If you are valuing an established company, business goodwill may well be a substantial part of the overall business value. One of the central methods to estimate the value of business goodwill is the Capitalized Excess Earnings technique, also known as the Treasury Method.
Business people and financial advisers are sometimes confused by the results they get when estimating the value of business goodwill. Is it possible that goodwill is actually negative? Can business have an unexpectedly high value of business goodwill compared to its industry peers?
A closer look at the Capitalized Excess Earnings valuation method
To address these questions, take a closer look at how the Treasury Method works:
First, the method requires that you specify the current business earnings, usually as some measure of its cash flow. In addition, you need to provide the values of business assets and its current liabilities. Finally, you need to specify the fair rate of return on these business assets as well as the estimate of the earnings growth rate going forward.
The Treasury Method first calculates the so-called capital charge – the portion of the earnings that indicates the return on the business tangible assets. The capital charge is subtracted from your earnings input and what is left is called excess earnings.
It is the capitalized value of the business excess earnings that defines the amount of business goodwill being present.
Some business valuation results may be unexpected
Note that if the business asset base is unusually high, the capital charge may well equal or even exceed the current business earnings. As a result, there are no excess earnings and hence, no business goodwill – at least not in the economic sense.
Conversely, the fair rate of return, representing your business risk, may be high. Here again, the capital charge can quite large even for reasonable values of business assets. The result may well be business goodwill that is lower than you expected.
Ways to handle unusual values of business goodwill
If you run into these situations, here are some ideas to consider:
Carefully examine the values of business assets you include in your calculations. Are all these assets used to produce the business earnings? Uncommitted or overvalued business assets are one reason the Treasury Method may underestimate your business goodwill.
Take a closer look at the fair rate of return on these assets. Ensure that it truly represents the risk associated with the business operations that use the assets to produce the earnings.