5.4 Excess earnings method
7 min read•august 21, 2024
The is a powerful tool for valuing businesses, especially those with significant . It combines elements of asset-based and income-based approaches to provide a comprehensive assessment of a company's worth.
This method separates earnings from tangible and intangible assets, offering insights into the sources of a business's value. It's particularly useful for small to medium-sized companies and professional practices where market data may be limited.
Definition of excess earnings
- Excess earnings method determines a company's value by separating earnings attributable to tangible assets from those attributable to intangible assets
- Plays a crucial role in business valuation by quantifying the value of both tangible and intangible assets, providing a comprehensive assessment of a company's worth
Historical context
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- Originated in the 1920s as a way to value businesses during Prohibition era
- Developed by the U.S. Treasury Department to compensate distilleries and breweries for lost goodwill due to alcohol prohibition
- Gained wider acceptance in the 1960s with the publication of
Purpose and application
- Aims to determine the value of a business by identifying earnings above the expected return on tangible assets
- Used primarily for valuing small to medium-sized businesses and professional practices
- Helps in situations where comparable market data is limited or unreliable
- Particularly useful for businesses with significant intangible assets (goodwill, patents, trademarks)
Components of excess earnings
- Excess earnings method combines elements of both asset-based and income-based valuation approaches
- Provides a framework for separating the value of tangible and intangible assets in business valuation
Normalized earnings
- Adjusted financial performance to reflect typical, sustainable business operations
- Removes non-recurring, extraordinary, or owner-specific items from reported earnings
- Considers historical trends and future projections to establish a representative earnings figure
- May include adjustments for owner compensation, non-operating expenses, and non-arm's length transactions
Required rate of return
- Represents the expected return on the company's tangible assets
- Typically based on industry standards, company risk profile, and current market conditions
- Often calculated using methods such as the Capital Asset Pricing Model (CAPM) or the Build-Up Method
- Varies depending on the nature of the business and the specific tangible assets involved
Excess earnings calculation
- Determined by subtracting the required return on tangible assets from
- Represents the portion of earnings attributable to intangible assets or goodwill
- Calculated using the formula:
- Provides the basis for valuing the intangible assets of the business
Valuation process steps
- Excess earnings method follows a structured approach to determine business value
- Combines analysis of financial statements, market data, and company-specific factors
Determining normalized earnings
- Review historical financial statements to identify trends and anomalies
- Adjust for non-recurring items, owner-specific expenses, and non-operating income/expenses
- Consider industry benchmarks and company-specific factors to establish sustainable earnings
- May involve multi-year averaging or weighted averaging of adjusted historical earnings
Estimating required return
- Assess the company's tangible asset base, including working capital, fixed assets, and other physical assets
- Determine appropriate required rates of return for different asset categories
- Consider industry norms, risk factors, and current market conditions
- Calculate the overall required return on tangible assets based on the weighted average of individual asset returns
Calculating excess earnings
- Subtract the required return on tangible assets from normalized earnings
- Ensure consistency in the time periods used for normalized earnings and required return calculations
- Verify that the resulting excess earnings figure aligns with industry expectations and company performance
Capitalizing excess earnings
- Determine an appropriate based on the company's risk profile and growth prospects
- Divide excess earnings by the capitalization rate to estimate the value of intangible assets
- Add the value of tangible assets to the capitalized excess earnings to arrive at the total business value
- Consider applying discounts or premiums for factors such as lack of marketability or control
Advantages of excess earnings method
- Provides a comprehensive valuation approach that considers both tangible and intangible assets
- Particularly useful for businesses where market comparables are limited or unreliable
Consideration of tangible assets
- Incorporates the value of physical assets and working capital into the overall business valuation
- Allows for differentiation between returns generated by tangible assets and those from intangible assets
- Provides a more accurate valuation for asset-heavy businesses or those with significant investments in equipment or inventory
Intangible asset valuation
- Quantifies the value of goodwill, brand recognition, customer relationships, and other intangible assets
- Particularly useful for service-based businesses or companies with strong intellectual property
- Helps identify and value key drivers of business success that may not be reflected in tangible assets alone
