Excess Earning Approach

Another earnings-based method is excess earnings. This method discounts company earnings based on two capitalization rates: a rate of return on tangible assets and a rate attributable to company goodwill. The method is often described as a hybrid method because it takes into account the company’s asset values as well as discounts expected cash flows.

The following equation represents the valuation based upon the two rates of return:

V = Ea / R a + Eg / Cg

Where,

V = The value of the business

E a = The earnings attributable to a return on assets

Ra = The appropriate rate of capitalization for earnings attributable to net tangible assets

E g = The earnings in excess of those attributable to a return on assets

Cg = The appropriate rate of capitalization for earnings attributable to goodwill In its most common form,

The value is calculated as follows:

V = E A*Ra / Cg + A

Where:

V = The value of the small business

E = The adjusted earnings of the firm

A = The net tangible assets of the firm

Ra = The appropriate rate of capitalization for earnings attributable to net tangible assets

Cg = The appropriate rate of capitalization of Goodwill

The excess earnings method was developed by the U.S. Treasury Department in 1920 to estimate lost goodwill suffered by breweries and distilleries as a result of Prohibition. The method was never intended to be a business valuation tool, but it became popular because of its simplicity.

Appraisers using the excess earnings method follow these basic steps:

• Estimate the value of the company’s net tangible assets.
• Multiply that value by a fair rate of return to calculate earnings attributable to the company’s tangible assets.
• Estimate the company’s total normalized earnings.
• Subtract earnings on tangible assets from total earnings to arrive at excess earnings that is, earnings above a fair return on the company’s net tangible asset value.
• Divide excess earnings by an appropriate capitalization rate to calculate the value of goodwill and other intangible assets.
• Combine the tangible and intangible asset values to determine the company’s overall value.

A typical procedure to establish the business value with the method is:

• Start with the business net tangible assets, obtained from its recast financial statements by subtracting adjusted liabilities from the tangible assets.
• Estimate the business earnings attributable to the net tangible assets. This is done by multiplying the net tangible assets by a reasonable rate of return, expressed as a percentage.
• Determine the excess earnings as the difference between the total business earnings and those attributable to the net tangible assets. These excess earnings reflect the business goodwill.
• Capitalize the excess earnings by dividing their value by an appropriate capitalization rate.
• Add the capitalized excess earnings value to the value of the business net tangible assets, to establish the overall business value.