Raising Entrepreneurial Capital

EXCESS EARNINGS APPROACH

D

EFINED

The excess earnings approach is a method developed by the U.S. Treasury

Department as a tool to value goodwill. Goodwill is the value created by

intangible assets such as brand name or reputat ion. These intangible assets

cause cash flows and earnings to be higher than they otherwise would be and

therefore increase firm value. Since internally developed goodwill, such as

with the Coca Cola or Nike brands, is not reflected in financial statements

prepared according to the generally accepted accounting principles (GAAP),

a method was needed to attach a value to the undeniable benefit of these

intangible assets.

Although originally developed as a tool for the valuation of good will, the

method has been extended to the valuation of the whole company. Total

firm value can be calculated by adding the value of goodwill to the value of

the company’s tangible assets.

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In this method, adjustments are made to both the company’s balance

sheet and its income statement. The company’s assets on the balance sheet

are restated to their fair market values. The income statement is ‘‘normal-

ized’’ to reflect normal, ongoing levels of revenue and expense, while remov-

ing non-recurring items and adjusting above or below market expenses

(wages, for example) to fair market values.

An interest rate reflective of current returns on tangible assets (plant,

equipment, land) is used to determine a fair return on the business’s assets.

This rate is a relatively low rate reflective of the relatively low risk of

investing in tangible assets. The risk is based on the projected change in

the value of the assets, which is usually easier to predict than the expected

level of earnings. The dollar return on tangible assets is calculated by

multiplying the fair market value of the assets by this risk-adjusted rate.

The imputed return is then subtracted from the forecasted normalized

earnings for the next year to calculate ‘‘excess earnings.’’ The idea here is

that the tangib le assets are forecast to return the risk-adjusted rate for

tangible assets. If the business actually produces more than this return,

given its investment in assets, the excess return is due to some intangible

factor left off of the balance sheet. The excess earnings are then capitalized at

a higher rate than the rate on tangible assets to determine the present value

of the company’s goodwill. The sum of the present value of goodwill and the

firm’s tangible assets equals the total firm value.

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It should be noted that the IRS does not condone the use of this method for firm valuation,

even though it is widely done.

164 Valuation—Survey of Methods

The problem in implementation of this method should be apparent. The

excess earnings, cap rate, and DCF methods all require the use of a risk-

adjusted discount rate. The calculation of this rate is difficult and fraught

with the potential for error. The excess earnings method requires the use of

two risk adjusted rates, which doubles the opportunity for error in the

valuation. It is important to remember that discount rates are reflective of

both the risk of the investment and the general level of interest rates at the

time of the valuation and are thus subject to change.

EXAMPLE

The Fairweather Company can be used to demonstrate the excess earn-

ings approach to valuation. The Fairweather Company has the following

book value and market value balance sheet:

Book value Fair market value

Current assets $100,000 $100,000

Plant and equipment 500,000 750,000

Land 200,000 300,000

Total assets $800,000 $1,150,000

If the current market return on tangible assets is estimated to be 10%, a

fair return on Fairweather’s assets would be:

10%  $1, 150, 000 ¼ $115, 000 an nually

If normalized earnings for next year are forecast to be $200,000, excess

earnings can be calculated as forecast earnings—fair return on asset s:

$200, 000

115, 000

Excess earnings $85, 000

Excess earnings would normally be capitalized at a rate 5% to 10%

higher than the rate on tangible assets. Let us assum e the going market

rate for intangibles is 18%. The present value of the excess earnings would

be:

$85, 000=0:18 ¼ $472, 222

The value of the business could then be calculated as the sum of the

present value of excess earnings, the goodwill, and the value of the firm’s

tangible assets:

Valuation—Survey of Methods 165