Lesson Learned (Dr. Roger Sinclair)
In the early 1980s I was managing director of a long established, but fast growing advertising agency. I owned a small stake in it, but the majority shareholder was the chairman who had established the business thirty years before. One evening, the deputy chairman and I met a team from FCB to discuss their offer to buy our little firm. We sat at a bar in Sandton City, whiskies in hand, and talked about the deal.
Eventually a price had to be struck. Our man and their man faced-up for ‘the wrangle’. Well, that is what I thought would happen. What they did was glance at the income statement and work out our average, after-tax profits for three years. Then they opened The Star to the stock exchange prices for the day.
No agencies were listed on the JSE at that time so they looked for companies that might be comparable. They ran their fingers down the column that said, “price to earnings ratio” (P: E) and decided that the appropriate multiple would be five. That was it. Five times the average three year profits was the price. They shook hands and poured another whisky.
Today, I have a doctorate in these kinds of deals and know that “we wuz robbed”. I still have the accounts, and properly done, we could have held out for a far better price. Five was just a number. It didn’t take into account the loyal clients who had stayed with the agency for many years. Neither did it incorporate the reputation we had built up as a skilled, talented young team who were winning awards and new business.
That is the issue that has exercised the minds of accountants, economists and investors ever since. Exactly what is it that drives up the price of an enterprise so its worth exceeds the value of its tangible assets? The mystery of “q” James Tobin, a Harvard Professor and Nobel Prize Laureate came close to answering this question in the 1960s. He devised a method for determining when firms are likely to invest in their assets and when they are not. You divide the market capitalisation of the firm by the replacement costs of its assets and liabilities. The numerator is the market value of the firm and the denominator is the current value of the assets that create that value. You’d think they’d equal each other, but they rarely do.
Tobin called the outcome of this calculation “q”. He explained that if “q” exceeded one, a firm would have an incentive to invest because of the value placed on its assets by the investment community. Conversely, a “q” which is less than one, indicated a firm ripe for take-over.
Subsequent commentators on Tobin’s “q” have argued that ratios exceeding one will be achieved by firms that have developed powerful, competitive advantages. They state that firms with the highest “q” will be those with strong brands and special know-how.
The old multiple method of valuation provides no explanation of why firms create value. The value is simply implicit in a number. Some people find that quite acceptable: the accountants did not. It became clear to the writers of accounting standards that investors were not happy with the information conveyed by the annual books of account. Firstly, these were as much as six months out of date by the time they were published. Secondly, the value of assets in the balance sheet was based on what the firm paid for them as opposed to their current market value. Thirdly, the accounts made no mention of the assets that create added value; intangibles such as brands.
This has partly been dealt with by the new accounting standards which came into effect in 2004. Called International Financial Reporting Standards (IFRS), they are primarily designed to ensure that the world’s accounting systems and ways of reporting are standardised. Wherever you go in the world, the financial reports will contain similar if not identical information. Thus comparisons can be made across borders. They also specified that brands will be measured as assets when they are acquired as part of a merger or acquisition, what they call a business combination. Another change is that they must no longer be valued at their cost; the modern accountant has to find a reliable way of valuing the acquired intangible assets at their “fair value”, what they would fetch in the market.
In vino veritas
Here’s an example of how significant this can be. In 2001 the former Distillers Corporation and Stellenbosch Farmer’s Winery merged. In 2003 the portfolio of brands owned by the recently formed Distell was valued. The aggregate value was an impressive R2,8 billion. The listed entity was capitalised on the JSE at R3, 3 billion, the net assets were just over R3 billion, which made the valuation look silly. This actually was a good indication of the true value of the firm. Distell management thought investors were undervaluing their company because of a pending decision by the Competition Board (CB). When the CB declared the deal to be in order, the shares rose so that the brand value was priced into the premium placed on the company by the investing public. The market capitalisation rose to over R7 billion and settled at R11 billion. The brands, as you would expect from a company that lives by them, formed the bulk of the premium. The market appreciated their value. More pertinent is that the brand value indicated, correctly, what the value of the firm should be.
Colour coded value
A company that has embraced this concept is Freeworld Coatings. In 2007, Barloworld announced it would unbundle some of its non-core operating divisions. PPC was one and Plascon was another. Having done valuation work for Plascon for seven years, we were asked to assist in preparing the division for its separation. The brand portfolio included brand leaders such as Double Velvet, Velvaglo and Micatex. We use economic profit as a proxy for an unbranded version of the brand being valuated. The argument is that if a product cannot generate profits, after taxation, that exceed the cost of capital invested in it, it is in effect a commodity. It has been shown that brands are among the intangibles that create added value. To work out the economic profit of a brand both an income statement and a balance sheet are needed. Companies tend to prepare revenue figures for individual brands and allocate costs to them. They do not develop complete income statements, and assets and liabilities are dealt with at the category level, at the divisional or corporate level. When first valueing the Plascon brands in 2000, the financial department created a format for capturing the information needed. The approach has now been used and tested. It was simply a matter of fitting the most recent numbers to the template. Each brand had its calculated revenue less its allocated costs and share of net assets.
The dilution estimate was also updated. In the chart below, the analysis for the Plascon consumer brands is shown. This percentage, 63, 9 percent is applied to the economic profit calculated for each consumer brand. For example, the economic profit for one of their flagship brands was R21 million which reduces to R13, 4 million once the dilution percentage is applied.
The resulting number is called the Brand Premium Profit (BPP) because it is the amount that can be attributed directly to the brand.
Coatings is a highly competitive market with robust pricing at the retail level. While Plascon, now Freeworld Coatings, has been cast adrift by its erstwhile parent to fend for itself, its long time competitor Dulux has been absorbed by European chemical giant ICI. This gave it greater marketing resources. Market research, however, shows that the Plascon brands are very strong in the market place and, in many cases, are the preferred brands. The market capitalisation of the new company at date of listing was R2,6 billion, with long term and short term debt of R900 million. The value of the Plascon brand portfolio was R686 million and the firm’s net operating assets were R610 million.
There was also goodwill in the balance sheet of R1,7 billion created when the corporatisation of the new company took place1. If the goodwill is ignored, the intangible assets (brands) represent almost 77 percent of the market premium. Experience tells us that a percentage of about one third would be more appropriate for a company of this nature. Does this imply an undervaluation such as Distell? If so, the brands indicate this is a share to watch. These are just two of the examples that illustrate how brands are increasingly playing a role in the value of companies. For decades the marketing industry has referred to brands as assets and has emphasised the role they play in creating shareholder wealth. Now we are seeing the reality and it is a welcome sight.
Goodwill (note 3 in the Freeworld Coatings pre-listing statement published in November, 2007) arises from the purchase price of R3,5 billion paid to Barloworld for the company and is the excess over net assets once the intangible assets and property revaluations have been deducted. The result of the BrandMetrics valuation is stated in note 4 to the accounts.
Dr. Roger Sinclair is an emeritus professor at Wits and is managing director of BrandMetrics, the brand valuation company he founded and runs.