ValuAdder Business Valuation Blog

Using the Capitalized Excess Earnings method in your business valuation? Then you might run into a scenario where your analysis produces negative goodwill. Good news: it usually points to issues with the input assumptions rather than the true economic value of the business. Follow these steps to identify and correct the problem:

Check earnings adjustments

First, review the earnings:

  • Normalize business income by removing extraordinary or one-time expenses and revenues.
  • Look for distortions from temporary factors such as unusually high capital expenditures or a surge in working capital investment.

Review net tangible asset values

  • Ensure asset values reflect realistic, fair market estimates.
  • Avoid overstating tangible assets, which can reduce or eliminate excess earnings.

Confirm the fair rate of return

  • Revisit the rate you applied to tangible assets. Remember that higher returns reduce excess earnings and can distort goodwill.
  • Make sure the return is consistent with what investors typically expect in the market for similar assets and risk levels.

Recalculate with adjusted inputs

Once earnings and asset values are normalized, rerun the analysis. Be sure to check whether excess earnings and resulting goodwill align more closely with your expectations.

Seek guidance if needed

If results still appear inconsistent after adjustments, consider reaching out for support. We can offer guidance on input selection and normalization to help you resolve distortions.

Example: Unusual Capital Expenditure Distorting Earnings

Suppose a company has normalized annual earnings of $500,000, the net tangible asset base of $1,500,000 and the fair rate of return on these assets of 25%. However, in the most recent year, it invested $150,000 in additional working capital for a one-time expansion. If this expense is left unadjusted, the net cash flow drops to $350,000.

With $350,000 as the income basis, the method produces no excess earnings and shows negative goodwill of ($100,000).

After adjusting for the unusual working capital outlay, the net cash flow figure returns to $500,000, reflecting the company’s true earning capacity.

Rerunning the analysis at this corrected level, excess earnings appear positive, and goodwill is calculated as a positive value as expected:

  • Excess earnings = $125,000
  • Goodwill = $500,000

This example shows how failing to normalize for unusual expenditures can lead to a misleading negative goodwill result.

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