June 14, 2019
One of the major challenges of valuing intangible assets is the determination of asset-specific risk and discount rates. There is agreement in the valuation community that different assets have different risk profiles, and require different rates of return and discount rates.
Risk is a function of the state of exploitation of an intangible assets (i.e. a new technology has a higher risk profile than an established customer relation), and its securitization (right and contract-based intangibles have a lower risk profile than non-contractual assets). Typically, brands and customer relations have lower risk profiles than patents. Goodwill requires the highest return, intellectual assets like knowhow and trade secrets are somewhere in between. The weighted sum of all asset-specific discount rates must equal the cost of capital of the enterprise. This is called the WARA (weighted average return on assets) to WACC (weighted average cost of capital) reconciliation.
Under the concept of a risk-based hierarchy of returns, most authors on intangible asset valuation advocate risk premiums above WACC for intangibles. However, such suggestions where rather intuitive than fact based.
Matthew Crane, PhD, ASA, has demonstrated in an empirical study that (significant) intangible assets reduce the risk of the enterprise and should therefore have return rates below WACC. One major reason is that goodwill – the asset with the highest assumed risk profile – accounts on average for nearly 50% of enterprise value. If this is the asset with the highest risk, the other half of the assets must have discounts below WACC. See Matt Crane’s article “The Legend of WARA and Benchmarking Purchase Price Allocation Data” here.