5.4 Excess earnings method

The excess earnings method is a powerful tool for valuing businesses, especially those with significant intangible assets. 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

• 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 IRS Revenue Ruling 68-609

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 normalized earnings
• Represents the portion of earnings attributable to intangible assets or goodwill
• Calculated using the formula: $Excess Earnings = Normalized Earnings - (Tangible Assets * Required Rate of Return)$
• 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 capitalization rate 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