The following is a guest post from Adrian Ashford, Founder and CEO of MRD Advisors, who recently published a report on music catalog valuations. 

Since the pandemic, investors have been clamoring to acquire music catalogues. And it has been widely reported that catalogues have been selling at historic multiples. And other outlets have opined upon how to a value a catalogue using these multiples, but no one has discussed how these multiples are determined, until now. In a recent report published by MRD Advisors, Artist Know Your Value: Lawyers Look Beyond the Multiple, MRD’s research revealed that artists may be leaving millions of dollars on the table.

In an interview with independent music catalogue valuation expert Alaister Moughan of Moghan Music, Moughan advised that the use of multiples is outdated, but they are still used because of their simplicity. He advised that the Discounted Cash-Flow {“DCF”) approach is used to value catalogues. As background, the DCF approach is a method of determining the value of a company or asset by estimating the present value of the projected future cash flows to be generated. The DCF formula is generally presented as the following:

Value of Asset =

E(CF1) + E(CF2) + E(CF3) …. + E(CFn)

(1 + r)    (1 + r)2    (1 + r)3       (1 + r)n

E(CF) = estimated free cash flow

r = discount rate

n = period.

One of the critical variables in determining the value of a business or asset is calculating the discount rate. The prevailing discount rate utilized in the music industry was generally unknown to the public. However, Barry Massarsky (“Massarsky”) of Massarsky Consulting shed some light on this measure in an interview with Synchtank in December of 2020.

In the interview, Massarsky advised that the “discount rate is really the internal rate of return.” Concerning the discount rate, he stated the following:

“When we started out eight or nine years ago, up until recent times, the prevailing notion was that the discount rate should be about  10%. . .. We’re now at 9% because the cost of capital is near zero in the US, and we think it’s going to stay there throughout the Biden administration.”

However for a fair market valuation, the weighted average cost of capital (“WACC”) is typically used as the discount rate to value a business or asset. The WACC is typically expressed as the following:

WACC = (We * Ke) + (Wd * Kd * (1-t))

Where

Kd = Cost of debt capital (pre-tax)

Ke = Cost of equity

Wd = % debt of target capital structure

We = % equity of target capital structure

t = Marginal corporate tax rate

Further, fair market value refers to the price at which property would exchange hands between a willing buyer and seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. And one would assume that in the recent catalogue sales that each party would be considered a “willing” participant.

In contrast, investment value is the value to a particular investor based on individual investment requirements and expectations. Investment value may reflect the risk appetite of a particular investor than the market as a whole. Thus, investment value is only concerned about the value to a particular investor, whereas the fair market value is determined by two parties, a hypothetical willing buyer and willing seller.

The internal rate of return (“IRR”) is used as the discount rate to determine the investment value of an asset. Further, investors want the IRR of any internal analysis to be greater than the WACC in order to cover the financing of a potential investment. Additionally, if the IRR is greater than the WACC, this may suggest that the price paid for the business or asset is not consistent with its fair value. In simple terms, the buyer may be buying the asset at a bargain price and not its fair value. Thus, if the IRR is used as the discount rate, then artists may not be receiving the fair value for their catalogues. In contrast, banks, private equity firms, and other investors may be purchasing catalogues at a bargain.

“If the IRR [internal rate of return] is used as the discount rate, then artists may not be receiving the fair value for their catalogues.”

In separate interviews of valuation experts, Aswath Damodaran of NYU and Jack Williams of Georgia State University, both conveyed that the appropriate discount rate for valuations was the WACC. Further, each conveyed that the cost of capital was not near zero. In fact, the variable that may have been near zero was the risk-free rate, which is used to calculate the cost of equity. The cost of equity is generally determined by using the modified capital asset pricing model (“MCAPM”), which is expressed as the following:

K_e = R_f + β(R_m – R_f) + R_s + R_c

K_e = Cost of Equity

R_f = risk-free rate

β = beta/measure of systemic risk

(R_m – R_f) = equity risk premium for the entire market

R_s = risk premium for smaller size

R_c = risk premium for company specific risk.

Thus, based upon the opinions of experts in the field valuation, the cost of capital is not near zero. Furthermore, if the music industry is utilizing the internal rate of return as the discount rate, then artists may not be receiving the fair value for their catalogues.

In addition to his above statement, Professor Damodaran stated that based upon his research, the cost of capital for the entertainment industry should be around 5 to 6%. However, if the risk-free rate was changed to .95 as of the date of Massarsky’s interview, the cost of capital would be 4.84%. Additionally, if we increased the equity risk premium to 7% as used by Professor Williams then the cost of capital would be 6.59%. Regardless, whether the cost of capital is 4.84% or 6.59%, these are lower than the projected cost of capital of 9% that is used in the music industry. And if you refer to Exhibits A, B, and C, one can see the implications of various discount rates, which could be a difference in millions of dollars for an artist.

For an oversimplified hypothetical, we have company XYZ, Inc. with a discount rate of 10% and the following free cash flow projections and terminal value:

Exhibit A: Discount rate – 10%

For company XYZ, Inc., using a discount rate of 10%, produces a total present value of $756.03. However, if the discount rate is calculated to be 8%, the following occurs:

Exhibit B: Discount rate – 8%

With a discount rate of 8%, the total present value is $801.10. If the discount rate is calculated as 5%, the total present value is $876.08 (see below).

Exhibit C: Discount rate – 5%

As evident by the previous calculations, the discount rate plays a critical role in determining the value of an enterprise or asset, which could be a significant difference in millions of dollars. And as discussed above, in order to properly value music catalogues, the WACC should be used because utilizing the IRR as the discount rate could be costing artists millions.

[1] Present Value Investment Factor (“PVIF”) = 1/(1 + r)ⁿ

[2] Present Value (“PV”) = FCF x PVIF

Found this article interesting? Why not check out:

• Barry Massarsky on Data-Driven Catalog Valuations and Drivers of Growth in the Music Investment Market
• For What It’s Worth: Putting a Value on Music Publishing Catalogs
• Merck Mercuriadis on Rewriting the Rules of the Songs Business