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TM Transfer Pricing Report - Using the Market Capitalization Method Volume 14 Number 6
Wednesday, July 20, 2005
ISSN 1521-7760
Using the Market Capitalization Method
To Value Buy-Ins: Beware of 'Thing Three'
By Perry D. Quick, Timothy L. Day, Brian J. Cody, and Susan R. Fickling

Perry D. Quick, Ph.D., is a vice president and Timothy L. Day, Ph.D., is a principal with CRA
International in Washington, D.C. Brian J. Cody, Ph.D., is a vice president and Susan R.
Fickling is a principal in the firm's Chicago office.

While buy-in payment calculations generate frequent controversy between cost sharing participants and the Internal Revenue Service, the determination of the buy-in valuation is, in principle, relatively straightforward: The proper arm's-length payment for the existing intangible property should be determined as the net present value of all expected future income associated with the specific intangible being transferred under the terms of the agreement. Though relatively straightforward in theory, applying this principle in specific situations with specific measurement approaches has proved problematic. Thus, the buy-in valuation question has been among the most contentious issues in ongoing controversies between taxpayers and the IRS, as well as in recent professional forums.1 The IRS is expected to issue new cost sharing regulations soon, including specified methods for the calculation of buy-in payments.2 One of the methods that has received significant discussion and appears to be favored by the IRS in many applications is the use of stock market values as benchmarks, particularly for valuing technology intangibles. This is the so-called market capitalization method. The IRS's interest in this method could be especially problematic to taxpayers if the Service adopts it as one of the specified methods for valuing intangibles transferred in a cost sharing agreement. The "specified" designation would give the market capitalization method superiority over other approaches heretofore favored by taxpayers for valuing buy-in payments.3 Reasonable Theory, Questionable Practice
The theoretical underpinnings for the market capitalization method are provided in a September 1999 article by R. William Morgan.4 Morgan first establishes the theoretical standard for what should be the arms-length valuation: "[A] buy-in payment represents payment for pre-existing intangible assets. There is no reason to believe that the valuation of such intangibles is any different than the valuation of other assets."5 While Morgan's theoretical foundation is sound, his structure becomes a bit shakier as he 4/28/2006 TM Transfer Pricing Report - Using the Market Capitalization Method adds alternative measurement constructs to this foundation. Morgan suggests three useful benchmarks for the fair market value of technology intangibles: acquisition prices paid for technology-driven companies; market capitalizations of publicly traded, technology-driven companies; and the level of in-process research and development valued and written off for book purposes by buyers in acquisitions of companies (public or private, technology-driven or not). Of these, only the market capitalization approach generally provides the publicly available data necessary for an independent quantitative evaluation. This is the measurement method the IRS is considering as a viable alternative to others. The IRS has incorporated the method in its training materials and set out its own logic for application.6 Implementing the market capitalization method typically involves the following steps: 1. allocating the market value of a company's intangible assets across a set of identified intangible assets (compensable and non-compensable); 2. using the capitalized cost method to calculate the stock values of intangible assets (if intangible development costs can be identified); 3. allocating the market value of a company's assets across the intangible stock values on a pro-rata basis; 4. calculating the market value of firm intangible assets allocated to the pre-existing intangibles made available to the cost sharing participant(s) (the buy-in); and 5. subtracting the value of a non-compensable intangible from the market value of firm intangible assets (if it can be valued reliably on an absolute basis using the cost capitalization method) rather than placing it into the intangible allocation base. Although the authors are not entirely unsympathetic to some of the usual criticisms of the market capitalization method (such as highly variable equity prices, bubble pricing theories, and so on), these criticisms have been well vetted and are not the subject of this paper. The more fundamental criticism is that in many situations the method is impossible to implement. That is, the implementation reaches an almost unscalable obstacle at step one--identifying the various kinds of intangible assets of the company and isolating those that are to be specifically included in the cost sharing agreement. As shown below, significant portions of many firms' intangible assets--assets that are not normally contemplated as having been transferred with the buy-in--are effectively unidentifiable. Because such assets are not separately identified in step 1, the market value allocated in step 3 will be over-allocated to the identifiable assets designated as part of the agreement, and thus the buy-in payment derived in step 4 will be overstated. The rest of this article offers some research results of recent events in securities markets that support the idea that equity prices often reflect value--potentially quite significant--that was never contemplated by the IRS to be included as part of the buy-in payment in cost sharing agreements. In addition, the article provides a warning to those structuring cost sharing agreements about how to specify the scope of the intangibles to be transferred. 4/28/2006 TM Transfer Pricing Report - Using the Market Capitalization Method What 'Things' Drive Market Value?
