Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 36

How Cost of Capital Relates to the Excess Earnings Method of Valuation

Introduction

Basic “Excess Earnings” Valuation Method

Conceptual Basis for the Method

Steps in Applying the Excess Earnings Method

Example of the Excess Earnings Method

Cost of Capital Reasonableness Check

Estimating a Build-up Method Capitalization Rate

Computing the Weighted Average Excess Earnings Capitalization Rate

Discussion of the Example

Vagaries of the Excess Earnings Method

Summary

INTRODUCTION

The excess earnings method of valuation was originally created for the purpose of valuing intangible assets, specifically intangible value in the nature of goodwill. It was devised to determine how much the U.S. government would compensate brewers and distillers for the economic loss of their goodwill as a result of Prohibition. This valuation method has since been embodied in Revenue Ruling 68-609, included as Exhibit 36.1. Although it was originally designed to value only intangible assets, it is widely used (and misused) today in the valuation of small businesses and professional practices, especially in family law matters.

This chapter has a single point: An estimate of the cost of capital, developed by methods discussed in this book, can be used as a test of the reasonableness of the assumptions and results achieved by using the excess earnings method. This test can be applied either by a person preparing an excess earnings method valuation or by someone reviewing an excess earnings method ...