If heterogeneous assets are hard to price using comparables, the reverse is also true. The market approach works better for commodities, or for assets whose attributes are easily delineated and are themselves easy to compare in a market that is actively traded. Pork bellies or bushels of corn are clas- sic tangible examples. Real estate can also provide insight. When one is try- ing to determine the market value of a two-bedroom, new- construction condominium in downtown Chicago, there are literally thousands of like properties. Even if those did not exist, there are thousands of one- and three-bedroom examples to bracket the value of the two-bedroom unit. In other words, the similarity of location, square footage, and construction
materials allows us to model the price of a two-bedroom unit with a fair amount of confidence.
Interestingly, the market approach usually is linked to other valuation principles. Prices at which the comparables are trading should take into account expected future cash flows. Because of this reliance on future cash flows, we scrutinize those underlying valuation assumptions as well. But a departure from other valuation ideas is that comparables give us an idea of relative value. The market approach is a benchmarking process with the implicit assumption that the comparables are priced correctly. If they have been systematically undervalued or overvalued (e.g., as were many Internet stocks in the late 1990s), so, too, will be the subject asset.
Another important point to remember is that what we observe in terms of prices of comparables is often the price of the commercialized embodi- ment of the intangible, not the underlying intangible itself. As we shall dis- cuss, the demand for the intangible asset is not the same as the demand for the product that makes use of it.
Also, the distinction between stand-alone intangibles and intangibles that are inextricably linked to a firm relates to the same separability crite- ria the accounting rules make. With the patent, we may be able to isolate some traded prices for comparable patents. If we are attempting to value something inseparable, such as firm know-how, we will need to compare whole businesses. This does not mean that identifiable intangibles neces- sarily can be valued apart from the businesses that create them, only that unidentifiables rarely can.
Framing the Comparables Analysis
Let us start with a patent example. Suppose that we wish to value the patent for a pharmaceutical company’s asthma medication designed for children.
For now assume that there is no generic equivalent. A good comparables analysis takes into account asset prices at different depths and scope of sim- ilarity. Figure 7.1 represents one approach. It depicts these levels:
■ All pharmaceutical patents
■ Just asthma medication patents
■ Just juvenile drug patents
■ Just juvenile asthma drug patents
At first blush we might be tempted to use recent transactions prices (if they exist) for the category with the narrowest market definition, juvenile asthma drug patents. Recent patent sales might establish our starting point.
Our next step is to ask why someone would pay more (or less) for our
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patent than for one of the recently sold comparables? Here are five good reasons to start:
1.Fit, extension, or context 2.History
3.Scope
4.Useful remaining life 5.Likelihood of infringement
It could be that the comparable patent benefited the existing portfolio of the buyer in some way that our patent would not. Suppose that phar- macies prefer streamlining their buying from a limited number of sales rep- resentatives. It is easy to imagine that the comparable patent was the missing piece for whoever bought it. The buyer may have been willing to pay a premium to complete their portfolio of offerings to pharmacies—a premium that would not be reflected in the price of our patent. In other words, the context matters. Here it is an economy of scope.
The same asset might not be a close substitute for two different firms.
An asthma medication patent may be worth about the same to Pfizer and Merck, but it may not present the same opportunities for a Baxter. Another possibility is that the price we are able to observe on the sale of a supposed comparable does not represent an arm’s-length negotiation.
Now let us suppose that the comparable patent was derived from an adult asthma formula. When this patent was sold, the buyer knew that the
Market Approach and Intangibles 93
All Pharmaceutical Patents
Juvenile medication
patents
Asthma medication
patents Juvenile
asthma medication
patents
FIGURE 7.1 Example of Depth and Scope of Comparables.
consumer, the drug’s manufacturer, the medical community, and the Food and Drug Administration already had some experience with the formula.
Comparatively, our as-yet-untried patent is less valuable. However, we might imagine that our long track record for developing successful products is bet- ter than the record of the firm that owned the comparable patent. This may make our patent more valuable than the comparable. Historyprobably tells us something (good or bad) about likelihood of success in the future.
It may be that the scope of the comparable patent is narrower (or broader) than our patent. Pretend the other patent can be used only in drug formulations for juvenile asthma; ours has proven beneficial in tests for arthri- tis as well. This wider scopemost likely increases the value of our patent.
One of the patents may have a longer useful remaining life(which does not necessarily mean years left on patent). We might imagine that for the comparable patent, competitors have already filed their ANDAs (abbrevi- ated new drug applications) and are waiting in the wings ready to introduce generic equivalents. Our patent, which may even have fewer years of pro- tection left, might have no reasonable substitutes in the foreseeable future.
It could be the case that either our patent or the comparable patent is more likely to be infringed. One of the patents may be more poorly written, or one may be in a market that is more attractive to a potential infringer. It also could be the case that one drug manufacturer presents a more credible threat in case of a lawsuit. Another way to measure this criteria is along a dimension of ownership. Ownership, along with the economic benefits being owned, takes us back to the PIE-B.
These are just some reasons that the price for a comparable might not reflect accurately on the price we should expect for our intangible. Other lines of delineation focus on supply factors, such as similarities in produc- tion processes and the use of raw material.
As readers may be able to tell, this discussion is related to a definition of the market or industry in which we find ourselves. Economists wrestle mightily with market definition, as the task is rarely easy. We will discuss it more in Chapter 9.
PIE-B Applied to Comparables
From our discussion of the PIE-B in Chapter 5, readers know that the two dimensions for measuring the value of an intangible are ownership and amount of economic benefit. We also can think about comparables in these terms.
For a change of pace, let us pretend that the asset in question is a trade secret. Where along the spectrum of ownership would we place it? A truly comparable trade secret either would need to be in the same place along the
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two dimensions, or we would have to adjust along one or both dimensions to reflect an equivalent value. For instance, Coca-Cola’s grip on the trade secret that is its formula for Coke is a lot firmer, than, say, my recipe for barbeque sauce. Coca-Cola has shown in the past its willingness to vigorously defend the secret. I have not spent much effort to protect my secret sauce formula.
But it is not just the legal muscle that Coke would employ to challenge a theft. It is the complexity of the recipe that ensures the firm’s ability to deter stealing. In other words, the Coke recipe is harder to reverse-engineer.
But consumer demand for the secret recipe is highly rewarded—much more so than for my barbeque sauce recipe. Therefore, the very fact that the secret is valuable might contribute to an increase in the possibility of dis- covery, since it will look attractive to other soda manufacturers. This would actually be a countervailing reduction in Coke’s grip.
A better comparable for Coke than my secret barbeque sauce formula would be McDonald’s recipe for French fries or Colonel Sanders’ secret spices recipe. Figure 7.2 shows the incentive to appropriate an intangible asset, over- laid on the PIE-B’s critical dimensions. The greater the economic benefit and the weaker the ownership, then the greater the incentive to appropriate.