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Sam Ghosh Founder and SEBI Regd. Investment Adviser at Wisejay Private Limited Bangalore, Karnataka
Capital Investment decision making for entrepreneurs part 5: Non-Traditional methods for investment assessment
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09:08:56 AM, 12th July, 2019
  • Sam GhoshFounder and SEBI Regd. Investment Adviser at Wisejay Private LimitedBangalore, Karnataka
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    How do we evaluate return when there is either no cash-flow expectations or cash-flows are expected after a few more events (such as the development of a new product which needs to be commercialised to generate cash-flows)?

    To deal with such questions, we can evaluate a project based on value created rather than expected cash-flows. We can use various methods used to value intangible assets to assess the value of the project outcome and then compare the value with the investments required. So, let us dive in.


    1. Relief from Royalty method

    This method is often used for evaluating intellectual properties, regulatory licences, brands etc. This method evaluates the value of the intangible asset based on hypothetical royalty payments saved by owning the intangible asset. We will need to adjust these payments for income tax as actual royalty payments would be considered as expenses and will lower the taxable income.

    Then we will need to calculate the present value of all these tax adjusted royalty payments with the appropriate cost of capital (WACC for the project to develop the intangible asset) and compare with the investment required.


    2. Replacement Cost Approach

    This method calculates a rather conservative value of the intangible asset based on the assumption that a potential buyer will not be willing to pay for the asset more than what would cost to develop a comparable asset by them.

    We can evaluate the return by calculating the IRR assuming a hypothetical sale of the intangible asset at the end of the project. The process of the hypothetical sale should be adjusted for costs associated the sale such as cost for searching such a buyer, legal and regulatory costs etc.

    The IRR can be compared with project WACC to decide on the project.


    3. Real Options Method

    How do you value an asset when its value is contingent on future events. Consider the development of new technology. Just development of the technology will not create cash-flow – it needs to be either commercialised which will involve further costs or licensed to other players. How do we evaluate the product development project?

    We can face the same issues with costs involving getting regulatory approval or licenses. Getting the approval or license will not create cash-flows but these are precursors to the venture which can generate cash-flows.

    Aswath Damodaran, professor at NYU Stern School of Business suggests using an option valuation method for such scenarios.

    Note: Link for Dr Damodaran’s document is provided below.

    The point is that we cannot asses such projects without considering the contingent options for future cash-flows associated with them. Let us consider the above-mentioned example of product development. To properly assess the product development project we need to consider a call option of product commercialisation. We can value the call option and then use the value as the outcome of the project in hand i.e. the product development project. Dr Damodaran’s document has some examples that I strongly recommend the readers to refer to.


    4. Market Comparables

    This method uses readily available market data for comparable assets which the project intends to develop. Using this method requires us to adjust the value of the asset based on the project specifics. Also, we need to remember that intangible assets may not be completely replicable for various reasons. Sometimes there can be regulatory or legal restrictions or simply strategic factors. For example, it will nearly impossible to replicate the brand values of Coka Cola or Starbucks even after considerable investment.



    It is always recommended to use various different methods to evaluate such complex project and making a judgement. More than readily available number pointing out clear decisions, use of these methods is about getting different insights about the project. None of the methods, traditional or non-traditional, will take the decision for us – they will just empower us to look at the project from different perspectives. The ultimate decision should be based on our judgement.



    The Value of Intangibles, Aswath Damodaran

    http://people.stern.nyu.edu/adamodar/pdfiles/ovhds/dam2ed/intangibles.pdf

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