Struggling to understand how the capitalized excess earnings valuation works? You are not alone. With quite a few ‘moving parts’, this venerable valuation method has tripped even the most experienced business appraisers.
But it does not have to be intimidating. Let’s dissect the enigma by stepping through the calculations step by step.
First, note the method’s name. There is a mention of something called ‘excess earnings’. Whoever in business ever felt any earnings were excessive!
Actually, this name was coined by the US Treasury for economic reasons which have nothing to do with business people enjoying excess cash. Put simply, this is the measure of business earnings over and above a reasonable return on invested capital.
The idea is that investors should expect to receive some reasonable returns given the business risk in order to justify the investment in the company. If the actual business earnings exceed this required amount, the overage is deemed ‘excess earnings’.
What this means is that the company may be producing superior earnings over and above what its investors expect to receive. These additional earnings are the basis of calculating business goodwill.
Enter the second term used in the method’s name: ‘capitalized’. In fact, the excess earnings are capitalized to measure the value of business goodwill.
So the calculation with the capitalized excess earnings valuation method proceeds as follows:
- Determine the total business earnings you will use in your valuation.
- Sum up the values of business tangible assets.
- Next, sum up the values of its current liabilities.
- Calculate the ‘net tangible assets’ by subtracting the sum of current liabilities from the sum of tangible assets.
- Pick a fair rate of return on business net tangible assets.
- Multiply the net tangible assets by this fair rate of return.
- This gives you the measure of return on invested capital.
- Now subtract this return from the total business earnings.
- The result is the excess earnings.
- Capitalize the excess earnings by dividing them by a capitalization rate. This gives you the value of business goodwill.
- Add the business goodwill value to the net tangible assets to calculate the total business value.
While the calculation is straightforward, the result you get may be very revealing. For example, what if your company shows no excess earnings at all? The value of business goodwill will be zero.
What this means is that the company is just able to generate enough returns on invested capital. There is no excess earnings to justify business goodwill, at least not from the economic perspective.
In some cases, your excess earnings can turn out to be negative. The implication is that the company fails to create sufficient earnings to cover the required return the investors expect, given the business risk represented by the fair rate of return. Never mind business goodwill in this case!
Some business appraisers prefer to limit the capitalization rate so as to bound the value of business goodwill to a reasonable number. For example, the appraiser may feel that some key business assets are prone to rapid obsolescence. This could require their early replacement to continue producing high earnings.
Let’s say the appraiser feels that the intellectual property will become obsolete in three years. It may prompt the selection of the excess earnings capitalization rate in the range of 33.3% or thereabouts. The appraiser in fact limits the excess earnings capitalization to no more than three years’ worth.
The capitalized excess earnings method straddles the asset and income approaches. Carefully assessing the values of business tangible assets and current liabilities is essential in order to ensure your valuation results make sense.
Overstate the value of assets and your excess earnings figure may be thrown out the window. Understate the true asset values and your business goodwill goes through the roof. Golden middle, anyone?