What it means
Balance sheets record intangibles poorly. A brand built over twenty years, a trained workforce and a patented process may all be central to why a company makes money, yet unless they were purchased in an acquisition they usually appear nowhere in the accounts.
CIV is one attempt to put a number on that missing value. The method works from returns rather than from the assets themselves.
It compares a company's return on tangible assets with the average return in its industry, on the reasoning that identical physical assets should earn roughly identical returns in a competitive market. Any persistent difference is attributed to the intangible side of the business.
The calculation runs in a set order. Take average pre-tax earnings over three years, take average tangible assets over the same period, apply the industry average return on assets to those tangible assets to find the expected return, subtract that expected return from actual earnings to isolate the excess, tax the excess, then capitalise the after-tax figure at the company's cost of capital.
The strengths of CIV are that it uses figures already available in published accounts and produces a single comparable number that can be tracked year on year. It is often used to compare a company against its own history, to make a case for investment in brand or training, or as a sanity check on other valuation approaches.
The weaknesses are real and should be stated plainly. The result is highly sensitive to the industry return figure chosen and to the cost of capital used, and it silently attributes all excess profit to intangibles when some of it may come from a temporary shortage, an unusual contract or simple luck.
A firm earning below the industry average produces a CIV of zero or less, which does not mean its brand is worthless.
In practice
Real-world examples.
Example
A software firm calculates an after-tax excess return of $1,200,000 and uses a 12% cost of capital. Its CIV is $1,200,000 / 0.12 = $10,000,000, a figure the board cites when arguing that its development team is the main asset.
Example
A restaurant chain earns exactly the industry average return on its tangible assets, so the excess return is zero and the CIV is zero. Management reads this not as proof of a worthless brand but as evidence it is not yet converting brand into superior returns.
Example
A consultancy with average pre-tax earnings of $2,500,000 and tangible assets of $5,000,000 faces an industry return of 14%, giving an expected return of $700,000. The excess of $1,800,000, taxed at 25%, becomes $1,350,000, and at a 10% cost of capital the CIV is $13,500,000.
Formula
Calculation
Excess return = average pre-tax earnings - (industry average return on assets x average tangible assets). After-tax excess return = excess return x (1 - tax rate). CIV = after-tax excess return / cost of capital.
A specialist chemicals company reports average pre-tax earnings of $4,000,000 over three years and average tangible assets of $16,000,000. The industry average return on assets is 12%, so the expected return on those tangible assets is 0.12 x $16,000,000 = $1,920,000.
The excess return is $4,000,000 - $1,920,000 = $2,080,000. At a 25% tax rate, the after-tax excess is $2,080,000 x 0.75 = $1,560,000. Capitalising that at a 10% cost of capital gives a CIV of $1,560,000 / 0.10 = $15,600,000, which is the estimated value of everything the company owns that does not appear as a tangible asset.Case study
Seen in the real world.
Ashgrove Analytics is an illustrative data services company whose founders were negotiating with an investor who valued the business on tangible assets and recent profit alone. The founders felt the offer ignored the client relationships and proprietary models that produced the profit in the first place.
Their accountant ran a CIV calculation. Average pre-tax earnings over three years were $1,800,000 and average tangible assets $4,500,000, against an industry average return on assets of 15%. Expected return was 0.15 x $4,500,000 = $675,000, leaving an excess of $1,800,000 - $675,000 = $1,125,000. After tax at 25% this was $1,125,000 x 0.75 = $843,750, and capitalised at a 12.5% cost of capital the CIV came to $843,750 / 0.125 = $6,750,000.
The investor did not accept the figure as a valuation, and rightly so, but in this fictional negotiation it shifted the conversation. The discussion moved from the value of the servers and office fit-out to the durability of the client relationships, which was the more useful question for both sides.
Watch out
Common mistakes.
- Presenting CIV as a formal valuation of the business, when it is an indicative estimate of intangible value that no buyer or auditor is obliged to accept.
- Using a single year of earnings, which lets one unusually good or bad year distort the result, instead of averaging over three years as the method intends.
- Picking an industry return figure that flatters the company, since a two-point change in that assumption can move the answer by millions of dollars.
Questions
People also ask.
What does a CIV of zero mean?
It means the company is earning no more than the industry average on its tangible assets, not that its brand or know-how has no value at all.
How is CIV different from goodwill on the balance sheet?
Goodwill is recorded only when one company buys another and pays more than the fair value of its net assets, while CIV estimates internally generated intangible value that accounting never records.
Which inputs matter most?
The industry average return on assets and the cost of capital, because the answer is a division by that cost of capital and is therefore very sensitive to both.
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