Under fundamental asset valuation theory, the value of an asset is equal to the net present value of its expected cash flow. As applied in securities market analyses, a firm's total enterprise value is equal to the net present value of all expected cash flows made available to equity and debt holders. Projects in place are the most identifiable source of these expected cash flows.7 Projects in place include not only those projects generating current earnings (for example, a currently marketed drug), but also identifiable projects under development (such as a drug in Phase II clinical trials). If carefully identified, these projects also include the potential of any additional projects--discounted by the probability, however small, that such add-ons will materialize. For example, if developers of a pharmaceutical compound for a specific indication have some reason to believe that at some point in the future this compound may have application for a different heretofore unspecified indication, expected sales from this additional indication also are considered projects in place. In other words, if a potential cash flow is known and identifiable, no matter how remote or improbable, it is considered a project in place for securities valuation purposes. In transfer pricing parlance, these two categories of projects in place are generally considered to be the intangibles transferred in the cost sharing agreement--both the make/sell rights (Thing One) and the platform rights (Thing Two).8 In addition to projects in place, however, the total enterprise value of a firm may include the net present value of all expected cash flows generated from unknown growth opportunities. In contrast to projects in place, growth opportunities do not represent specific identifiable products under development or future applications, but are based on the expectations of the firm's ability to develop projects generating positive cash flow in the future. For companies with highly successful development histories, it is possible for investors to place a relatively high value on this potential and assign relatively significant expected future dividend streams to growth opportunities. Although investors may not know the exact nature of these potential growth opportunities, they could reasonably assume that these growth opportunities will be uncovered and thus will provide additional cash flow in the future beyond the identifiable projects in place. Such growth opportunities are especially prevalent in industries with high market-to-book ratios, such as pharmaceuticals, chemicals and electronics. (See Exhibit 1.) Where do growth opportunities fit with respect to the intangibles identification process for valuing cost sharing buy-ins? Since projects in place are composed of both the make/sell rights (Thing One) and the platform rights (Thing Two), growth opportunities represent a category of intangibles previously overlooked in the current discussion: "Thing Three." Reliable application of the market capitalization method assumes the ability to identify all intangible assets and assign appropriate portions of the firm's market values to each. But, if growth opportunities have a material impact on the firm's market value and are not quantified, the method's reliability must be questioned. Cost sharing agreements typically involve the transfer of rights associated with projects in place, such as the development efforts of a new drug. Thus, estimations of buy-in payments calculated by reference to a company's stock prices should include only the portion of the stock price attributable to the projects in place and exclude the portion attributable to growth opportunities. However, because growth opportunities are by definition unidentifiable, it cannot be accounted for easily or with precision in the application of the market capitalization method as described in the five-step process in the previous section. As demonstrated below, the value attributable to growth opportunities can be substantial, and for pharmaceutical companies it often is several times the value of projects in place. Thus, for these and other growth companies, using the market value of equity to value buy-in payments would substantially overvalue the intangible rights transferred under most cost sharing arrangements. 4/28/2006 TM Transfer Pricing Report - Using the Market Capitalization Method Empirical Test
