COVER STORY - Make the brand on the can a part of the bigger picture.

“What’s in a name?” asked Juliet, rhetorically. “That which we call a rose by any other name would smell as sweet.” Clearly, poor innocent Juliet was not up to speed with the latest thinking on brand valuation. (On the other hand, her creator obviously understood branding perfectly. Shakespeare sensibly opted to call Juliet’s love interest Romeo, instead of naming him, say, Bottom.) The branding of products, services and companies, and the building and valuing of those brands, has proved that the power of a name, an image or even a colour (Coke red, Orange, er, orange), is huge – and the financial rewards for successfully promoting them are equally massive. Now that the Accounting Standards Board has also accepted that brands form part of the value within companies, branding has a new strategic importance. FRS10, which affects accounts with a year end after 23 December 1998, allows companies to incorporate acquired goodwill and intangible assets (including brands) onto their balance sheets and depreciate them according to their presumed useful life (see box, opposite). While the standard merely tries to codify a long-standing practice on balance sheet treatment of intangibles, it did appear to be a major step forward for companies, auditors and the branding industry (encompassing advertising, marketing and customer care). It also raised further questions about the usefulness of the balance sheet in a world where knowledge is increasingly the most valuable commodity. In fact, most practitioners within the brand valuation industry have been deeply underwhelmed by the effect of FRS10. “I thought when FRS10 came in that we’d get a lot of work because companies would need independent valuations done,” says David Haigh, managing director of Brand Finance (and a former advertising industry finance director). “They obviously do need independent valuations, but they don’t want the expense and they’re trying to get round it by using the auditors.” (See Insight, page 10.) Haigh reckons that 44% of FTSE-350 companies have balance sheet items “activated” by FRS10, but his concern is that the valuation work on the brands – separated from goodwill and other intangibles – is being done by accountancy firms less expert in the arena than the boutiques, such as Brand Finance or Interbrand. Alex Batchelor, project director in the brand valuation team at Interbrand, tends to agree with this assessment. While the valuation of property, raw materials or plant is fairly straightforward, largely because these items are frequently traded on an open market that then sets a value for them, brands are all unique. For example, share price betas – the risk factors used for calculating cost of capital – are well established and have years of data and thousands of businesses as their foundation. “If I’m going to have to come up with things like brand betas (risk factors for brands), I’ve got to be a little smarter because I haven’t got a big dataset to crunch,” Batchelor points out. “But internally, within businesses, managers need to know more about their brands.” This is understandable: Cadbury Schweppes was worth £7bn in 1998, yet its tangible assets made up only £100m of this, leaving 98.6% of its market cap as goodwill. If the company doesn’t understand the value of its brands, it can have no understanding of its value, full stop. This is perhaps the key point: while FRS10 (getting goodwill items onto the balance sheet) and FRS11 (impairment of fixed assets and goodwill) provide a way for finance people to handle the balance sheet, the real benefit of brand valuation is in driving strategic decision-making. “Valuations are just a technique for putting a bit of system behind the way in which you do your business planning,” says Haigh. “Brand valuation is simply another name for sensible business planning around marketing entities.” Even within the big accountancy firms, there is an acceptance that the balance sheet issues for brands are fairly limited. “There is a demand from clients, but there are restraints on what we can do, especially on balance sheets,” admits James Eales, partner in Ernst & Young’s corporate finance division. “You must consider what the potential exploitation of any brand is – but that can be risky.” Eales insists that there are sound, relatively objective measurements to be made, however. “It’s important not to lose sight of the economic fundamentals,” he says. “You can be over-sophisticated. You need to look at all the methodologies (for valuing brands) and check them against each other. If there’s one methodology out of line, you have to ask why. It might be inappropriate or there might be other elements to consider.” The problem with valuing a brand is that there are several ways to do it, and although, as Batchelor points out, accountancy has never been the exact science its practitioners would like to believe, once you start using valuations on the balance sheet, the way you calculate them becomes more important. And there are other, non-balance sheet, issues at stake, too. “Exploiting brands in new territories, for example, brings with it tax issues, and the tax authorities are more inclined to challenge companies on this kind of valuation nowadays,” Eales explains. This is best typified by the problems of transfer pricing. IBM recently admitted that it was liable for a £500m tax bill from the early 1990s after it was revealed that the parent company had been grossly overcharging for royalties on the IBM name in the UK. At the time, it had been running huge losses in the US, so the additional revenues from the UK didn’t attract any tax at home either. With a justifiable valuation of a brand in place, companies are far better able to avoid this kind of embarrassment. On this point, Haigh agrees with his Big Five counterpart: “The