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A Closer Look at the Excess Earnings Method

Posted on Tue, Jul 17, 2018

The Excess Earnings Method was originally created to compensate wineries and distilleries during Prohibition. Valuation experts often criticize this method, calling it ambiguous, over-simplified or outdated. But it's still used in some jurisdictions as a way to value small businesses and professional practices, especially in a divorce setting.

The Excess Earnings Method is the subject of IRS Revenue Ruling 68-609. In that pronouncement, it was referred to by Earnings Graphthe IRS as "the formula approach." In the headnote, the IRS says that it should be used "only if there is no better basis available for making the determination." Despite this disclaimer, the Excess Earnings Method found its way into common usage by some business valuation experts and continues to be used today.

IRS Revenue Ruling 68-609 describes the Excess Earnings Method as:

"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 asset of the business determined under the `formula' approach."

Here are 10 steps valuators follow when applying the Excess Earnings Method:

  1. Determine the fair market value of the "net tangible assets."
  2. Develop normalized cash flows.
  3. Determine the appropriate return for the net tangible assets.
  4. Determine the "normalized cash flows" attributable to "net tangible asset" values.
  5. Subtract cash flows attributable to net tangible assets from total cash flows to determine cash flows attributable to intangible assets.
  6. Determine an appropriate rate of return for intangible assets.
  7. Determine the fair market value of the intangible assets by capitalizing the cash flows attributable to the intangible assets by an appropriate capitalization rate determined in step 6.
  8. Add the fair market value of tangible assets to the fair market value of intangible assets.
  9. Subtract any interest bearing debt to arrive at a value conclusion for equity.
  10. Observe the overall capitalization rate for reasonableness.

Note: The rates of returns for both tangible and intangible assets should be market rates of return, not the generalized rates provided in IRS Revenue Ruling 68-609. The actual process in arriving at a value under the Excess Earnings Method is in-depth and detailed, if done correctly. It should result in an overall discount or capitalization rate similar to the discount or capitalization rate determined when using the Discounted Cash Flow Method.

In divorce cases, the Excess Earnings Method can help separate the value of tangible assets from intangible assets. But the value of intangible assets may include more than just goodwill. It may also include other identifiable intangibles -- such as customer lists, contracts and brands -- that typically aren't listed on the balance sheet unless they were acquired by a third party. The valuator may need to value these assets separately -- and subtract them from the total value of intangibles -- to arrive at the value of goodwill. In some jurisdictions, he or she also may need to perform additional analyses to distinguish entity goodwill from personal goodwill.

An Alternative View

A variation of the traditional Excess Earnings Method is the use of an Excess Compensation Method. This method was affirmed in an unpublished trial court opinion in Indiana. The trial court stated:

"(Expert's) capitalization of Husband's excess earnings, by calculating only Husband's earnings which exceed the earnings of anesthesiologists in the United States who bill a similar number of ASUs as Husband does as reported by the MGMA [Medical Group Management Association], properly eliminated Husband's personal goodwill from the calculation…"

(Note: An ASU is a unit of billing for anesthesiologists, similar to billable hours for attorneys.)

The expected excess earnings are calculated and then divided by a risk adjusted capitalization rate. For a professional practice, the compensation (distributions) and income allocated to a particular professional related to his or her interest in the practice in excess of the normalized compensation that could be expected from a similarly situated professional, is divided by a risk-adjusted capitalization rate. Normalizing differentiates between the return received by the owner for services rendered to the enterprise and the additional enhanced return received as a result of the ownership in the enterprise.

The result is a determination of the entity goodwill to be allocated to an individual practitioner in a large professional practice. This is helpful in situations in which the valuator might not be able to obtain data on the entity as a whole or on the individual practitioners other than the one whose interest is being valued.

Excess Earnings Method Lives On

The Excess Earnings Method generally should be reserved for cases in which no better alternate method of valuation is available. Despite its limitations, the Excess Earnings Method continues to be used by some experts to value small businesses and professional practices. It can be especially helpful to the parties in a divorce when determining the value of goodwill. But applying it correctly requires the use of a trained EHTC valuation professional.

Tags: Valuation, Business Valuation, Small Business