Accounting of Brand Equity

Management Accounting, MMS I, Batch of 2014

Jamnalal Bajaj Institute of Management Studies
Prepared and Submitted By :(In order of the presentation) Rajiv Parwani (98) Vibhuti Mhatre (93) Priyanka Pardeshi Amit Mutha (94) Vivek Metkar (92) Preethi Parthasarathy (100) Neha Dave (95) Rohan Pai (96)

What is Brand Equity?

It is a brand's power derived from the goodwill and name recognition that it has earned over time, which translates into higher sales volume and higher profit margins against competing brands.Mass marketing campaigns can also help to create brand equity.

Positive Brand Equity

A brand has positive customer-based brand equity when consumers react more favourably to a product and the way it is marketed when the brand is identified than when it is not. Positive brand equity is the positive effect of the brand on the difference between the prices that the consumer accepts to pay when the brand known compared to the value of the benefit received. If the brand's equity is positive, the company can increase the likelihood that customers will buy its new product by associating the new product with an existing, successful brand. For example, if Nestle releases a new soup, it would likely keep it under the brand name of Maggie, rather than inventing a new brand. The positive associations customers already have with Maggi would make the new product more enticing than if the soup had an unfamiliar brand name.

Negative Brand Equity

If consumers are willing to pay more for a generic product than for a branded one, however, the brand is said to have negative brand equity. This might happen if a company had a major product recall or caused a widely publicized environmental disaster. Negative brand equity occurs when a companys brand actually has a negative impact on its business meaning that the company would be better off with no name at all. It happened in the Seventies when Tescos brand was so poorly perceived that Imperial Tobacco decided not to acquire the retailer for fear of being associated with such a tarnished and unpopular organisation. It happened again in the Nineties when Skoda discovered to its horror that it could not get British consumers to buy its cars despite spending millions on advertising. Consumer research later confirmed that two-thirds of its target market would literally not consider anything at any price that carried the Skoda badge

Importance of Brand Equity

In the last quarter of the 20th century there was a dramatic shift in the understanding of the creation of shareholder value. For most of the century, tangible assets were regarded as the main source of business value. These included manufacturing assets, land and buildings or financial assets such as receivables and investments. They would be valued at cost or outstanding value as shown in the balance sheet. The market was aware of intangibles, but their specific value remained unclear and was not

specifically quantified. Even today, the evaluation of profitability and performance of businesses focuses on indicators such as return on investment, assets or equity that exclude intangibles from the denominator. Measures of price relatives (for example, price-to-book ratio) also exclude the value of intangible assets as these are absent from accounting book values. This does not mean that management failed to recognize the importance of intangibles. Brands, technology, patents and employees were always at the heart of corporate success, but rarely explicitly valued. Their value was subsumed in the overall asset value. Major brand owners like The Coca-Cola Company, Procter & Gamble, Unilever and Nestl were aware of the importance of their brands, as indicated by their creation of brand managers, but on the stock market, investors focused their value assessment on the exploitation of tangible assets. High brand equity offers numerous competitive advantages:

It can help buffer the impact of a sagging economy It can reduce marketing costs due to increased brand awareness and loyalty It offers more trade leverage in bargaining with distributors and retailers Strong brand equity facilitates the launch of (new) brand extensions because your brand already carries high credibility

Strong brand equity can help stave off price battles

Strong brand equity helps achieve larger margins because the consumer becomes less price conscious and expenses go down through more cost effective marketing initiatives. This allows you to generate revenue through increased sales and higher price margins, while at the same time continually strengthening your brands competitive position by building the consumers positive perception of your brand. Evolution: Studies Involved Initial research into the valuation of brands originated from two areas : marketing measurement of brand equity, and the financial treatment of brands. The first was popularized by Keller (1993), and included subsequent studies by Lassar et al (1995) on the measure of brand strength, by Park and Srinivasan (1994) on evaluating the equity of brand extension, Kamakura and Russell (1993) on singlesource scanner panel data to estimate brand equity, and Aaker (1996) and Montameni and Shahrokhi (1998) on the issue of valuing brand equity across local and global markets.