tax authorities are increasingly getting into litigation and there’s a lot of money at stake,” he says. “The balance sheet thing has been a bit of a phoney war, and most companies are doing taxation or marketing.” This second area is vital for FDs looking to spread cost control and a value-based approach to the more nebulous parts of the enterprise. As Nick Rose, FD at Diageo, told Financial Director in June, “One of the things we will spend more time on is how best the finance team can support the marketing function, and how best can we help drive forward the growth of our brands.” Diageo is on the leading edge of brand valuation in the UK, and Rose sees huge benefits for improving the effectiveness of marketing spend. “We have discussions going on with some of the top US MBA schools to see whether they might tailor a programme for us to help finance people learn the language and skills of marketing, and ultimately make us more effective in terms of supporting the marketing or brand-building efforts of Diageo,” he said. “That’s an extremely important area for finance people in FMCG companies – how do you get close to, and how do you support, the marketing function?” Brand Finance is keen to promulgate this idea. “Marketing people are increasingly concerned about accountability of the way they spend their money,” says Haigh. “And FDs are increasingly demanding a justification of marketing spend. One of the techniques they’re using is brand valuation.” In essence, all a company has to do is undertake regular assessments of brand value. If marketing spend is producing proportionate increases in brand value, the marketing team gets a pat on the back; if not, it’s P45s all round. This is actually a more accurate measure of marketing effectiveness than, for example, sales, which may be driven by a range of unrelated inputs, such as market pressures, competition, pricing policy or even the weather (ice cream sales, for example, may suffer from a poor summer, but if good marketing has improved the recognition of a brand, its value will increase). The problem for some FDs is that this marketing-based approach relies to a degree on market research, as well as the more arithmetical measures of brand value. And when subjectivity creeps in, sensible FDs are wary. Interestingly, just before FRS10 came into force, Sema Group conducted a survey which showed that 42% of marketing directors in major brand-owning businesses did not expect brands to become an issue at board level. But in the same research, 77% of them also said the new standards would force them to improve brand protection. Companies like Brand Finance and Interbrand hope to bridge this gap between finance and marketing. “You tend to get a stream of marketing information – awareness, how much people see adverts, whatever – and a stream of financial information that is usually transaction-based and deals with how much money is made each time a new account is opened,” says Interbrand’s Batchelor. “One would have thought it would make sense to drag these two information streams together, because then you have a business model that says how you make money, from whom and why.” Note that this view, as with using brands for tax or royalty calculations, takes brand valuation away from the balance sheet and towards FDs taking a more holistic approach to valuation and planning. Batchelor is effusive on this point. “If a brand is one of the most important assets I have in my business, and I don’t have any metrics for it, then I’m probably failing in some broad fiduciary duty,” he says. “The reason things like EVA and shareholder value came to the fore is that capital markets dislodged this idea of the clubby world where managers do what they like. As far as the accounting profession is concerned, FRS10 and brand valuations are only a potential solution to the problem of what to do with goodwill on acquisitions.” So for Batchelor, FRS10 is a red herring. “The real point is: as a director of a business, I am charged with stewardship of our assets, exploitation of them in the long-term and delivery of shareholder value – full stop. If the managers of a business don’t realise what the asset is, and they aren’t managing it to deliver shareholder value, what they do in their financial reporting is irrelevant. What we’ve got is an accounting solution to a balance sheet problem. But it isn’t a balance sheet problem that needs to be solved.” Haigh is also keen to promote the strategy and demote the balance sheet. “Brand valuation has a bit of a bad name, because it uses fairly complex calculations and because it’s a bit of a point-in-time valuation,” he admits. “Where this has actually moved on to is understanding the inter-relationships within a business that drive the value of the business. That then helps answer all these questions: Where do we put the resources? Should we put them into distribution, staff training, marketing? Then how do you go back later and check that you made the right decisions? It’s an overall monitoring system.” Both experts are keen to dispel the idea that brand valuation is only relevant for international FMCG companies. Batchelor stresses that making a valuation is part of a mindset – and even if small companies can’t see a benefit in a wide-ranging analysis of their brands, they’d be well advised to tackle some back-of-envelope sums based on the principles of brand valuation. “I would ask whether managers can add up their business from an individual customer level and get to roughly the same profit that they do when they add it up by product or anything else,” he says. “If they’ve got great customer management and they can add up their business in terms of chunks of customers, then some of the benefits of brand valuation are not as crucial, even though there may be tax benefits or other things they’ll miss out on.” For Batchelor, what is