The future is invisible

There is a very good reason why financial market dealers use the term "betting". They bet on price increases or decreases; or on a change in exchange or interest rate; inflation and economic growth. They use the term "bet" for the very sensible reason that it describes precisely what they are doing.

Take the past few months in South Africa. In April and early May commentators were saying that the amazing climb in the JSE index would continue. When it didn't they claimed that the drop was the market taking a breather. They stated firmly that the rand was set in a narrow range below R7/USdollar. In both cases they got their bets wrong - very wrong!

An old English idiom is "to hedge one's bet", which usually means to protect oneself by cross betting. In other words, place one's chips on both the red and the white, or back the favourite as well as an outsider. The investment market has appropriated that word and made it sound far more important than it is. They do exactly the same thing. They hedge their bets to protect themselves against unforeseen events.

Even the accountants, staid and conservative as they are, are not immune to the vagaries of the future. When they have to work out the "future economic benefits" that are at the basis of an asset, they are advised by their text books to "use their judgement."

And those superior accountants, the actuaries, use econometric models to do just the same. Their forecasts and present value calculations are incredibly complex and are based on sound statistical principles. They are nonetheless a guess. Highly educated, but a guess.

Psychic statistics

Valuation is a guess. It is a bet that cash flows will perform in a particular way because an asset is the capitalised present value of the future economic benefits that it generates for its owner. Nobody really knows what these will be.

Over the past five years of working with the country's leading brand owning companies, if I want to raise wry smiles, I comment on marketing managers' inability to get forecasting right. In one case when I was given a business plan that looked optimistic, the manager laughed and said this is the same plan that had simply been shifted forward each year for the past four. They had never met even the first year's target, let alone the fourth.

Valuation can never be precise. Actuaries and property owners are possibly the most accurate because in the case of insurance the embedded value of existing policies is known. What is not known is what new business will be written to replace the existing as the policies mature or the insured die. Then the actuaries have to guess. Similarly, property managers usually have a good idea of what their leases are worth. They do not know if they will be renewed or at what rate. They too just bet on the future.

That invisible hand again

Sitting on a bicycle in the gym recently I watched two TV programmes on adjacent screens. The one was CNN and the feature was the return of London as the art capital of the world. The other was an auction of racing thoroughbred horses. How do the buyers of these assets determine the right price? It must be what they think will give them future value. But they do not know what economic conditions will be like when they want to sell their Gauguin or Matisse, of if the horse really will perform as its form promised. It's a gamble; a bet and a guess.

If brands were regularly traded at Sotheby's or on the world's capital markets, there would be no need for complex valuation models. The market would set the price. But brands are not often bought or sold. When they are, they are frequently part of the package that goes with the corporate entity that was the target of the acquisition.

Who to believe

For many years brand owners have relied on accountants and lawyers to value their brands. These professionals use a method of valuation that is featured in most valuation books and is the common practice. It is called Relief from Royalty and is based on a strange premise. If you did not own the brand that you do, you would have to pay a third party a royalty for its use. Since you do indeed own the brand and don't pay a royalty, the value of the brand must be the present value of the future stream of royalties that you do not have to pay.

The approach is credible because it is used by credible professionals. But consider the inputs used.

The calculation is based on turnover projected at some growth rate. I have seen examples from well respected law firms where the period is ten years and constant growth rates of 17% and 35% respectively have been used - for all ten years.

There seems to be no rhyme or reason as to whether the period is five or ten years or something in between.

There are companies that offer guidelines on royalty rates but most that I have seen use a thing called the 25% rule (a dip stick proportion), or make an assumption for a product class. There is no science behind it.

Relief from Royalty - apart from the weakness that it uses turnover, not profit (profit is what shareholder look to for their wealth, not turnover) - is a huge guess.

Judgement day?

Valuing assets will never be a precise science. It cannot be when its basis is a guess at what might happen years down the line. Valuing intangibles is even more tricky because there is no market for most of them and by definition they have no substance.

There is no question though that these valuations are needed. The prices set for art; the use of a celebrity name; the premium placed over NAV on company value; and the value of a brand are just some of the aspects of modern economies that use these values all the time. Now accountants are acknowledging that intangible assets rank equally with tangibles. Valuations of intangibles are here to stay and their implied "crystal ball" imprecision is part of the process.

Criteria to judge the suitability of approach are starting to take shape in guidelines, like those being finalised by the accounting bodies that deal with "fair value" measurement and in the Guidance Notes issued in 2005 by the International Valuation Standards Committee.

These will help, but there are already a few rules: time value of money approaches are understood and preferred; inputs should be conservative and the valuation model should be robust and defensible. Where possible, sensitivity tests and comparisons should be used. As far as possible, recognised corporate finance tools should be the gears and pistons of the valuation methodology.

Finally, there can be no "black box" approach. If the valuation model is to be credible the methodology must be fully explained to the users of the valuation.

Over the next few years the need for valuations of intangibles and brands in particular will intensify. Significantly it is the accountants who are leading the charge. That they were stimulated to do so by unforeseen, external pressures is of little importance. The fact they have made this seminal change to their fundamental principles is what counts!