The financial treatment of brands has traditionally stemmed from the recognition of brands on the balance sheet (Barwise et.al., 1989, Oldroyd, 1994, 1998), which presents problems to the accounting profession due to the uncertainty of dealing with the future nature of the benefits associated with brands, and hence the reliability of the information presented. Tollington (1989) has debated the distinction between goodwill and intangible brand assets. Further studies investigated the impact on the stock price of customer perceptions of perceived quality, a component of brand equity (Aaker and Jacobson, 1994), and on the linkage between shareholder value and the financial value of a company's brands (Kerin and Sethuraman, 1998). Simon and Sullivan (1993) developed a technique for measuring brand equity, based on the financial market estimates of profits attributable to brands. The co-dependency of the marketing and accounting professions in providing joint assessments of the valuation of brands has been recognized by Calderon et al (1997) and Cravens and Guilding (1999). They provide useful alternatives to the traditional marketing perspectives of brands (Aaker, 1991; Kapferer, 1997; Keller, 1998; Aaker&Joachimsthaler, 2000). The debate over the appropriate method of valuation continues in the literature (Perrier, 1997) and in the commercial world. The commercial valuation of brands has been led by Inter-brand, a UK-based firm specializing in valuing brands, Financial World, a magazine which has provided annual estimates of brand equity since 1992, and Brand Finance Limited, a British consulting organization. These organizations utilize formulae approaches, and highlight the importance of brand valuation in the business environment. Brands on the balance sheet: The wave of brand acquisitions in the late 1980s resulted in large amounts of goodwill that most accounting standards could not deal with in an economically sensible way. Transactions that sparked the debate about accounting for goodwill on the balance sheet included Nestls purchase of Rowntree, United Biscuits acquisition and later divestiture of Keebler, Grand Metropolitan acquiring Pillsbury and Danone buying Nabiscos European businesses. Accounting practice for so-called goodwill did not deal with the increasing importance of intangible assets, with the result that companies were penalized for making what they believed to be value enhancing acquisitions. They either had to suffer massive amortization charges on their profit and loss

accounts (income statements), or they had to write off the amount to reserves and in many cases ended up with a lower asset base than before the acquisition. In countries such as the UK, France, Australia and New Zealand it was, and still is, possible to recognize the value of acquired brands as identifiable intangible assets and to put these on the balance sheet of the acquiring company. This helped to resolve the problem of goodwill. Then the recognition of brands as intangible assets made use of a grey area of accounting, at least in the UK and France, whereby companies were not encouraged to include brands on the balance sheet but nor were they prevented from doing so. In the mid-1980s, Reckitt & Colman, a UK-based company, put a value on its balance sheet for the Airwick brand that it had recently bought; Grand Metropolitan did the same with the Smirnoff brand, which it had acquired as part of Heublein. At the same time, some newspaper groups put the value of their acquired mastheads on their balance sheets. By the late 1980s, the recognition of the value of acquired brands on the balance sheet prompted a similar recognition of internally generated brands as valuable financial assets within a company. In 1988, Rank Hovis McDougall (RHM), a leading UK food conglomerate, played heavily on the power of its brands to successfully defend a hostile takeover bid by Goodman Fielder Wattie (GFW). RHMs defence strategy involved carrying out an exercise that demonstrated the value of RHMs brand portfolio. This was the first independent brand valuation establishing that it was possible to value brands not only when they had been acquired, but also when they had been created by the company itself. After successfully fending off the GFWbid, RHM included in its 1988 financial accounts the value of both the internally generated and acquired brands under intangible assets on the balance sheet. In 1989, the London Stock Exchange endorsed the concept of brand valuation as used by RHM by allowing the inclusion of intangible assets in the class tests for shareholder approvals during takeovers. This proved to be the impetus for a wave of major branded-goods companies to recognize the value of brands as intangible assets on their balance sheets. In the UK, these included Cadbury Schweppes, Grand Metropolitan (when it acquired Pillsbury for $5 billion), Guinness, Ladbrokes (when it acquired Hilton) and United Biscuits (including the Smiths brand). Today, many companies including LVMH, LOral, Gucci, Prada and PPR have recognized acquired brands on their balance sheet. Some companies have used the balance-sheet recognition of their brands as an investor-relations tool by providing historic brand values and using brand value as a financial performance indicator. In terms of accounting standards, the UK, Australia and New Zealand have been leading the way by allowing acquired brands to appear on the balance sheet and providing detailed

