Valuing Brands Using a Discounted Cash Flow Approach

In a recent Tax Notes International piece, Alexander F. Peter discussed an October 27, 2022 decision by the French Conseil d’Etat involving the transfer of certain brands from Coverguard to its Luxembourg affiliate. Sacla SA v. Ministre de l'économie considered several applications of the discounted cash flow (DCF) model as well as historical cost-based approaches, where the tax authority asserted a valuation in excess of €20 million while the taxpayer asserted a valuation of only €0.5 million. Peter notes:

Whereas the court-appointed expert witness calculated a weighted average from the results of applying the historical cost-based method and the discounted cash flow method, the lower courts relied only on the latter method without sufficient reasoning, the Conseil d’Etat said. Coverguard Sales SAS (formerly Sacla SA) designs, manufactures, and distributes personal protective equipment for the workplace. In October 2008 it sold a set of brands for €90,000 to Luxembourg subsidiary Involvex SA, which was 100 percent owned by Coverguard’s shareholders.

DCF approaches critically depend on the assumptions with respect to the economic useful life of the intangible asset, projected sales, what represents a reasonable royalty rate, any expenses borne by the owner of the intangible asset, and the appropriate discount rate. Our discussion presents a steady state version of DCF to explore how these key assumptions may lead to what the tax authority originally asserted as well as lower plausible valuations.

The Tax Authority’s Valuation

A simple version of DCF would estimate the value (V) of a brand as:

V = C_t/(r – g),

where C_t = the cash flows from the brand, g = the steady state growth rate of these cash flows, and r = a reasonable discount rate. Some valuations are based on the questionable premise that cash flows represent the royalties from the use of the brands, which ignores ongoing marketing expenses required to maintain the brand value. Our original application of DCF maintains an infinite useful life, and this questionable premise that maintaining the brand value does not require ongoing marketing expenses.

Let’s assume that sales initially were €64 million per year and were expected to grow by 2% year. Let’s also assume a 10% discount rate. The value to cash flow ratio in this case would be 0.125 and the value to sales ratio would be 0.375 if the ratio of cash flows to sales were 3%. The court record noted that the tax authority’s expert used a similar value-to-sales ratio based on a reasonable royalty rate = 3%. Under these assumptions, the estimated value of the brand would be €24 million.

Critiques of the Tax Authority’s Approach

The 3% royalty rate was based on an application of the Comparable Uncontrolled Transaction (CUT) method that relied on only one third-party agreement, even though the search for potential agreements reached back almost 20 years. The court rejected an application of CUT based on a single agreement. Whether a more extensive search for potential third-party agreements would have yielded higher or lower third-party royalty rates is unclear.

Accounting for ongoing marketing expenses necessary to maintain the value of the brand could be addressed in a variety of means. Peter noted:

… under the tax authorities’ transfer pricing calculations using the income method, the value of the brands was €21 million, taking into account royalties at 3 percent for the brands sold, and reducing the value by 11 percent because Involvex agreed to forgo the royalties for five years after the transfer.

If this forgoing of royalties and the implied discount in the estimated value of the brand was the means for addressing the role of marketing expenses, such an approach would be a rather crude means for addressing this issue. Other valuation approaches address this issue by arbitrarily choosing a limited economic useful life for the intangible.

I discussed the latter approach in a recent paper on applying DCF models. Infinite-life approaches implicitly assume that an asset will continue to have value indefinitely if reinvestment in such occurs. Such an approach requires defining cash flows as net profits, which equals royalties minus ongoing intangible development costs. Applying an infinite useful life to projections where the owner does not reinvest would overstate the asset value. Such a valuation would provide no place for the costs of investing or the declining profits over time from not investing. Valuation approaches that rely on short economic lives but also deduct ongoing intangible development costs would, on the other hand, underestimate value by double counting the entity’s investment and the loss of value from lack of investment.

If DCF is applied using the infinite life approach, an estimate of the cost of ongoing marketing expenses (MktEx) must be included. Table 1 illustrates this issue by assuming marketing costs represent from 1% to 2% of sales while maintaining the assumption that royalties = 3% of sales. While the tax authority’s approach determined the brand value to be €24 million by ignoring marketing costs, the value of the brand would be €16 million if marketing costs = 1% of sales and would be €8 million if marketing costs = 2% of sales. Table 1 also considers an alternative application of DCF where the reasonable royalty rate = 4% and marketing costs = 2% of sales. In this case, the estimated value of the brand would be €16 million.

Table 1: Coverguard Brand Valuation Under Alternative Assumptions (in Millions)

Application to the Sale of the Calvin Klein Brand

Warnaco was a third-party company that sourced apparel and distributed its goods using Calvin Klein’s brand name. PVH became the owner of both the licensee and the licensor. Table 2 presents a simple example of the financials involving the licensing of Calvin Klein and Warnaco before the PVH acquisition. The example assumes that licensee sales (S) = $1.75 billion per year, the cost of sourced goods = 60% of sales, and licensee operating expenses (OpEx) = 24% of sales. The licensor incurs advertising costs relative to sales (a) = 4%, while charging a royalty rate (p) = 8%. Consolidated profits represent 12% of sales with the net profits for the licensor being 4% of sales. The licensee retains a profit margin = 8%, representing the profits attributable to distribution, sourcing, and any intangible assets owned by the licensee.

Table 2: Calvin Klein Example (in Millions)

If the licensor retains ownership of the brand names and continues to incur ongoing advertising costs, then the value of its brand name relative to sales (V) = (p – a)/r where r = the cost of capital. If r = 10%, then V = 40% or a value of intangible assets = $700 million, which was consistent with the price PVH paid Calvin Klein for this brand name.

Concluding Comments

The IRS was criticized for its application of DCF in Veritas Software Corporation v. Commissioner, which transferred certain intangible assets to an Irish affiliate. Part of the disagreement was over what intangible assets were transferred. Veritas argued that the valuation should be based on an application of CUT involving licenses of the same intangible assets. The tax court rejected the IRS approach, which it viewed was based on unrealistic useful lives, growth rates, and discount rates.

We posed a simple application of DCF to the estimation of the value of the Coverguard brands, which should have been a simpler issue if reasonable assumptions with respect to the key issues could be made. Our illustration considered alternative estimates of the reasonable royalty rate, which might rely on an application of the CUT approach. Our illustration also relied on reasonable estimates of the discount rate and expected growth. The key issue remains how to address the role of the need to incur ongoing marketing costs. Our approach relied on an infinite useful life but also made the important distinction between reasonable royalties and cash flows when the brand owner incurs the ongoing marketing costs need to maintain the brand value.

References

Alexander F. Peter, “Transfer Pricing Expert's Testimony Distorted, French Court Says,” Tax Notes International, November 8, 2022.

Harold McClure, “Everything You Wanted (and Didn’t Want) to Know About Useful Lives,” Tax Management International Journal, October 7, 2022.