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Capitalizing Excess Earnings

19 January, 2016 - 14:33

A widely used variation of the capitalized earnings method is called the capitalization of excess earnings. This hybrid method reflects the concept that earnings are derived from both the tangible assets and intangible assets of the business. Earnings from tangible assets are assumed to be relatively constant from one firm in an industry to another, whereas earnings from intangible assets may vary widely. The method proceeds as follows:

  • Estimate the value of net tangible assets
  • Estimate the earnings attributable to the tangible assets, perhaps by multiplying the value of the tangible assets by the average industry return
  • Subtract this amount from total reported earnings; the difference is excess earnings, the amount above what is explained by the company’s tangible assets
  • Capitalize the excess earnings.

The value placed on the business has two components:

Business value = Net tangible assets + Capitalized value of excess earnings

Because we tend to consider earnings attributable to intangibles to be more risky than earnings attributable to tangible assets, we tend to use high capitalization rates (low multiples).

When we calculate negative excess earnings, the business is still presumed to be worth the value of its net tangible assets and we make no reduction for apparent negative intangibles.

For example, suppose a company reports earnings of $50,000 and net tangible assets of $350,000. Average industry earnings are 10% of net tangible assets, and we decide to capitalize excess earnings at 25%. The value estimate for the business is $410,000, as shown in Table 11.3.

The excess earnings method, like much of business valuation, has its foundation in materials promulgated by the Internal Revenue Service. Revenue Ruling 68–609 sets forth a so-called formula method, as follows:

The question presented is whether the “formula” approach, the capitalization of earnings in excess of a fair rate of return on net tangible assets, may be used to determine the fair market value of the intangible assets of a business. The “formula” approach may be stated as follows:

A percentage return on the average annual value of the tangible assets used in a business is determined, using a period of years (preferably not less than five) immediately prior to the valuation date. The amount of the percentage return on tangible assets, thus determined, is deducted from the average earnings of the business for such period and the remainder, if any, is considered to be the amount of the average annual earnings from the intangible assets of the business for the period. This amount (considered as the average annual earnings from intangibles), capitalized at a percentage of, say 15 to 20 percent, is the value of the intangible assets determined under the “formula” approach.

The percentage of return on the average annual value of the tangible assets used should be the percentage prevailing in the industry involved at the date of valuation, or (when the industry percentage is not available) a percentage of 8 to 10 percent may be used.

The 8 percent rate of return and the 15 percent rate of capitalization are applied to tangibles and intangibles, respectively, of businesses with a small risk factor and stable and regular earnings; the 10 percent rate of return and 20 percent rate of capitalization are applied to businesses in which the hazards of business are relatively high.

The above rates are used as examples and are not appropriate in all cases.…

The past earnings to which the formula is applied should fairly reflect the probable future earnings. Ordinarily, the period should not be less than five years, and abnormal years, whether above or below the average, should be eliminated. If the business is a sole proprietorship or partnership, there should be deducted from the earnings of the business a reasonable amount for services performed by the owner or partners engaged in the business.…

The “formula” approach should not be used if there is better evidence available from which the value of intangibles can be determined.…

Table 11.3 Capitalization of Excess Earnings ($)

Value of net tangible assets

 

350,000

Reported earnings of the company

50,000

 

Earnings attributed to tangible assets = $350,000 × 0.10

35,000

 

Excess earnings

15,000

 

Capitalized value of excess earnings = $15,000/0.25

 

60,000

Estimated value of company

 

410,000

 

Because of the extensive guidance given in Revenue Ruling 68–609, many business valuation analysts follow it closely, even though it contains many cautions and qualifications, especially in performing valuations for tax purposes. This approach has come to be known as the Treasury Method. 1