How Prophet Thinks About Brand Valuation
In many companies marketing and accounting follow totally separate paths. Accounting is the process of managing income, expenses, assets and liabilities. Marketing is the customer-focused function. In broad terms, accountants monitor and regulate the marketing allocation; marketing is concerned with achieving sales targets set by its finance colleagues and keeping the marketing spend within constantly changing parameters. That is about the extent of this functional mutual interest.
This separation is artificial because the two functions in reality are indivisible. Marketing is responsible for building and sustaining the revenue line on the income statement; accounting records the value of the assets that marketing builds. This is the essence of the Prophet philosophy and in this paper we will set out the reasons for holding this view.
The Prophet Approach
Prophet combines art with science in that it is as concerned with creative solutions to marketing problems as it is with the statistical analytics that describe markets and consumers. Its focus is on devising strategies and tactics to achieve short term financial gain and build long-term brand equity.
In recent years it has taken this further by adopting a view that has accounting resonance: Prophet recognizes brands as “cash generating units” which produce “future economic benefits”. This language places brands in the realm of the balance sheet because accountants define assets as “resources under the control of an enterprise that generate future economic benefits’ for the enterprise”.
A brand is a resource because the registered trademark on which it is based is a trade-able entity owned by the enterprise (or under its control). The marketing function creates the brand elements (logo, colors, packaging and slogan). It uses communication tactics to build a user community that prefers the brand to alternative choices thus building brand equity. A brand with established equity has a long-term future because the consumer community can be expected to buy it for the foreseeable future. Hence the second part of the asset description is fulfilled: the brand is generating future economic benefits.
Given a value for the brand asset, marketers are able to communicate with finance in the language they understand because the value is derived from a discounted cash flow calculation that bases the measurement on the time value of money. Marketing investment and the achievement of marketing goals can be measured against changes to the asset value and the return on the investment.
Current accounting standards (IFRS 3; SFAS 141) require companies to record the costs that comprise what historically was called goodwill. Companies frequently pay a premium over and above the net value of a firm they wish to buy. Since the early 2000s this premium has to be broken down, post-M&A, to show what that premium represents. Only the residual, after this exercise, is ascribed to goodwill. In 2005, P&G bought the Gillette Company for $57 billion. When the post purchase accounting was complete the brand portion alone was valued at $25.5 billion or just less than 50%.
In 2012, the P&G Company is valued on the NY Stock Exchange at $183 billion. In conformity with accounting standards the price paid for Gillette in 2005 is carried on the balance sheet at the original price. The standard requires P & G to conduct an annual “impairment” test to see if the current value remains as it was or has fallen below the carrying cost. If it has, this is considered to be a loss and is applied to the P&G profits for the year. Naturally the Gillette brand has not been impaired because it is a valuable brand that the company takes care of with its renowned marketing ability. There is a paradox here because the opposite of impairment is accretion but there is no requirement that assets be tested for this. Any increase in value is therefore ignored in the accounts.
Even at its 2005 value, Gillette represents 13% of the market value of P&G. Another anomaly is that while acquired brands are valued and included as assets in the accounts, brands that the company developed itself or which it acquired prior to 2001 when the standard was introduced are not considered to be assets. This is being debated by the accounting authorities and a change will occur, but right now brands that are bought are assets; internally generated brands are not. Imagine what the impressive portfolio of P&G brands must be worth. The entire portfolio plus Gillette must represent the bulk of the P&G market value of $183 billion.
Another example is CVS Caremark, the United States pharmacy chain that has been moderately acquisitive over the past six years. It shows $9. 8 billion in the balance sheet for intangibles of which $6.4 is for trademarks. The market premium for CVS currently is about $20 billion. The acquired brands therefore represent about 33%; a substantial component of the value placed on the business by the investing community.
This financial reality (replicated many times by publicly-listed companies that have bought brand-owning enterprises in the past seven years) makes the results of the recent (2012) Columbia Business School study in which only 30% of the CMO sample is concerned with financial outcomes and 57% does not use any measurement of ROI, a marketing calumny.