guidelines on how to deal with acquired goodwill. In 1999, the UK Accounting Standards Board introduced FRS 10and 11 on the treatment of acquired goodwill on the balance sheet. The International Accounting Standards Board followed suit with IAS 38. And in spring 2002, the US Accounting Standards Board introduced FASB 141 and 142, abandoning pooling accounting and laying out detailed rules about recognizing acquired goodwill on the balance sheet. There are indications that most accounting standards, including international and UK standards, will eventually convert to the US model. This is because most international companies that wish to raise funds in the US capital markets or have operations in the United States will be required to adhere to US Generally Accepted Accounting Principles (GAAP). The principal stipulations of all these accounting standards are that acquired goodwill needs to be capitalized on the balance sheet and amortized according to its useful life. However, intangible assets such as brands that can claim infinite life do not have to be subjected to amortization. Instead, companies need to perform annual impairment tests. If the value is the same or higher than the initial valuation, the asset value on the balance sheet remains the same. If the impairment value is lower, the asset needs to be written down to the lower value. Recommended valuation methods are discounted cash flow (DCF) and market value approaches. The valuations need to be performed on the business unit (or subsidiary) that generates the revenues and profit. The accounting treatment of goodwill upon acquisition is an important step in improving the financial reporting of intangibles such as brands. It is still insufficient, as only acquired goodwill is recognized and the detail of the reporting is reduced to a minor footnote in the accounts. This leads to the distortion that the McDonalds brand does not appear on the companys balance sheet, even though it is estimated to account for about 70 per cent of the firms stock market value, yet the Burger King brand is recognized on the balance sheet. There is also still a problem with the quality of brand valuations for balance-sheet recognition. Although some companies use a brand-specific valuation approach, others use less sophisticated valuation techniques that often produce questionable values. The debate about bringing financial reporting more in line with the reality of long-term corporate value is likely to continue, but if there is greater consistency in brand-valuation approaches and greater reporting of brand values, corporate asset values will become much more transparent.

Brand Valuation Methods:

A number of methods have been proposed to define the value posted in the balance sheet when a brand is part of the assets of an acquired company, or any other instance when this valuation is needed. They can be positioned on a two-dimensional mapping.

The horizontal axis refers to time (but do we base the analysis on the past, the present or the future?). This axis discriminates between valuations based on historical costs (those that helped build the brand), valuations based on present earnings, on market price, and those which rely on a business plan: that is to say, a forecast. The vertical axis is a real/virtual dimension. Some analysts rely on hard facts (historical accounts are facts, as well as present earnings). The brand valuation methods can be broadly classified into 3 types Cost based Income based Market based

Cost Based Methods: The cost approach measures the value of a brand based on the costs invested in building it, or duplicating or replacing it. The premise is that a prudent investor would not pay more for a brand than the cost to replace or reproduce it. The actual amount invested encompasses all expenses to build and support it up to the valuation date. Replacement costs include those to create, at current prices, a similar brand of equivalent utility. Duplication costs represent the expenses needed to recreate an identical brand, adjusted for any potential losses of awareness and strength. When adopting the cost approach, a comparison must be performed between past expenditures and awareness of the brand generated by them. It should not be automatically assumed that there is a link between money spent and value created. The cost approach is often based on retrospective data and does not consider a companys future earnings potential. It may be used when other valuation approaches cannot be implemented and there is no other reliable data. It is sometimes used to ascertain the consistency and reasonableness of values obtained through other approaches.

