Economic Value Approach to Brand Valuations

This page collates the current Economic Value Approach used to value brands.

The underlying principle in the economic value method (also called the earnings valuation method) is based on the life cycle approach to the firm. The firm as whole (using tangible and intangible assets) creates ‘Future Free Cash Flows. The value of the firm is then seen as the value of these future free cash flows. These are discounted at a discount rate to cater for the risk that are present, to obtain a present value and a terminal value of firm.

The economic approach to valuing brands uses this same methodology and is based on the principle that brands both ‘create’ and ‘sustain’ demand (following the marketing principles of ‘awareness’ and ‘loyalty’) which are then translated into ‘free cash flows’ and captured in much the same way as the share holder valuation of the firm.

Some variants of this approach take a ‘differential approach’ between a branded product or service, and a non branded generic product or service, to work out the premium price and therefore the incremental cash flows of a brand.

A more recent method (championed by Interbrand) extracts the value of the cash flows attributable to the brand from the cash flows of the firm, by using marketing metrics like ‘branding indexes’, ‘brand strength’ etc thereby allowing for the seamless use of marketing metrics into cash flow based valuations of the brand. A short technical description of these techniques is placed below.

Technical Descriptions – Economic Value Approach Methods

Economic Value Methods for valuing brands centre around the earnings potential of the brand and its impact on the earnings valuation of the firm. There are several well known brand valuation companies that have valued brands, each of them going through several iterations before they have evolved into the methodology generally accepted today.

The diagram below captures three such methodologies currently in use. A fourth method by Interbrand is described in subsequent paragraphs.

Brand valuations - economic value models

The Differential Share Price Approach

This approach was utilised by Professor Ashwath Damodaran (Stern School of Business) to value Coca-Cola and Kelloggs in 2001. It derives the differential share price between a branded and a generic company to obtain a value. The earnings valuation (share price), premium on sales and free cash flows between a branded and non-branded company form part of the calculation.

The Differential Earnings Approach

This approach was originally designed by Interbrand (which has since been replaced by their current combination approach described below). It measures the differential earnings between a branded and non-branded company and uses a customised brand multiple to capture the brand strength and therefore the risk factor of the brand.

Both these approaches require an intimate knowledge of the value drivers of generic companies that may not be easily or readily available.

Economic Value Added (EVA) Method by Houlihan Valuation Advisors

This method uses EVA instead of NPV to provide essentially the same result as a typical discounted cash flow earnings valuation and is fairly similar to the methodology in use for economic valuations today. A modified EVA method is currently used by Interbrand in their newest avatar for measuring the value of 3,500 brands.

Combination Approaches to Brand Valuation

Economic Value Method

The difficulty with most top-down valuation methods are that they focus on the company as a whole, and are rarely able to separate the brand from the other intangibles of the company.

Likewise many bottom-up methods that work from the brand upwards fail to link up with the key value drivers of share price.

Early economic value models whilst taking both a share price and market driven approach (differential approach) sometimes do not find a clear and visible link between marketing metrics that are nearer the consumer, and are therefore difficult to use as internal brand management models.

The combination approach currently in force uses a combination of marketing metrics and shareholder value pricing methods (earnings based DCF valuations) to value a brand. A typical example is the Interbrand method used to value 3,500 of the world’s top brands and which may well emerge as the industry standard. Note: The Business Binnacle makes this comment without agenda, and is otherwise committed to using the best valuation method that is needed.

Combination models typically undergo the following steps…

  • They measure the cash flows over the life cycle of the brand i.e. the cash flows over the immediate horizon plus the terminal cash flows from the brand. (Interbrand typically measures the cash flows in separate non overlapping, homogeneous segments and measures the NPV or EVA in each segment);
  • They extract the value of the brand from the intangibles using a customised set of marketing metrics (Interbrand uses a ‘Role of Branding Index’ to work out the share of cash flows attributable to the brand);
  • They measure the Cost of Capital to obtain the discount factor. Clearly the higher the risk, the higher the discount factor. Brands with high Brand Equity, comprising ‘Brand Awareness’ and ‘Brand Loyalty’ in particular would typically rate as being stronger, and therefore less risky;
  • A benchmarking exercise to obtain the unique risk of the brand (beta) against comparative companies is usually used. (Interbrand measures Brand Strength based on ten weighted factors to obtain the discount rate);
  • The aggregate sum of the discounted cash flows (NPV or EVA) plus the terminal value in each segment, then becomes the aggregate value of the brand.

The advantage of using this combination method is that although it is directly linked to the key drivers of share price, the method allows for key marketing metrics to interact seamlessly with brand valuation. This is critical to good brand management.

Real Options Valuations

Some brands (or even branded businesses) operate under conditions of very high risk and uncertainty. The volatility surrounding these brands is intense, and simple earnings valuation models tend to either understate or overheat their cash flows.

Many of these brands provide managers with valuable options; viz. the option to invest in developing the brand would typically kill the option to wait, learn or stage an investment to see if (or how) key uncertainties can be resolved.

Conversely, where waiting is not an option, the option to invest and then abandon the investment (depending on the price of abandonment) become key drivers in the value matrix of a brand.

Typical examples might feature around brands where the dominant design has not yet emerged. A good example is the VHS versus Beta Max battle in the early ’80s, Blu-ray versus HDDVD recently, or the battle between Blackberry and iPhone. New pharmaceutical products, where the private and market risks of success and failure are fairly high, are other examples.

The value of the underlying options require valuations techniques derived from the science of Real Options Valuations or Contingent Claim Valuations.

Allan Rodrigues specialises in brand valuations. You can contact him at [no spam]




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