- Provides insights into the sustainability and transferability of a company's competitive advantages
Limitations and criticisms
- Excess earnings method, while widely used, has several limitations that can affect its accuracy and reliability
- Understanding these limitations is crucial for proper application and interpretation of valuation results
Subjectivity in calculations
- Relies heavily on assumptions and judgments in determining normalized earnings and required returns
- Different valuators may arrive at significantly different results using the same underlying data
- Requires careful documentation and justification of assumptions to support valuation conclusions
- May be challenged in legal or regulatory settings due to the subjective nature of key inputs
Potential for double-counting
- Risk of overvaluing intangible assets if not carefully applied
- May inadvertently include value of intangibles in both tangible asset base and excess earnings
- Requires clear delineation between returns attributable to tangible and intangible assets
- Can lead to inflated valuations if not properly adjusted for overlapping asset contributions
Excess earnings vs other methods
- Comparing excess earnings method to other valuation approaches helps understand its strengths and weaknesses
- Choosing the appropriate valuation method depends on the specific circumstances of each business
Excess earnings vs DCF
- Discounted Cash Flow (DCF) focuses on future cash flows, while excess earnings considers current earnings
- DCF may be more suitable for high-growth companies or those with predictable future cash flows
- Excess earnings better captures value of existing assets and current operational efficiency
- DCF typically requires more detailed financial projections compared to excess earnings method
Excess earnings vs market approach
- Market approach relies on comparable company data, while excess earnings is more company-specific
- Excess earnings can be useful when reliable market comparables are not available
- Market approach may provide more objective valuation based on actual transaction data
- Excess earnings offers more insight into the sources of value within the specific business being valued
Industry-specific considerations
- Application of excess earnings method varies across different industries due to unique characteristics
- Understanding industry-specific factors is crucial for accurate valuation and interpretation of results
Service-based businesses
- Often have higher proportion of intangible assets (client relationships, reputation, expertise)
- May require careful consideration of key person dependency and transferability of goodwill
- Normalized earnings adjustments often focus on owner compensation and discretionary expenses
- Required return on tangible assets may be lower due to typically lower investment in physical assets
Manufacturing companies
- Generally have higher investment in tangible assets (equipment, inventory, facilities)
- May require more detailed analysis of required returns for different asset categories
- Normalized earnings adjustments often include considerations for inventory valuation and depreciation
- Excess earnings may represent a smaller portion of total value compared to service-based businesses
Regulatory and legal aspects
- Excess earnings method has been recognized and used in various regulatory and legal contexts
- Understanding its legal standing and regulatory guidance is important for proper application
IRS Revenue Ruling 68-609
- Provided official recognition and guidance for the excess earnings method
- Outlined specific steps and considerations for applying the method in tax-related valuations
- Established the concept of "formula method" for valuing intangible assets
- Continues to influence the application of excess earnings method in various valuation contexts
Court acceptance and precedents
- Excess earnings method has been accepted in various legal proceedings, including divorce cases and shareholder disputes
- Courts have established precedents regarding the application and limitations of the method
- Legal decisions have addressed issues such as appropriate capitalization rates and normalization adjustments
- Understanding relevant case law is crucial when using excess earnings method in litigation-related valuations
Common pitfalls and errors
- Awareness of potential mistakes in applying excess earnings method helps ensure more accurate valuations
- Avoiding these pitfalls requires careful analysis and adherence to best practices in business valuation
Misestimating required return
- Using inappropriate benchmarks or failing to consider company-specific risk factors
- Applying the same required return to all tangible assets without differentiation
- Neglecting to adjust required returns for changes in market conditions or company circumstances
- Failing to consider the impact of leverage on required returns for different asset categories
Incorrect normalization adjustments
- Overlooking or improperly adjusting for non-recurring or extraordinary items
- Failing to consider industry-specific factors in determining normal operating expenses
- Inconsistent treatment of owner compensation across different periods or comparable companies
- Neglecting to adjust for changes in accounting policies or reporting standards
Practical application examples
- Real-world examples illustrate how excess earnings method is applied in different business contexts
