Tangible assets at fair value, a fair return on each, and the excess capitalised as goodwill, then the cross-check that tells you whether the rate on the excess holds.
The excess earnings method values the tangible assets at fair value, charges them a fair return, and capitalises whatever earnings are left as goodwill. On an illustrative company with 900,000 of normalised earnings and 2,400,000 of net tangible assets earning 8.67 per cent, the excess is 692,000; capitalised at 22 per cent it gives goodwill of 3,145,455 and a business value of 5,545,455. The figure that decides the answer is the capitalisation rate on the excess, so it has to be reconciled to a direct capitalisation of the whole business before it is used.
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The method goes back to the US Treasury's formula approach, restated in Revenue Ruling 68-609, which is why it is also called the treasury method or the formula method. It survives in small-business and professional-practice valuation because it answers a question buyers and courts both ask: how much of this price is equipment and working capital, and how much is the reputation, the customer list and the people. It is a different tool from the multi-period excess earnings method used to value one intangible in a purchase price allocation, although the logic of charging the other assets a return is the same.
| Input | Value |
|---|---|
| Normalised earnings, next year: after a market salary for the owner, after tax, debt-free | 900,000 |
| Net working capital at fair value | 800,000 |
| Required return on working capital | 6.0% |
| Fixed assets at fair value (book value 1,100,000) | 1,600,000 |
| Required return on fixed assets | 10.0% |
| Capitalisation rate on excess earnings | 22.0% |
| Business discount rate and long-term growth, for the cross-check | 18.0%; 3.0% |
The earnings must be on the same basis as every rate applied to them. Here everything is after tax and before interest, so the result is the value of the whole business, debt-free. Working capital earns a lower rate than equipment because it is the asset a lender will finance most readily; the intangibles earn the highest rate because nobody will lend against them.
1. Net tangible assets = 800,000 + 1,600,000 = 2,400,000
2. Return on tangibles = 800,000 × 6.0% + 1,600,000 × 10.0% = 48,000 + 160,000 = 208,000, a blended 8.67 per cent
3. Excess earnings = 900,000 − 208,000 = 692,000
4. Goodwill = 692,000 ÷ 22.0% = 3,145,455
5. Business value = 2,400,000 + 3,145,455 = 5,545,455
Excel: =NTA+(Earnings-SUMPRODUCT(Assets,Rates))/CapRate
The value is 6.16 times normalised earnings, and goodwill is 56.7 per cent of it. The implied overall rate of return on the business is 900,000 over 5,545,455, or 16.23 per cent, which sits between the 8.67 per cent on the tangibles and the 22 per cent on the intangibles, as it must.
The method has a weakness its critics point to: the 22 per cent is chosen, and the answer is far more sensitive to it than to anything else. The defence is to reconcile it to a direct capitalisation of the same earnings, done the way set out in the capitalization of earnings method:
Direct capitalisation = 900,000 ÷ (18.0% − 3.0%) = 900,000 ÷ 15.0% = 6,000,000
Intangible rate that reconciles = 692,000 ÷ (6,000,000 − 2,400,000) = 19.22%
The two methods are 454,545 apart, 8.2 per cent of the excess earnings value. Either the 22 per cent on goodwill is too high, or the 15 per cent capitalisation rate for the whole business is too low. A reviewer will ask which, and "the build-up said so" is not an answer to both at once. The discipline is to pick the business rate first, from the build-up or the market, and then to check that the rate on the intangibles implied by it is plausibly above every other rate in the table. At 19.22 per cent it is, above even the 18.0 per cent business discount rate, so the direct capitalisation is the more defensible of the two here.
| Cap rate on excess | Goodwill | Business value | Times earnings |
|---|---|---|---|
| 18% | 3,844,444 | 6,244,444 | 6.94x |
| 20% | 3,460,000 | 5,860,000 | 6.51x |
| 22% | 3,145,455 | 5,545,455 | 6.16x |
| 25% | 2,768,000 | 5,168,000 | 5.74x |
| 28% | 2,471,429 | 4,871,429 | 5.41x |
Ten points on the intangible rate move the value by 1,373,016, a quarter of it. By comparison, 100,000 more of normalised earnings adds 454,545 at 22 per cent: earnings of 800,000 give 5,090,909, earnings of 1,000,000 give 6,000,000. The normalisation of the owner's salary and of one-off costs usually matters as much as the rate, which is why the earnings line deserves the same evidence file as the rate.
Three methods applied to one company, and the arithmetic of the gap between them, are set out in the free workbook for this case, with every figure traced to a live formula.
A rate above every other rate in the business, because goodwill cannot be borrowed against and is the first value lost if the business struggles. It should be checked against a direct capitalisation of all earnings. On an illustrative 900,000 of earnings, 2,400,000 of tangibles and a 15 per cent business cap rate, the consistent rate on the 692,000 excess is 19.22 per cent, not the 22 per cent chosen first.
Revenue Ruling 68-609 describes it, but says it should be used only when no better basis is available, and courts have criticised mechanical use of it. In practice it is used as a cross-check and to split value between tangible assets and goodwill. On illustrative figures, it puts 3,145,455 of a 5,545,455 value, 56.7 per cent, in goodwill.
The return charged to the tangibles is based on what they are worth today. Carrying 1,600,000 of equipment at a 1,100,000 book value lowers the required return by 50,000 and raises goodwill, but the net effect understates value: here 5,272,727 instead of 5,545,455, a 272,727 error.
This article is one calculation from Business Valuation. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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