Creation costs method: this brand valuation methodology estimates the amount that has been invested in creating the brand. In this all the assets are taken at a current value and summed to arrive at a value. This includes tangible assets, intangible assets, investments and stocks. Replacement value method: this brand valuation method estimates the investment required to build a brand with a similar market position and share.

Even assuming that historical cost data of the brand is available and/or the replacement cost can be estimated with a reasonable degree of reliability and confidence, these approaches are generally inappropriate. The reason is that cost is not relevant for determining the value of a brand, which, is derived from future economic benefits. There is no direct correlation between expenditure on an asset and its value. Probably one of the few occasions where cost can be a relevant benchmark is one where the brand has been recently acquired. Income Based Methods: In general this involves estimating the expected after-tax cash flows attributable to the brand over its remaining useful economic life, and present valuing them at an appropriate discount rate. The cash flows (or another measure of brand earnings) used shall be those reasonably attributable to the brand. Various methods are available to determine the cash flows to be calculated after tax.

Valuation by royalty method: This is often chosen to determine the cash flow generated by a brand. It measures the present value of expected future royalty payments, assuming that the brand is not owned but licensed. The royalty rate selected shall be determined after an in-depth analysis of available data from licensing arrangements for comparable brands and an appropriate split of brand earnings between licensor and licensee. It should be as close as possible to those for brands with the same characteristics and size. Valuation by Earnings Multiple method: The cash profit is multiplied by what is known as earnings multiple which in turn is estimated on the basis of various attributes of Brand such as Leadership, Stability, Market position, Internationality, Support and Protection

Out of the above two approaches, the earnings multiple approach is easy to use, but it is not based on strong conceptual underpinning. Generally DCF approach is considered as the conceptually superior method of Brand Valuation.

Market based Method: A measure of value may be based on what other purchasers have paid for reasonably similar assets. The market approach should result in an estimate of the price reasonably expected to be realized if the brand were to be sold. Data on the prices paid for reasonably comparable brands shall be collected and adjustments made for differences between them and the subject brand. For selected comparables, multiples are calculated on the basis of their acquisition price and then applied to the aggregates of the subject. When applying this approach, comparables should have similar characteristics to the subject, such as brand strength, goods or services, economic and legal situation, as well as a transaction reasonably close in time to the valuation date. The valuator shall take into account the fact that the actual prices negotiated by independent parties in transactions may reflect strategic values and synergies that cannot be realized by the present owner. The number of transactions relating to brands as isolated assets is very small. In addition, when the data is known, the characteristics of the subject may differ significantly from those of the few examples of brands sold. Apparently the methodology sounds simple, attractive, and objective. But the methodology is frequently impractical due to lack of market information. Arms length transactions involving similar brands in similar industries are infrequent, given the uniqueness of individual brands. In addition, for transactions that are comparable, it is likely that market and financial information concerning the asset will not be publicly available. However this method can be used as a counter check.

How to Calculate Brand Value

To capture the complex value creation of a brand, take the following five steps:

1. Market segmentation: Brands influence customer choice, but the influence varies depending on the market in which the brand operates. Split the brands markets into non-overlapping and homogeneous groups of consumers according to applicable criteria such as product or service, distribution channels, consumption patterns, purchase sophistication, geography, existing and new customers, and so on. The brand is valued in each segment and the sum of the segment valuations constitutes the total value of the brand.

2. Financial analysis: Identify and forecast revenues and earnings from intangibles generated by the brand for each of the distinct segments determined in Step 1. Intangible earnings are defined as brand revenue less operating costs, applicable taxes and a charge for the capital employed. The concept is similar to the notion of economic profit.