- Understanding these applications helps in adapting the method to specific valuation scenarios
Small business valuation
- Local retail store valued using excess earnings to account for both inventory and customer goodwill
- Normalized earnings adjusted for owner's above-market salary and non-operating real estate expenses
- Required return calculated separately for working capital, inventory, and fixed assets
- Resulting valuation provided basis for negotiation in a potential sale of the business
Professional practice valuation
- Medical practice valued using excess earnings to capture both tangible assets and professional goodwill
- Normalized earnings considered typical physician compensation and industry-standard operating expenses
- Required return on tangible assets relatively low due to limited physical asset investment
- Capitalized excess earnings represented significant portion of total value, reflecting importance of intangible assets in professional services
Key Terms to Review (20)
Adjusted EBITDA: Adjusted EBITDA refers to earnings before interest, taxes, depreciation, and amortization, modified to exclude one-time or non-recurring expenses that are not expected to occur regularly. This metric provides a clearer picture of a company's operating performance by removing anomalies that can distort the underlying earnings power. Adjusted EBITDA is particularly useful in business valuation as it allows for more accurate comparisons and assessments, especially in methods that rely on consistent earnings figures.
American Society of Appraisers: The American Society of Appraisers (ASA) is a professional organization that represents appraisers in various fields including business valuation, real estate, and personal property. The ASA plays a crucial role in setting standards for appraisal practice, promoting ethical behavior, and enhancing the competency of appraisers through education and certification.
Beta coefficient: The beta coefficient is a measure of a stock's volatility in relation to the overall market. It indicates how much a stock's price is expected to change for a given change in the market index, typically the S&P 500. A beta greater than 1 signifies higher volatility than the market, while a beta less than 1 indicates lower volatility. Understanding beta is crucial in evaluating risk and return in investment decisions, as it plays a key role in determining intrinsic value and assessing company performance in methods like the excess earnings approach.
Business sales: Business sales refer to the transactions involved in selling a company or its assets, encompassing everything from negotiations to final agreements. These sales are often driven by various motivations such as strategic growth, financial restructuring, or exit strategies for business owners. Understanding business sales is crucial for valuing companies accurately, as they provide insights into market trends and potential earnings that can influence valuation methodologies like the excess earnings method.
Capitalization rate: The capitalization rate, often referred to as the cap rate, is a financial metric used to evaluate the profitability and potential return on investment of an income-generating property. It is calculated by dividing the net operating income (NOI) by the property's current market value or acquisition cost. This rate helps in comparing investment opportunities and assessing risk across different properties, making it vital in various valuation methods and standards.
Control Premium: A control premium is the additional amount that a buyer is willing to pay for a controlling interest in a company, reflecting the value of having the ability to influence management and strategic decisions. This concept is essential in business valuation as it highlights the differences between minority and controlling ownership interests, often impacting how valuations are approached and understood.
Discounted Cash Flow Method: The discounted cash flow (DCF) method is a valuation technique used to estimate the value of an investment based on its expected future cash flows, which are adjusted for the time value of money. This method calculates the present value of projected cash flows by discounting them back to their value today using a specific discount rate. Understanding the time value of money is crucial as it highlights how cash flows are worth more now than they will be in the future, and this principle is vital when applying the DCF method to determine the fair market value of a business or asset.
Excess earnings calculation: The excess earnings calculation is a valuation method used to determine the intangible value of a business by evaluating the income generated above the normal return on tangible assets. This approach estimates the additional earnings attributable to intangible assets, such as goodwill, by subtracting a fair return on tangible assets from the total earnings of the business. This method is particularly useful for valuing businesses with significant intangible elements that are not reflected in their physical assets.
Excess Earnings Method: The excess earnings method is a valuation technique used to determine the value of a business or an intangible asset by calculating the earnings that exceed a normal return on tangible assets. This approach is particularly useful in the context of valuing businesses with significant intangible assets, like intellectual property or brand reputation, and helps in understanding the contribution of these intangibles to overall business value.