important is the perspective that brand valuation brings: “It’s about helping them understand their business from a customer level by dragging together the marketing and the financial information and getting a cut at the business that’s different to the slice they always take.” FRS10: THE STANDARD IS STILL BEHIND THE TIMES FRS10, according to many in the branding industry, is a fig-leaf hiding the wrong embarrassment. For a start, it allows companies to place acquired brands on the balance sheet, but not internally generated ones. So a company may buy a business for £1bn and place the acquired brands under intangibles on the balance sheet at, say, £700m; but an organic brand, which cost £1bn to develop (in marketing costs, for example), just won’t appear at all. Brands are presumed to have a 20-year useful life for amortisation purposes, but it’s up to the company to decide whether or not to amortise them and if the 20-year yardstick is accurate (Coca-Cola is a great example of a brand you’d never depreciate). Either way, an impairment review must be conducted annually (or if the brand value is thought to have fallen) to show that the value on the balance sheet is actually recoverable. Interestingly, while FRS10 doesn’t recognise internally generated brands, it does allow companies to put other forms of organic intangible asset on the balance sheet, providing they have a “readily ascertainable market value” (RAMV). In other words, if it is part of a population of similar assets that can be traded (ie, not brands, which are unique) it can be an asset. This also means that while licences can be revalued upwards to reflect greater value over the course of their life, brands are only ever shown as being worth their value at acquisition. FRS10 will have some positive effects. When Grand Metropolitan, whose assets were worth $4.1bn at the time, bought Pillsbury for $5.8bn (book value: $1bn), it was faced with either writing off $4.8bn of goodwill (result: Grand Met’s book value falls to minus-$700m!) or capitalising the goodwill and depreciating $240m a year for 20 years. Valuing the brands, as companies are now able to do under FRS10, at $3.5bn, allowed the company to write off just $1bn. Of course, the balance sheet is outdated, and many companies choose to inform shareholders of non-balance sheet assets elsewhere in the annual report. But it’s becoming clear that the accounting standards bodies, both here and internationally, need to get their stories straight on brand valuation. FRS10 is only one side of that story. CALCULATING BRAND VALUES There are several methods for working out the financial worth of a brand. The three most commonly used valuation methods are: – Cost-based: either using the historical cost of setting up a brand or an estimate of the cost of replacing the brand. Both measures are extremely difficult to calculate, especially for old brands with a long history of investment; and in any case, some factors contributing to the value of a brand cannot be expressed financially. – Market-based: what the brand would be worth on the open market to a buyer. Also tricky: since no two brands are the same, calculating the value based on a “comparable” rival simply doesn’t work. – Economic-based: if a company can ascertain the revenues attributable to a brand, a discounted cash-flow model can be used to establish its net present value. One method of coming up with the “branded” revenues is royalty relief, which simply asks what a brand owner would expect in licence revenues from use of its name. Like the market-based calculations, this suffers from the fact that there is unlikely to be a comparable brand being licensed from a trademark owner in the same market. So Interbrand and Brand Finance both favour the “economic use” method. Brand Finance’s flow chart (see right) explains how economic-based brand valuation works. Market analysis and brand financial analysis are combined to reflect competitive conditions and identify earnings directly attributable to branded business, and then the EVA, or economic profit, is calculated after factoring out the charges for tangible assets used to support the brand (including maintenance and finance costs). Next, Brand Finance applies its (admittedly judgmental) measure of how much the brand itself drives the earnings for a particular product, giving a figure for “Brand Value Added”. It then derives a discount rate to accommodate risk, applying a Brandbeta eta analysis, which is based on a number of factors, such as time in market, market share, price premium, marketing spend etc. Finally, apply the discount rate to future earnings, discount back and voila: you have a net present value for the brand. AND THE BRAND PLAYS ON … In our October 1995 cover story, “Brands under pressure”, we reported on the phenomenal growth of “own-label” products, and warned that branded goods might find themselves forced off the supermarket shelves by retailers’ copycat products. In the past four years, the supermarket brands have certainly become more sophisticated, and the big players have all found that understanding their customers has enabled them to launch powerful brands – not necessarily bearing the name of their parent companies – of their own. But the brand owners have not retreated, and if anything, they have used their own power-marques to extend sales into new areas. We also reported on the ASB’s first moves towards what would become FRS10. “With the future assessment of a brand’s financial worth based on value and earnings potential, brand owners would be forced to invest in marketing support …” we insisted. But as Sainsbury’s has recently found, supporting your brand still requires good marketing and popular advertising. Spending money on John Cleese might look like investment; but it turns out you have to throw your branding money into the right places for it to work.