To add some empirical content to the debate about the validity of the market capitalization approach, it is useful to employ a technique from securities markets analysis--an "event study" approach--to better understand the potential magnitude of growth opportunities relative to projects in place. Event studies, a common tool in estimating damages in securities fraud cases, link specific events to changes in share prices over a given period of time. The study described below compares the change in the stock market value of pharmaceutical companies on major product announcement days to market analysts' revisions of the net present value of the expected cash flows of the product considered in the announcement. Since the product and its related applications are known and identifiable, they are considered projects in place. If market value reflects only the projects in place, the entire change in the stock price on the announcement date should be explained by revisions in investors' expectations of the product's discounted cash flow as a result of the announcement. If the market value changes by more than the revisions in investors' discounted cash flow forecast, some other factor must be influencing market value. This additional factor is growth opportunities, or Thing Three. To illustrate, consider one such testable announcement, the so-called Prozac patent announcement of Aug. 9, 2000. On that date, a U.S. Appeals Court in Washington D.C. rejected a field-of-use patent that would have extended the period of protection for Prozac from generic competition until 2003. The court did, however, uphold the original compound patent that protected the drug until 2001. The ruling effectively shortened Eli Lilly & Co.'s patent protection by two years, opening the door to generic competition sooner than expected. This was a major financial setback to Lilly, but the magnitude of the impact was measurable and contained.9 Testing the validity of the market capitalization method requires comparing the change in the net present value of Lilly stock analysts' cash flow projections for Prozac both before and after the announcement to the change in Eli Lilly's market value both before and after the announcement. This event represents a "clean" event for analytical purposes, since no other significant announcements were made about Lilly on or around Aug. 9, 2000, and the Prozac announcement did not reveal additional information beyond the direct effect of the accelerated release of generics on Prozac sales forecasts. Nor were there other news stories pertaining to Lilly specifically or the pharmaceutical industry in general that could explain any material changes in Lilly's share price independent of the Prozac announcement. If the change in Lilly share price on Aug. 9, 2000, were fully explained by the revision to the net present value of analysts' cash flow forecast for Prozac both before and after the Aug. 9, announcement, this event would be consistent with the underlying conditions necessary to apply the market capitalization method with the appropriate precision. If not, other factors must have been affecting Lilly's market value--unidentified factors that could be unrelated to existing products or products in the pipeline. As expected, the stock analysts who followed Lilly revised downward their sales and earnings forecasts after the announcement. The revision in the expected discounted cash flow value of Prozac as the result of the announced decision was $2.18 billion on a net present value basis.10 This cash flow revision was consistent with the revisions to the stock analysts' consensus earnings per share (EPS), which are shown in Exhibit 3. In fact, the analysts' consensus EPS forecasts for 2001 through 2003 fell only marginally after the Aug. 9, 2000 announcement, and the consensus longer-term EPS growth rates were almost unchanged.11 The stock market also reacted adversely to the announcement of the negative ruling. Indeed, the news appeared to stun the market. Trading in Eli Lilly shares on Aug. 9 was halted for nearly three hours, reopening only minutes before the market closed. During those minutes of 4/28/2006 TM Transfer Pricing Report - Using the Market Capitalization Method regular trading, the stock plunged $31.81, or 31 percent, to close at $75. As a result of the announcement, Eli Lilly's market value dropped by $35.8 billion.12 This change in market capitalization was fourteen times the size of the analysts' change in the net present value of the cash flows associated with Prozac (see Exhibit 4). What could cause such a large discrepancy between the change in market valuation and the expected change in the net present value of Prozac cash flows? Four possible explanations come to mind, but only one appears accurate. First, market participants may have believed the analysts significantly underestimated the effect of the announced ruling on Prozac's future revenues. However, the stock analysts covering Lilly routinely perform such valuations, and this valuation--affecting only the timing of Lilly's sales of Prozac at a premium price--should have been especially straightforward. Second, the market is irrational. However, there is a breadth of literature in the finance area refuting the irrationality of securities markets except in cases of momentary disequilibria.13 Thus, at the very least, one would not expect the drop in Lilly share price to have been sustained for so long after the announcement if there was clear evidence that the market reaction did not reflect the consensus view of future prospects for the overall