I want to address the use of the Excess Earnings method when performing a business valuation. This methods originated in Revenue Ruling 68-609. A number of treatises have developed and should be followed by business valuation experts.
Application of the Excess Earnings Methodology
The excess earnings methodology for performing a business valuation is based on both an income and asset approach. The premise is that the value of the business is the total of the tangible and intangible assets of the business,
The process of valuing a company using the excess earnings uses the historical weighted or unweighted normalized earnings. The business valuation expert should consider using at least one business cycle of the information that is available, five to seven years. The weighted unweighted average of the assets, excluding intangible assets needs to be determined.
The weighted or unweighted average of the net assets, before intangible assets is sometimes not calculated correctly. Sometimes, the final year net assets are used instead of the weighted or unweighted average of the assets. This approach is not a generally accepted appraisal practice for business valuations related to closely held companies.
Not using a weighted or unweighted tangible assets but a final year net asset base, the misapplication will produce an incorrect value and it is not a generally accepted appraisal practice.
Reasonable Rate of Return
A reasonable rate of return on the assets need to be determined to understand the earnings on the tangible assets.
In the business valuation process a capitalization rate will need to be determined. The majority of the information needed comes from published data. However a company specific risk will need to be determined to complete the capitalization rate.
There are several methods of calculating a company specific risk. There is no generally accepted methodology of estimating accompany specific risk. What I typically see is a number being presented with no rhyme or reason for the result. I do feel that the number should be supported with reasonable support and included in the business valuation report.
Determination of Net Tangible Assets at Fair Market Value
The Fair Market Value is calculated as usual using the Adjusted Net Asset Method. The intangible assets are not included in this calculation.
Mathematics to Determine the Excess Earnings
The math to calculate excess earnings is presented below.
Not using a weighted or weighted average asset or earnings base can have a dramatic impact on the business valuation. In the table below is an example of having assets and earnings being under and overstated.
This is more difficult for the attorney to recognize as the calculations may not be included in the report and therefore are over looked.
Although the excess earnings method is relatively simple, it is not reliable. Revenue Ruling 68-609 states that the method “should not be used if there is better evidence available from which the value of intangibles can be determined”.
Why is the excess earnings still being used? I believe that is has been around for a very longtime and attorneys and Judges are familiar with it. However, there are better ways to determine the intangible asset values.
The issues discussed above should provide ample information for the attorney to use in a deposition or trial to discredit a business valuation expert if they have used excess earnings for determining the value of a business.
I welcome and encourage comments and feedback. If you are benefiting from this series, please recommend to your friends and colleagues and suggest that they sign up to receive posts regularly.