RoyaltyStat Blog

Valuation of Intangibles - Perpetual Inventory Method

Posted by Ednaldo Silva on Mar 12, 2016 1:25:38 PM

The NPV (net present value) of intangibles has serious break-points. To avoid them, we propose using the perpetual inventory method (PIM). A major advantage of PIM is that no forecasting of revenue attributed to the intangible is needed; instead, we use actual annual expenditures recorded on the company's general ledger (GL), say annual R&D and annual advertising expenses attributed to creating self-developed separate and distinct intangibles. Another major advantage of PIM is that intangible value is not sensitive to changes in discount rates, which in turn depend on an applicable interest rate and a controversial measure of risk attributed to projected royalties.

A third advantage is that PIM has been used since the early 1940’s NBER estimates of assets (“wealth”) in the U.S., made by Simon Kuznets, Raymond Goldsmith, etc. See e.g., NBER, Studies in Income and Wealth, vol. 12 (1950) and vol. 14 (1951), the latter book including a seminal study by Goldsmith, “A Perpetual Inventory of National Wealth”.

It’s well-recognized that R&D expenses generate technology (called “trade” by the OECD Transfer Pricing Guidelines (2010), ¶ 6.3) intangibles, such as patents, know-how, and trade secrets; and advertising expenses generate marketing intangibles, such as brands and trademarks. According to GAAP and the international accounting standards (IAS), R&D and advertising costs are expensed as incurred (they are not capitalized on the balance sheet) because of difficulties in establishing a connection between these expenses and future income (profits or royalties). However, these annual expense flows can be converted into stocks of intangible assets by using the PIM formula:

     (1)     Ki,t = (1 – δi) Ki, t – 1 + Ii,t

In nonhomogeneous formula (1), Kt is the stock of intangibles (e.g., R&D or advertising “capital”), It is the annual R&D or annual advertising expenses (here, treated as investment), δ is the amortization rate, i is the identifier of the type of expenses generating the self-developed separate and identifiable intangible assets, and t is time.

For intangibles, the PIM formula (1) has been used in numerous academic studies, including by Zvi Griliches & Jacques Mairesse, “Productivity and R&D at the Firm Level,” in Zvi Griliches (ed.), R&D, Patents and Productivity (University of Chicago Press, 1984) and Bronwyn Hall, “The Manufacturing Sector Masterfile, 1959-1987,” NBER Working Paper 3366, 1990. See also Philipp Sander, The Valuation of Intangible Assets (Gabler, 2009), pp. 51, 125, and Federico Munari & Raffaele Oriani (eds.), The Economic Valuation of Patents (Edward Elgar, 2011), pp. 360-361.  

The initial “capital” stock K0, for t = 0, can be calculated by using the related formula:

     (2)     Ki,0 = Ii,0 / (gi + δi),

where g = ∆K/K is the estimated growth rate of the i-th type of “separate and distinct” asset (R&D, advertising, etc.).

See Bronwyn Hall, “Measuring the Returns to R&D: The Depreciation Problem,” NBER Working Paper 13473, 2007, published in Annales d’Économie et de Statistique, No. 79/80, 2005, equations (3) and (4). See also Sander, op. cit., pp. 51, 125, who cites Hall.

Formulae (1) and (2) have a long-standing academic legacy, and are employed by the OECD and government agencies; they show that the PIM valuation of intangibles is not a "hard-to-value" enigma.

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Ednaldo Silva (Ph.D.) is founder and managing director at RoyaltyStat. He helped draft the US transfer pricing regulations and developed the comparable profits method called TNNM by the OECD. He can be contacted at: [email protected]

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Topics: Valuation of Intangibles