3. Demand analysis: Assess the role that the brand plays in driving demand for products and services in the markets in which it operates, and deter- mine what proportion of intangible earnings is attributable to the brand measured by an indicator referred to as the role of branding index. This is done by first identifying the various drivers of demand for the branded business, then determining the degree to which each driver is directly influenced by the brand. The role of branding index represents the percentage of intangible earnings that are generated by the brand. Brand earnings are calculated by multiplying the role of branding index by intangible earnings.

4. Competitive benchmarking: Determine the competitive strengths and weaknesses of the brand to derive the specific brand discount rate that reflects the risk profile of its expected future earnings (this is measured by an indicator referred to as the brand strength score). This comprises extensive competitive benchmarking and a structured evaluation of the brands market, stability, leadership position, growth trend, support, geographic footprint and legal protectability.

5. Brand value calculation: Brand value is the net present value (NPV) of the forecast brand earnings, discounted by the brand discount rate. The NPV calculation comprises both the forecast period and the period beyond, reflecting the ability of brands to continue generating future earnings. An example of a hypothetical valuation of a brand in one market segment is shown in Table. This calculation is useful for brand value modeling in a wide range of situations, such as:

 predicting the effect of marketing and investment strategies; determining and assessing communication budgets; calculating the return on brand investment; assessing opportunities in new or underexploited markets; and tracking brand value management.

Table 1 SAMPLE BRAND VALUE CALCULATION

Year 1

Year 2

Year 3

Year 4

Year 5

Market (Units) 250,000,000 Market growth rate 4% 4% 4% 4% 258,750,000 267,806,250 277,179,469 286,880,750

Market share (Volume) 15% Volume 37,500,000 17% 43,987,500 19% 50,883,188 21% 20%

58,207,688 57,376,150

Price ($) 10 10 10 11 11

Price change 3% 2% 2% 2%

Branded Revenues 375,000,000 Cost of sales 150,000,000 180,348,750 212,793,490 248,536,469 250,130,653 450,871,875 531,983,725 621,341,172 625,326,631

Gross margin 225,000,000 270,523,125 319,190,235 372,804,703 375,195,979

Marketing costs 67,500,000 Depreciation 2,812,500 3,381,539 3,989,878 4,660,059 4,689,950 81,156,938 95,757,071 111,841,411 112,558,794

Other overheads 18,750,000 22,543,594 26,599,186 31,067,059 31,266,332

Central cost allocation 3,750,000 4,508,719 5,319,837 6,213,412 6,253,266

EBITA (Earnings Before Interest, Tax and Amortization) Applicable taxes 35%

132,187,500

158,932,336

187,524,263

219,022,763

220,427,638

46,265,625

55,626,318

65,633,492

76,657,967

77,149,673

NOPAT (Net Operating Profit After Tax)

85,921,875

103,306,018

121,890,771

142,364,796

143,277,964

Capital Employed 131,250,000 Working capital 112,500,000 135,261,563 159,595,118 186,402,351 187,597,989 157,805,156 186,194,304 217,469,410 218,864,321

Net PPE 18,750,000 22,543,594 26,599,186 31,067,059 31,266,332

Capital Charge

8% 10,500,000 12,624,413 14,895,544 17,397,553 17,509,146

Intangible Earnings 75,421,875 Role of Branding Index 79% 90,681,606 106,995,227 124,967,243 125,768,819

Brand Earnings 59,583,281 Brand Strength Score Brand Discount Rate 66 7.4% 71,638,469 84,526,229 98,724,122 99,357,367

Discounted Brand Earnings 55,477,916 62,106,597 68,230,515 74,200,384 69,531,031

NPV (Net Present Value) of Discounted Brand Earnings (Years 15) 329,546,442

Long-term growth rate 2.5% NPV of Terminal Brand Value (beyond Year 5)

1,454,475,639

BRAND VALUE 1,784,022,082

Applications of Brand Valuation

Strategic Brand Management:

