported return on capital, especially for merger-active companies. Such write-offs were stopped by a new accounting standard, FRS10, which also prevented capitalisation of ‘home-grown’
brands. (FRS 10 obliged UK firms to follow US practice by depreciating goodwill. Under IFRSs, to be adopted by listed UK firms from 2005, acquired goodwill need only be depreciated if there is judged to be a ‘substantial impairment’ in the value of the asset.) Brand valuation raises the value of the intangible assets in the Balance Sheet and thus the NAV. Some chairpeople have presented the policy as an effort to make the market more aware of the ‘true value’ of the company. Under strong-form capital market efficien- cy, the effect on share price would be negligible, since the market would already be aware of the economic value of brands. However, under weaker forms of market efficiency, if placing a Balance Sheet value on brands provides genuinely new information, it may become an important vehicle for improving the stock market’s ability to set ‘fair’ prices.
■ Methods of brand valuation
Many methods are available for establishing the value of a brand, all of which purport to assess the value to the firm of being able to exploit the profit potential of the brand.
1 Cost-based methods
At its simplest, the value of a brand is the historical cost incurred in creating the intan- gible asset. However, there is no obvious correlation between expenditure on the brand and its economic value, which derives from its future economic benefits. For example, do failed brands on which much money has been spent have high values? Replacement cost could be used, but it is difficult to estimate the costs of re-creating an asset without measuring its value initially. Alternatively, one may look at the cost of maintaining the value of the brand, including the cost of advertising and quality control. However, it is difficult to differentiate between expenditure incurred in maintaining the value of an asset and investment expenditure which enhances its value.
Table 4.2
Football clubs quoted on the London Stock Exchange
■ Aston Villa ■ Heart of Midlothian ■ Shelfield United
■ Birmingham City ■ Leeds United ■ Southampton Leisure Holdings
■ Burndene ■ Manchester United ■ Sunderland Investments (Bolton) ■ Millwall ■ Tottenham Hotspur
■ Celtic ■ Newcastle United ■ Watford Leisure
■ Charlton Athletic ■ Preston North End ■ West Bromwich Albion
2 Methods based on market observation
Here, the value of the brand is determined by looking at the prices obtained in trans- actions involving comparable assets, for example, in mergers and acquisitions. This may be based on a direct price comparison, or by separating the market value of the company from its net tangible assets or by looking at the P:E multiple at which the deal took place, compared to similar unbranded businesses. Although the logic is more acceptable, the approach suffers from the infrequency of transactions involving similar brands, given that individual brands are supposedly unique.
3 Methods based on economic valuation
In general, the value of any asset is its capitalised net cash flows. If these can be readi- ly identified, this approach is viable, but it requires separation of the cash flows associ- ated with the brand from other company cash inflows. The ‘brand contribution method’ looks at the earnings contributed by the brand over and above those generat- ed by the underlying or ‘basic’ business. The identification, separation and quantifica- tion of these earnings can be done by looking at the financial ratios (e.g. profit margin, ROI), of comparable non-branded goods and attributing any differential enjoyed by the brand itself as stemming from the value of the brand, i.e. the incremental value over a standard or ‘generic’ product.
For example, if a brand of chocolates enjoys a price premium of £1 per box over a comparable generic product, and the producer sells ten million boxes per year, the value of the brand is imputed as (£1 10 m) £10 m p.a., which can then be dis- counted accordingly to derive its capital value. Alternatively, looking at comparative ROIs as between the branded manufacturer and the generic, we may find a 5 per cent differential. If capital employed by the former is £100 million, this implies a profit dif- ferential of £5 million, which is then capitalised accordingly.
Such approaches beg many questions about the comparability of the manufacturers of branded and non-branded goods, the life span assumed, and the appropriate dis- count rate. Adjustments should also be made for brand maintenance costs, such as advertising, that result in cash outflows.
4 Brand strength methods
Other, more intuitive, methods have been devised which purport to capture the
‘strength’ of the brand. This involves assessing factors like market leadership, longevi- ty, consumer esteem, recall and recognition, and then applying a subjectively deter- mined multiplier to brand earnings in order to derive a value. Although appealing, the subjectivity of these approaches divorces them from commercial reality.
