Now you must think someone is joking, right? Surely, there is no such thing in business as excess earnings. As the saying goes, the more the better. Don’t get confused though – in business valuation, as in many financial analysis areas, technical definitions make all the difference.
Excess earnings – more than a pretty name
No, the business you are valuing does not have extra earnings it could spare. The excess earnings though, may well be within its many positive attributes. This technical term arises in the context of valuing business by the so-called Treasury Method, otherwise known as the capitalized excess earnings.
Say thank you to US Treasury for excess earnings
This method has been used for decades in valuing private companies and was first described in the US Treasury memorandum No 34. The original idea was to value going concern companies that were more valuable than merely the assemblage of assets they had at their disposal.
Business owners felt their companies were worth keeping alive when they produced superior returns. On the other hand, a smart business investor would likely consider unloading business assets if the company starts to look like a drain on resources. Makes common sense, to be sure.
Excess earnings = total earnings – return on capital asset investment
So what’s in the name? To find out, you would need to study the details of the Treasury valuation method. At the outset, you make a reasonable assumption that a business that commits a certain amount of capital must generate the returns sufficient to cover the costs of the assets in play. So if you examine the returns from operations, you could deduct the amount equal to the so-called capital charge. At a minimum, the business owners must justify sinking the capital into the company by making sure they get sufficient returns. Otherwise, they should consider investing their money elsewhere.
So far, so good. But the top performing company should do one better. To reward the owners for an investment well made, such businesses generate returns in excess of merely covering the costs of invested capital. In the economic parlance, there are earnings over and above the required return on committed capital. Enter the excess earnings. That is the difference between the actual business earnings and the costs of the capital investment in its assets.
What is more, the excess earnings can be used to calculate the value of business goodwill. That sometimes elusive intangible business asset that points to a well run company putting a nice income into the pockets of beaming business owners. A wish come true.
Got business goodwill? Excess earnings tell all
Indeed, estimation of business goodwill is one of the biggest advantages of the capitalized excess earnings valuation method. The idea is that business goodwill captures the synergies available in a well run company. You can’t ascribe the superior returns to any particular business asset, it is the coordination of all of the them in a successful company that makes it possible to enjoy all that extra income.
Capitalization of the excess earnings is the standard technique to quantify this happy outcome. The typical way is to use the constant growth capitalization calculation to estimate business goodwill. The sum of the values of business assets and goodwill gives you the total business value.
See, it was worth getting to the bottom of the excess earnings name. There are many situations when you need to justify the value of business goodwill, and the Treasury method is an excellent way to do it.