It helps in the purpose of analysis; which fosters economic value of brands. Analysis helps to know how well the brand is established in the market, what is the customer acceptance of the brand. Brand Valuation helps in knowing the strategies that need to be implemented in order to increase brand presence or brand recall. There are 4 major implications of strategic brand management: 1) Making decisions on business investments: Brand valuation helps to decide how much one should invest in a brand, in a way it also helps to decide whether or not to go for cobranding. For example, Nike the market leader in sports category, very closely followed by Reebok and Adidas, collaborated with Apple to launch the Nike+ shoes, this increased their brand value tremendously 2) Making decision on licensing the brand to a subsidiary: When a brand is licensed to a subsidiary, the subsidiary becomes responsible for management of that brand. So before doing so, proper evaluation of the subsidiary is necessary. Brand evaluation can help to know how the subsidiary is performing over the years and how well it is managing its own brands 3) Measuring the return on brand investments: It helps to know the return-on-investment in a brand. What was the brand value before investment and what is the brand value after investment 4) Awarding and promoting the employees: Depending upon the growth in brand value, responsible employees for the growth can be awarded to keep them motivated

Financial Transactions : Brand valuation helps in transactions with external partners There are 3 major implications of Financial Transactions are:
1) Assessing fair transfer prices for the use of brands in subsidiaries 2) Determining a price for brand assets in mergers, acquisitions or sale of company 3) Capitalizing brand assets on the balance sheet according to accounting standards

Benefits of Brand Valuation:

Budget allocation decision making: Depending on how much value does a brand have in the market, budget can be allocated according for the marketing activities of that brand. Use of brand values supports a better way to hold managers accountable for their actions: If two managers are working on two different projects, there should be a common platform on the basis of which these two managers can be evaluated. Now, based on the value that each manager has added to his brand, one manger can be evaluated against other, thus brand valuation forms the common platform. Brand value is a meaningful metric that provides marketers and accountants with a common focus in brand planning.

Case Study: Value of a brand name

Our case: We are going to compare and find out the value of the brand name of Coca Cola. For this, we will compare the Value of firm/ Sales ratio of a generic cola company and that of Coca Cola. The model being used to find out the value has been proposed by Aswath Damodaran who is a Professor of Finance at the Stern School of Business at New York University (Kerschner Family Chair in Finance Education), where he teaches corporate finance and equity valuation. Value of a brand: Traditional valuation fails to consider the value of brand names and other intangibles. One of the benefits of having a well-known and respected brand name is that firms can charge higher prices for the same products, leading to higher profit margins and hence to higher price-sales ratios and firm value. The larger the price premium that a firm can charge, the greater is the value of the brand name. In general, the value of a brand name can be written as: Value of brand name = {(V/S)b-(V/S)g}* Sales (V/S)b = Value of Firm/Sales ratio with the benefit of the brand name (V/S)g = Value of Firm/Sales ratio of the firm with the generic product Formula:

Where: P: Value of firm g: expected growth rate r: cost of capital n: no of years Consider the Value/Sales ratio of Coca Cola. The company had the following characteristics: After-tax Operating Margin =18.56% Sales/BV of Capital = 1.67 Return on Capital = 1.67* 18.56% = 31.02% Reinvestment Rate= 65.00% in high growth; 20% in stable growth; Expected Growth = 31.02% * 0.65 =20.16% Length of High Growth Period = 10 years Cost of Equity =12.33% E/(D+E) = 97.65% After-tax Cost of Debt = 4.16% D/(D+E) 2.35% Cost of Capital= 12.33% (.9765)+4.16% (.0235) = 12.13% Substituting these values in the formula, we get Value to firm/ Sales ratio as 6.10. The values for Coca-Cola and generic cola brand are as follows:

Value of Cokes brand name: Value of Cokes Brand Name = (6.10 - 0.69) ($18,868 million) = $102 billion Value of Coke as a company = 6.10 ($ 18,868 million) = $ 115 billion Approximately 88.69% of the value of the company can be traced to brand name value