MARKABLES Bulletin #2
Discount Rates in Trademark Valuation
Ⓒ MARKABLES, July 2014
The valuation of trademarks and brands under an income approach requires the projection of future brand-related income and the subsequent discounting to present value. The appropriate discount rate is to reflect risk associated with income projected in the future. The more risk is inherent in future brand related income, the higher the discount rate, and the lower the present value of such future income.
Discount rates under an income approach are typically derived with CAPM (capital asset pricing model), WACC (weighted average cost of capital) and WARA (weighted average returns on assets). Accordingly, the appropriate return of an asset should reflect its non-diversifiable, systematic market risk, and its different sources of capital. Typically, a discount rate analysis for a subject trademark starts with the WACC of the underlying business. From here, the appraiser starts to assign asset-specific risks to the different classes of assets. He has to analyze if the trademark specific risk is equal, higher or lower compared to the overall business risk. Some authors argue that trademarks require an additional illiquidity risk premium on top of WACC because they cannot be sold on active markets. Other authors argue that trademarks reduce volatility and make important contributions to stabilize future revenues of the business. Hence trademarks reduce business risk and discount rates. There is no consensus between these two lines of thought.
In practice, many trademark appraisers use the WACC of the business as base discount rate in the valuation of trademarks. The basic assumption is that all the revenues of the business are generated under the trademark, thus the revenue stream from the trademark has the same underlying risk than the one from the business. From there, they make the appropriate adjustments to arrive at the trademark specific discount rate.
MARKABLES analyzed the net discount rates applied in nearly 1,000 trademark valuations worldwide between 2005 and 2013. Net discount rate means the pre-tax discount rate minus the long-term, constant growth rate beyond the planning period. Listed below are the major findings.
The median discount rate was 11.0%, and the 25% and 75% percentile values were 8.6% and 13.4%. The mean value was 11.7%.
On average, the trademark specific discount rate is 1.5% higher than the discount rate of the related cash generating unit. This difference can be explained with a trademark specific risk premium (i.e. for illiquidity, obsolescence, reputation or other risks).
Despite historically low cost of debt, trademark discount rates were fairly stable since the financial crisis in 2008. As equity market risk premiums were also stable, appraisers obviously must have applied increased risk premiums in their valuations.
There is evidence that discount rates are highest in the valuation of trademarks with short useful lives. For trademarks with lives from one to ten years, the average discount rate was 14.1%. This seems to be an inconsistency with CAPM and a double counting of risk. As a general rule, the farther revenues are projected into the future, the higher is the risk that these revenues effectively materialize. Therefore, discount rates for indefinite or long lived trademarks should be higher than for short lived trademarks. In valuation practice, the opposite can be found. Risk-averse appraisers sometimes seem to double-count for risk by reducing the useful life of the trademark asset and at the same time by increasing the discount rate.
By region, Europe and Asia show the lowest average discount rates, while North America, Australia and South Africa are highest. These findings reflect the different approach to risk premiums. Risk premiums like small size, key person, illiquidity and specific asset risk premiums are quite common in the Anglo-American accounting and valuations community, but more exceptional in continental Europe. These differences must be considered when comparing the value of assets in different regions.
The discount rate has an important impact on trademark value. All other things equal, an increase of the discount rate from 10% to 12% would result in a 21% decrease of trademark value, and a decrease of the discount rate from 10% to 8% to a 35% increase of trademark value for an indefinite lived trademark. This impact of the discount rate becomes weaker with shorter life.
More details are illustrated in the charts below.