company. Third, the market's reaction in this particular case was an anomaly. However, research has found a number of situations similar to the Lilly-Prozac case. Exhibit 4 shows the results of the analysis of six additional product announcements from pharmaceuticals companies. In these cases, the change in market capitalization both prior to and following the announcement was 1.7 to 17.8 times the analysts' estimated impact on cash flows from projects in place. The fourth possible explanation is that the announcement signaled to the market something more than the direct loss of Prozac--that the market viewed the announcement as affecting the value of other, non-Prozac related Lilly intangibles. This is the only explanation that is supported by basic economics and the facts in this case and in the others studied. Firms have know-how and other intangibles that are not part of the specific product--and in the case of cost sharing agreements, not specifically transferred with compounds or other intangibles as part of the buy-in. These include experience and reputation in achieving favorable regulatory outcomes, and skill in managing the company's overall intangibles portfolio for maximum value at predictable and acceptable levels of risk. Announcements regarding developments in one product area can reasonably affect market expectations regarding not only the projects-in-place cash flows under specific scrutiny, but also those of other unrelated growth opportunity areas. In the Prozac case, the announcement may have shaken the market's confidence in Lilly's overall management and its ability to develop and hold onto their proprietary position on a broad range of compounds. In other cases involving a regulator's non-approval of a drug or compound, the announcement may have prompted a revision in expectations regarding management's ability to get other drugs through the regulatory process successfully. Whatever the specific reasons in each case, empirical research suggests that distinct and significant discrepancies can exist between market expectations regarding changes in a company's capital value and reasonable estimates of the changes in the underlying projects-in-place cash flows associated with a particular product and its identifiable future extensions--be they Thing One or Thing Two. Such differences suggest the existence of other--Thing Three--intangibles, much more difficult to identify and measure, which are related to activities of the firm beyond those associated with the specific product but affect general growth opportunities of the company. If the observations above are correct, then applications of market capitalization must not only identify and separately value the Thing One rights and the Thing Two intangibles associated with a qualified cost sharing agreement. They must also identify and consider the relative value of the Thing-Three intangibles that are outside the agreement. If they do not, the method could prove a highly unreliable indicator of intangible value for purposes of 4/28/2006 TM Transfer Pricing Report - Using the Market Capitalization Method Conclusion
In summary, empirical evidence drawn from changes in stock market values for pharmaceutical companies on major product announcement dates calls into question the reliability of a company's market capitalization as a measure of the arm's-length value of a specific package of intangibles. In particular, these results have two implications for those considering the valuation and structure of cost sharing buy-ins. First, great care, and considerable skepticism, should be exercised in applying the market capitalization method for valuing buy-in payments--even in the case of a single-product company. Second, whatever method is used to value the intangibles contributed to a qualified cost sharing agreement, the structure of the agreement must be explicit about the intangibles to be transferred. Unless the cost sharing agreement is drafted in a "kitchen sink" manner to include all possible products--whether currently under development or no--and all other intangibles of the company, the portion of the market value of firm equity composed of future growth opportunities, or Thing Three, is not valid for calculating the buy-in payment in cost sharing. Only that portion of market value composed of projects in place should be considered in the calculation of the buy-in payment. Exhibit 1
Market to Book Values: By Industry
Median Market to Book Value Selected Industries
Exhibit 2
Exhibit 3