The Valuation Gap
Brand valuation should bring these two paths together. To forge a link between these two functions the valuation technique used should satisfy both marketing and finance. This is not presently the case. Marketing employs a wide range of valuation techniques for a variety of uses. The annual lists of published Top Brands are used by many company managers to compare one brand’s worth with another and to track trends over time. Company or brand specific valuations are commissioned for post transaction mergers and acquisitions (M&A); board reporting; benchmarking; brand positioning and portfolio work.
Accountants rarely use marketing valuation methods for balance sheet measurements. They prefer the Relief from Royalty approach which, although crude and lacking any marketing input, is universally employed by the financial community.
Once all brands have to be valued for balance sheet purposes - which will be the case in the near future - it would be sensible for measurement techniques to be applicable to both disciplines. A method grounded in finance and accounting principles that uses discounted cash flow (DCF) and the Weighted Average Cost of Capital (WACC) and which recognizes the vital role brand strength plays in securing future cash flows, should be the common tool. It would be crucial for this approach to be open and transparent with no hidden algorithms or black boxes.
How Prophet Does It
Accountants have drawn an important distinction between assets that have finite, definable lives and those which are long-lived with lives that are indefinite. Most traditional assets (machinery, vehicles, computers, office equipment, furniture and buildings), have predictable useful economic lives and can therefore be depreciated over that period. Brands, with a few exceptions, fall into the indefinite category and in fact grow over their lifetime rather than decline. This calls for a valuation approach that takes this into account. Most assets that have finite lives are valued by the income approach with cash flows being projected for their anticipated expected economic life. Typically this is five years and normally a perpetuity is calculated and added to the present value (PV) of the five years to take account of life beyond the anticipated useful life. This is inappropriate for brands and the Prophet approach deals with this.
The Prophet on-line approach models the entire expected economic life of the brand. The portion of economic profit (the net profit that exceeds the cost of capital) ascribable to brand equity, is projected into the future. An analysis of the category and the strength of the brand relative to the other category players, determines the shape and duration of the expected life curve. The cash flows captured by this curve are discounted to present value and capitalized to produce the value of the brand.
Because the method employs known corporate finance and marketing tools and links these together with recognized mathematical and geometric equations and transformations it is suitable for use in marketing, finance and accounting. The marketing inputs encourage companies to use it for marketing planning; brand portfolio management and positioning benchmarking and for justifying budget requests employing the Net Present Value (NPV) tool.
There are three critical aspects of brand measurement, that Prophet understands and which in future will be crucial to how brands are valued:
1. The revenue line in the income statement is almost entirely dependent on consumer choice. It is appropriate to use marketing research methods to predict the direction this will take. Without revenue there is no bottom line, but it is the after tax profit that must always form the basis of the valuation. Prophet takes this one step further by employing the net profit after a charge has been made for the expected rate of return on capital employed, i.e. economic profit. Economic profit is a function of management control of expenditure. The calculation of the contribution the brand makes to economic profit is only indirectly associated with consumer choice.
2. The weighted average cost of capital (WACC) is generally thought to be the correct discount rate to use for both the economic profit calculation and the discounted cash flow that forms the basis of the valuation. If the valuation is to be acceptable to finance and accounting the WACC must be constructed properly. This implies a risk free rate; a sovereign risk premium; a beta for the company (adjusted if required for specific risk); a cost of equity and a cost of debt balanced by the leverage of the company. There is a strong movement towards taking risk into account in the projected cash flows as opposed to the WACC; a trend which is highly appropriate for brands.
3. A major flaw in the Relief from Royalty approach and in a few of the leading valuation methods is the use of perpetuity to take account of the long lived indefinite lives of brands. These methods focus attention on the five year DCF forecast and then divide a sixth year by the discount rate to work out the terminal value. The problem is that the tail invariably represents the bulk of the value (often as much as 80%). The Prophet approach does the reverse. The bulk of the value is in the up-front years with the minor proportion represented by the decay tail.
Accounting for brands is going to play an increasingly important role in the lives of both marketers and their finance colleagues. Adopting a valuation approach that is useful to both functions will be beneficial for the company and its investors and will bring marketing and finance closer together.
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