What is the Excess Earnings Method of Valuation? 

Another earnings-based method is excess earnings. This method discounts company earnings based on two capitalization rates: a rate of return on tangible assets and a rate attributable to company goodwill. The method is often described as a hybrid method because it takes into account the company's asset values as well as discounts expected cash flows.

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What is the Excess Earnings Equation? 

 The following equation represents the valuation based upon the two rates of return: 

V = Ea / R a + Eg / Cg 

where 

V = The value of the business 

E a = The earnings attributable to a return on assets 

R a = The appropriate rate of capitalization for earnings attributable to net tangible assets 

E g = The earnings in excess of those attributable to a return on assets 

C g = The appropriate rate of capitalization for earnings attributable to goodwill In its most common form, 

The value is calculated as follows: V = E A*Ra / Cg + A 

Where: 

V = The value of the small business 

E = The adjusted earnings of the firm 

A = The net tangible assets of the firm 

Ra = The appropriate rate of capitalization for earnings attributable to net tangible assets 

Cg = The appropriate rate of capitalization of Goodwill 

The process for valuing the firm based on the excess earnings method is as follows. Estimate the value of the company's net tangible assets. Multiply that value by a fair rate of return to calculate earnings attributable to the company's tangible assets. Estimate the company's total normalized earnings. Subtract earnings on tangible assets from total earnings to arrive at excess earnings. This represents the company's earnings above the return on the company's net tangible asset value. 

Divide the excess earnings by an appropriate capitalization rate to calculate the value of goodwill and other intangible assets. The capitalization rate may be subjective or obtained from a market indices. Once you have obtained both amounts, add them to arrive at the company's valuation.

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Issues with the Excess Earnings Method

The excess earnings method artificially divides a company's earnings into two separate earnings streams: one for tangible assets and one for intangible assets. The problem is that these assets don't generate earnings by themselves. Rather, a company's earnings are derived from a combination of tangible and intangible assets working together. 

There is no market data to support an objective determination of a fair rate of return for tangible assets or a reasonable capitalization rate for intangible assets. So, application of the excess earnings method is highly subjective and easily manipulated. Also, the type of valuation method or discount rate for the subject earnings is not determined. 

This approach may only be appropriate for closely-held businesses or situations where the individual assets of a business must be distributed (such as the dissolution of a business). IRS 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.