No broad measure of agreement has yet been reached about the best method to use in brand valuation, or whether the whole exercise is meaningful. Indeed, a report com- missioned by the ICAEW (1989), which rejected brand valuation for Balance Sheet purposes, was said to have been welcomed by its sponsors. The report claimed that brand valuation ‘is potentially corrosive to the whole basis of financial reporting’, arguing that Balance Sheets do not purport to be statements of value!
Capturing the indefinable value of a brand FT
European companies find them- selves having to value their intangibles
Two-thirds of Coca-Cola’s market value is attributable to one asset: the
soft drink maker’s brand. So said Interbrand, the consulting firm, last year when it ranked the Coca-Cola name as the world’s most expensive at $67bn.
Its contribution to the company’s worth is far from unusual. Brands, together with other intangibles such
Continued
as customer relationships and tech- nology, account for an ever-growing proportion of corporate value: 48 per cent, according to PwC research on the American M&A market in 2003.
European Union companies have not had cause to put detailed num- bers on what makes them what they are. But that is now changing, because international accounting standards force acquirers to spell out, item by item, the value of the busi- nesses they are buying.
That has created a new market for expertise from the US, where intan- gibles have been shown separately on balance sheets for several years.
Two specialist groups are in expan- sion mode in Europe – American Appraisal and Standard & Poor’s Corporate Value Consulting – while the big four accounting firms are plugging their services more heavily.
But as Sarpel Ustunel, senior manager at American Appraisal in London explains, there is no simple way to put a price on something ‘that is difficult to put your arms around’.
Mr Ustunel, one of 200 staff in Europe, says there are several options with brands.
One method is to calculate what proportion of a company’s future earnings can be attributed to its property, machinery and other assets.
The rest should represent the value of the brand. But this assumes there are already neat values for the other intangibles.
Another way is to estimate how much it would cost to buy the brand if the company did not own it already.
Alternatively, and if possible, val- uers look for the equivalent of two tins of soup made to exactly the same specifications, and sold on the same supermarket shelf – but one under a specialist mark and one under the supermarket’s own label. ‘Whatever the difference in price is attributable to the brand,’ says Mr Ustunel.
Valuing intellectual property, too, is vexatious. If a patent for a similar technology has been sold before that price can be a starting point, he says, but such data is difficult to come by.
The solution is to talk to as many people as possible about the technolo- gy’s importance. ‘Engineers,’ he cau- tions, ‘can be overenthusiastic in explaining what their technology is about. Once you talk to the acquirer
you may find they were unaware it existed.’
Valuing intangibles takes account- ing, and the auditors who have to check financial statements, into a murky area. Given the need to make assumptions and estimates, Richard Winter, partner in valuation and strategy at PwC, concedes: ‘There is a degree of rattle room.’
People may think there is a defin- itive answer, but inevitably there is scope for judgment.’
Critics say the whole exercise is misleading because it implies a pre- cision that is not really there.
‘The huge danger with going into inordinate detail is that readers of accounts cannot understand how the numbers arise,’ says Ian Robertson, president of the Institute of Chartered Accountants of Scotland.
Mr Ustunel accepts there are no black and white answers, but says putting more numbers on the bal- ance sheet is a useful step forward.
‘Would you rather I tell you there are three cupboards, a table and a few chairs in this room,’ he asks, ‘or would you prefer just to know there is some furniture?’
Source: Barney Jopson,Financial Times, 9 February 2005.
■ The role of the NAV
Generally speaking, the NAV, even when based on reliable accounting data, only really offers a guide to the lower limit of the value of owners’ equity, but even so, some form of adjustment is often required. Assets are often revalued as a takeover defence tactic.
The motive is to raise the market value of the firm and thus make the bid more expen- sive and difficult to finance. However, the impact on share price will be minimal unless the revaluation provides new information, which largely depends on the per- ceived quality and objectivity of the ‘expert valuation’.
We conclude that while the NAV may provide a useful reference point, it is unlikely to be a reliable guide to valuation. This is largely because it neglects the capacity of the assets to generate earnings. We now consider the commonest of the earning-based methods of valuation, the use of price-to-earnings multiples.