Fifth Capital Management

Fifth Capital Management

Monday, February 10, 2014

5 Steps to Value Intangible Assets

Let’s assume that Widget Corp., is a small company with stable residual income growth of 3% annually. Upon meeting with the CFO he provides you with the following figures: 

• Current Assets are $5,000,000 and current liabilities are $2,500,000. 

• Book value of fixed assets is $7,000,000, which is $1,000,000 less than fair value. 

• Free cash flow to the firm for the most recent 12 months is $900,000. 

• Required returns on working capital, fixed assets and intangibles are: 3.0%, 6.0% and 10.5%, respectively. 

• Weighted average cost of capital is 11.5%. 

As the analyst, you proceed in using the excess earnings method (EMM) to calculate the value of Widget’s intangible assets. The EEM estimates the earnings remaining after the required return on working capital and fixed assets is calculated and deducted. The EEM then capitalizes the residual earnings to obtain and estimate the value of the intangible assets. Here’s how it works: 

1. Determine the value of working capital and the fair value of fixed assets. Working capital equals: CA – CL = $2,500,000. The fair value of fixed assets is: $8,000,000. 

2. Estimate normalized earnings. Based on the information given, we can use FCFF of $900,000. 

3. Calculate the required returns on working capital and fixed assets from normalized earnings: $900,000 x 3% = $27,000 and $8,000,000 x 6% = $480,000, respectively. 

4. Estimate residual income by subtracting the required returns on working capital and fixed assets from normalized earnings: $900,000 - $27,000 - $480,000 = $393,000. 

5. Value the intangible assets by capitalizing the excess earnings using a growing perpetuity formula. The excess earnings are multiplied by the residual income growth rate to determine normalized earnings for the next period. Then, the next period earnings are capitalized by the required return for intangibles assets less the residual income growth rate. 

Here’s the calculation: 

$393,000(1+0.03) / (11.5% - 3%) = $4,762,235 (value of Intangibles)

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