If you need to determine the value of goodwill of a business or professional practice, the capitalized excess earnings method is an excellent tool. This asset-based valuation method, known as the Treasury method, is especially well suited for goodwill estimation for all types of privately owned companies.
Treasury method uses two rates of return
One important element of this technique is the use of two rates of return in the calculations. One is the so-called fair return on net tangible assets. The other is the capitalization rate used to calculate the value of goodwill from the business excess earnings.
Improper selection of these two rates is perhaps the most common source of errors in business valuation using this method. So it behooves you to choose these values with care.
Choosing the rates of return for your business valuation
Since the excess earnings method looks at the sum total of tangible business assets, it makes sense to use the firm’s discount rate as the fair rate of return.
The idea is that the business owners, acting as investors in their own company, expect the return on the committed capital to be commensurable with the overall business risk. That is exactly what the company’s discount rate captures.
The discount and capitalization rates are related. In fact the cap rate is just the difference between the discount rate and the firm’s expected long-term earnings growth rate.
This being the case, it is reasonable again to use the overall business capitalization rate when calculating the value of your firm’s business goodwill. The Treasury method accomplishes this by capitalizing the excess earnings.
Business goodwill needs to be a finite number
One final note on your business goodwill result. It is common practice to assume that the excess earnings can be capitalized over a finite number of years. So the cap rate should be limited to a number that does not drop below a certain threshold. The typical limits are 3 to 10 years. For example, setting the 10 year limit will give you the cap rate of 10% or greater.