Exhibit 4 4/28/2006 TM Transfer Pricing Report - Using the Market Capitalization Method ________________________________________ 1 See, for example, Cole, Robert T., "Recent TAM May Foreshadow Cost Sharing Buy-In Regulations," 13 Transfer Pricing Report 936, 1/19/05; "Buy-In for Technology Should Include More Than Current Generation Rights, Musher Says," 13 Transfer Pricing Report 855, 12/22/04; "At Arm's Length, Licensee Pays Buy-In, Intangibles Development Costs, Frisch Says," 13 Transfer Pricing Report 621, 10/13/04; "Xilinx, IRS Address Specific Cost Issues, Arm's-Length Standard at Closing Argument" 13 Transfer Pricing Report 567, 9/29/04. 2 "Musher Says Cost Sharing Rewrite To Focus on Valuing Buy-In Payments," 12 Transfer Pricing Report 1046, 3/31/04. 3 Current regulations for valuing intangibles transferred between related parties describe three specified methods for determining the appropriate arm's-length consideration: the comparable uncontrolled transaction method, the comparable profits method, and the profit split method. Unspecified methods may be used provided the taxpayer can show first that the specified methods do not yield a reliable arm's-length result under the particular facts and circumstances of the case. See, for example, Finan, William, "Reliably Determining a Buy-In Payment Under Code Section 482," Global Transfer Pricing, February-March 1999, pp. 12-27. 4 "Cost Sharing Agreements: Buy-In Payments and Market Valuations," 8 Transfer Pricing Report 449, 9/15/99. Morgan also makes clear why he believes the IRS is interested in the method as an alternative to the taxpayers' current approaches: "IRS audits . have been concerned with what appear to be extremely low 'buy-in' payments made by offshore subsidiaries for existing intangible property developed in the United States. These low buy-in payments raise the question of whether their valuations are consistent with the arm's-length standard." 5 Ibid. Morgan then develops some straw-man examples of how failure to follow the theory leads to improper results, followed by a discussion that links the positions of "many taxpayers" to the straw-man position. His criticism is that these taxpayers do not value the intangibles associated with the future returns on profits generated on future investments using the intangibles generated--only the returns on investments already made. 6 Weissler, Robert, "E. APA Program Training on Cost Sharing Buy-In Payments," 11 Transfer Pricing Report 533, 10/2/02. 7 Brealey, Richard A. and Myers, Stewart C., Principles of Corporate Finance, 7th Edition, McGraw-Hill, New York, 2003, p. 71. 8 See Cole, Robert T., as cited in footnote 1. 9 To put this into perspective, Lilly's Prozac revenue in 1999 stood at $2.61 billion, more than one quarter of its total annual sales of $10 billion. However, in the years prior to the announcement date, Eli Lilly's dependency on Prozac had decreased substantially as represented by its declining share of total net sales, falling from 34 percent in 1996 to 24 percent in 2000. 10 The analysts' forecasts appeared to agree with company statements about the impact. Charles E. Golden, executive vice president and chief financial officer for Lilly, reported, "While we're clearly disappointed with today's ruling and plan to appeal it, we nonetheless are thoroughly prepared to implement a comprehensive contingency plan. This plan will allow us to absorb the loss of Prozac sales while continuing to invest the resources necessary to expand the growth of our existing newer products and launch several exciting new products 4/28/2006 TM Transfer Pricing Report - Using the Market Capitalization Method beginning with Zovant and Forteo. . A detailed program of strict expense controls will be implemented that is designed to shift a majority of spending to support our growing products in the marketplace and to bring new products to market." Sources: Eli Lilly & Co., Form 10-K for the Fiscal Year Ended December 31, 1999 and Fiscal Year Ended December 31, 2000.; Eli Lilly & Co. Web site (, Prozac Web site ( 11 The stock actually retained its "buy" rating, based on its "strong new product dynamics and attractive valuation." See, for example, Big Decline in Stock Post Reversal of Prozac Court Ruling Offers Buying Opportunity, SG Cowen Analyst Report, 8/10/00. 12 Eli Lilly share price still remained well above the 52-week low of $54 on March 7, 2000. The stock had soared in recent months on optimism about the company's pipeline, reaching a 52-week high of $109 on June 29. Chairman and chief executive Sidney Taurel said, "We believe we have the strongest pipeline in the industry." He further said it [the Prozac ruling] was only a "temporary setback." Eli Lilly Executive: Late-Stage Pipeline Best In Industry, Dow Jones & Co., 8/09/00 (13:42) (See Exhibit 2). 13 For a readable summary of the research on market efficiency, see "Chapter 13: Corporate Financing and the Six Lessons of Market Efficiency," Brealy and Myers, op. cit. _____________________________________________________________________ Contact customer relations at: or 1-800-372-1033 Copyright 2005, The Bureau of National Affairs, Inc. Copyright FAQs | Internet Privacy Policy | BNA Accessibility Statement | License Reproduction or redistribution, in whole or in part, and in any form, without express written permission, is prohibited except as permitted by the BNA Copyright Policy, 4/28/2006


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