Ibrahim a. alhassan: Ibrahim A. Alhassan is a notable figure in the field of business valuation, recognized for his contributions to valuation methodologies, particularly in the context of the excess earnings method. His work emphasizes the importance of understanding intangible assets and how they contribute to the overall value of a business. By examining how earnings can be allocated between tangible and intangible assets, Alhassan’s insights provide clarity on calculating excess earnings, which is critical for accurate business valuation.
Intangible Assets: Intangible assets are non-physical resources that provide value to a business, such as patents, trademarks, copyrights, and goodwill. These assets play a crucial role in determining a company's overall worth and are often critical for competitive advantage in various industries.
IRS Revenue Ruling 68-609: IRS Revenue Ruling 68-609 is a guideline established by the Internal Revenue Service that outlines the method for determining the fair market value of a business using the excess earnings method. This ruling is significant because it provides a systematic approach to valuation, particularly for businesses that have intangible assets, by segregating earnings attributable to tangible assets and those attributable to intangible assets. It helps in understanding how to derive value from both operational and intangible factors in business valuations.
Marketability Discount: A marketability discount is a reduction in the value of an asset, typically a business or equity interest, that reflects the lack of marketability or liquidity associated with it. This discount is essential in valuation as it accounts for the challenges faced by investors in selling an ownership stake quickly and at full value. Understanding this discount is crucial for assessing various levels of value, making financial statement adjustments, applying valuation methods, and addressing issues like minority interests or bankruptcy scenarios.
Mergers and Acquisitions: Mergers and acquisitions refer to the processes where companies consolidate through various types of financial transactions. A merger involves two companies joining to form a new entity, while an acquisition occurs when one company purchases another. Understanding the intrinsic value of a company is crucial in these processes, as it helps determine fair pricing and negotiation strategies.
Net Income: Net income is the total profit of a company after all expenses, taxes, and costs have been subtracted from total revenue. It serves as a crucial indicator of a company's profitability and financial health, reflecting its ability to generate earnings for shareholders. This metric plays a key role in assessing performance in areas like free cash flow to equity, enterprise value multiples, excess earnings method, and adjustments like key person discounts, along with offering insights into the income statement analysis.
Normal earnings: Normal earnings refer to the sustainable level of profitability that a business can expect to achieve under typical operating conditions. This concept is crucial in evaluating a company's financial performance and is often used in business valuation methodologies to determine a fair market value for the enterprise. Normal earnings are usually calculated by adjusting reported earnings to remove any irregularities or one-time events that could distort the financial picture.
Normalized earnings: Normalized earnings refer to the adjusted net income of a company that removes any irregular, one-time, or non-recurring items to present a clearer picture of its true operating performance. This concept is crucial for valuing a business, especially when using valuation methods that require a consistent measure of earnings, such as the excess earnings method. By normalizing earnings, analysts can assess the company's sustainable profit potential and better compare it with peers in the industry.
Required Rate of Return: The required rate of return is the minimum return an investor expects to earn on an investment, considering the risk associated with that investment. This rate serves as a benchmark for evaluating potential investments and is influenced by factors such as market conditions, inflation, and the perceived risk of the asset. It's crucial for determining the value of cash flows and dividend payments, as well as assessing whether a business or investment opportunity meets the investor's performance expectations.
Return on Investment: Return on Investment (ROI) is a financial metric used to evaluate the profitability of an investment by measuring the return relative to its cost. It provides a way to assess the efficiency of an investment, allowing for comparisons between different opportunities. A higher ROI indicates a more profitable investment, which connects to understanding intrinsic value, determining replacement costs, and estimating excess earnings in business valuation.
Risk-adjusted discount rate: The risk-adjusted discount rate is the interest rate used to determine the present value of future cash flows, accounting for the risk associated with those cash flows. This rate helps investors assess the attractiveness of an investment by considering both the time value of money and the inherent risks of the cash flows, such as market volatility and project uncertainties. By adjusting the discount rate for risk, it allows for a more accurate valuation of assets and helps in making informed investment decisions.