THE COMPLEX CAPITAL METHOD FOR DETERMINING ECONOMIC CAPITAL FOR BUSINESS VALUATION PURPOSES

In the previous paper, https://bit.ly/3XmZoqr, the simple capital method for determining economic capital for business valuation purposes was analyzed: in the present paper, however, it is considered appropriate to deal with the "complex" capital method, as another widely used methodology in Italy.

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DEFINITION

As already stated, capital methods aim to quantify the amount of capital that an investor would have to employ to establish a company with the same balance sheet composition, assets and liabilities, as the one being bought and sold: in fact, in such methods prospective profitability is not to be considered, but an analytical estimation of assets and liabilities at current replacement values takes place. Specifically:

• analytical indicates that it is carried out separately for each element of the company's assets,
• at current values indicates that it is directly or indirectly based on the contextual values at the time of valuation,
• of replacement given that it considers the assumption of repurchase or renegotiation of the assets elements considered.

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THE COMPLEX CAPITAL METHOD

The complex capital method also seeks to provide a value for those intangible assets susceptible to transfer, which are not considered in the simple method: the corporate value will be equal to 

W = K + I,

where 

• K stands for adjusted shareholders' equity,
• I represents the value of intangibles. 

Regarding the determination of adjusted net worth, please refer to the references previously provided, https://bit.ly/3XmZoqr, however, with regard to the value of intangibles, the following explanation is offered.

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DETERMINATION OF INTANGIBLES

The doctrine is divided regarding the consideration of intangibles, according to some scientific theories the intangible should be susceptible to independent valuation with respect to the company, while for others this would be limiting, since some components relevant to the company, such as managerial capacity or existing relationships, should not be considered. 

Therefore, these 3 parameters are considered with regard to the intangible:

• costs must be related to a utility that is deferred over time; 
• the transferability i.e., the possibility of disposing of the intangible must be there without changing its capacity for use; 
• the measurability of the value of the intangible must be quantifiable in terms of future economic benefits, such that it gives rise to a value function that is rational and demonstrable.

An intermediate position between the two views is considered correct: the asset must be measurable and alternatively be extractable from the business context or be a guarantee of future profitability. Examples of intangible assets to be considered in the valuation may be: goodwill, trademarks, patents, software, personnel know-how, personnel training charges, research and development costs, advertising and promotion charges, other multi-year charges specific to the business sector.

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VALUATION METHODS OF INTANGIBLES

In doctrine, the valuation of intangibles can be done mainly through the use of cost-based or, alternatively, profitability-based methods.

As for cost-based methods, they are easily demonstrated but have the limitation of not including the future benefits that intangibles are capable of generating; they are distinguished:

• the historical cost method, which comes to be used to value mainly intangibles in the process of formation, when investments and the resulting probability of success are components that are difficult or almost impossible to monitor;
• the revalued historical cost method used for intangibles that have already been deployed over time, for which all costs incurred in the past, whether related to the establishment of the same or to subsequent development, are brought back, proceeding to update the items of costs incurred up to the level of current use;
• the replacement or reproduction cost method, which consists of estimating the costs that the company would have to incur if it were to recreate the intangible being valued currently, with the current market status. It is important to discount the value of the estimated necessary investment to create an intangible equivalent to the one under consideration, for a reasonable discount rate, reflective of the risk of cost forecasts;
• lastly, the cost-of-loss method, which estimates the loss the firm would incur if it gave up the use of the intangible.

As for profitability-based methods, on the other hand, these methods focus on the ability of the intangible to contribute to firm profitability, a component ignored in the methods listed above; they distinguish:

• the premium price method, which considers the company's ability to obtain higher returns through the possession of the intangible, compared to those obtainable without its use. For this reason, the related value is to be deducted from the differential sales flows, separating the flows of sales of products/services with or without the use. The extra income is to be commensurate on a multi-year basis, including through comparison with parallel products/services existing in the market, by subtracting the value of production, commercial and advertising costs incurred to maintain the intangible and constitute it;
• the gross profit method, which evaluates the benefits obtainable over a given number of years by monitoring the gross profit, gross profit, by virtue of ownership of the intangible, which generates a more favorable cost differential due to lower marketing expenses, as it appears to be established in the market;
• the operating income method, which consists of comparing the operating income of the intangible's owner, thus including other expense items such as selling, general and administrative expenses, against the operating income of a representative sample of firms that may be comparable but without intangibles, and then discounting the resulting differential;
• the royalty rate method, which estimates the value of the intangible as the present value of the consideration receivable from a generic counterparty that intends to make use of the asset for its remaining life.

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CONCLUDING CONSIDERATIONS

Regarding the advantages, certainly the capital methods, both simple and complex, assume greater verifiability because accounting data are used: there is thus a soundness of the underlying assumptions. Considering the disadvantages, these methods do not consider the future profitability of the company under consideration, except in the limited consideration of the use of the intangible, and this is a significant shortcoming of the model, as the economic entity is interested not in recreating a company with such values, but in understanding what the future prospects are: in fact, by doing so, a corporate picture is provided at the date of valuation, but no prospective considerations are made; lastly, very often in relation to the elements to be adjusted that are difficult to identify, it is also complicated to re-express them at current values. 

The simple equity method alone has little international application because only in some cases does it make it possible to arrive at a value that expresses the company's reality with an acceptable degree of approximation, especially with regard to companies with significant intangible component this method is inappropriate: all intangibles not recorded in the balance sheet are ignored, and for a part of the doctrine this method neglects what are the essential levers of value. Thus, it turns out to be less and less used, except for real estate management companies, that is, brokerage but not leasing, and pure holding companies: in these companies the intangible component is limited or even absent.

However, it is often used when patrimonial information is required, such as in connection with Articles 2343 and 2465 of the Civil Code on the subject of non-cash contributions, i.e., the estimation of contributions of assets in kind and receivables: it turns out to be one of the most widely used methods in Italy, because of the importance of capitalization in the Italian fabric, including with respect to credit intermediaries.

The complex asset method fills the gap in the simple asset method by valuing intangibles that are not accounted for: in business practice, valuation through the complex asset method is increasingly used, since it allows for a more correct determination of economic value, as it considers the business more correctly, also allowing for the examination of amortization allowances of intangibles and other reinstatement costs; in this, companies adopting IAS/IFRS are facilitated, since they determine the value of the assets concerned by applying the impairment test.

 

Edited by: Antonio Russo, Chartered Accountant and Statutory Auditor

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For more information:

antoniorusso@valoreassociati.it