Some alternatives to estimate net tangible assets when valuing a business by capitalized excess earnings.
One of the well established business valuation methods, the capitalized excess earnings technique has a long and storied history. The method is described by the United States IRS in its Revenue Ruling 68-609. Unfortunately, the ruling does not specify what it means by the net tangible asset value, a key input into this valuation method.
The business appraisal profession has not formed consensus on the preferred way of estimating the net tangible asset value. Instead, there are several commonly used alternatives:
- Gross business assets net of accumulated depreciation, also known as the net current value.
- Net current value of the financial and tangible assets less current liabilities.
- Net current value of tangible assets minus all liabilities.
Most business appraisers adopt the second definition when valuing a business by the capitalized excess earnings method. This is not to say that the other definitions are less acceptable.
What’s more, the definition you use is not all that important to the results you get with this valuation method. The end result is always the indication of value the business owners hold and as such it should not be affected by the particular definition of the asset value.
How can this be the case? Remember that the capitalized excess earnings method uses two rates of return: the fair rate of return on the net tangible assets and the capitalization rate used in calculating business goodwill. Depending on your choice of measuring the net tangible assets, these two rates of return can vary.
The important part of applying this valuation method correctly is not to dwell excessively on what comprises the asset values. The key is consistency across all choices you make in your calculations.
In other words, the measure of net tangible assets should be consistent with:
- The choice of the fair rate of return.
- The selection of the excess earnings cap rate.
Make sure your choices match, and the method will provide a supportable estimate of business value, including its goodwill.