Critics of the excess earnings method call it subjective, ambiguous and outdated. IRS Revenue Ruling 68-609 recommends using it “only if there is no better basis available.”
Yet the method remains a viable tool, especially when valuing small professional practices for divorce purposes. Because of its perceived simplicity, the excess earnings method can also serve as a meaningful sanity check for other methods. Here’s how it works.
The first step of the excess earnings method is to value the company’s net tangible assets. Book value may be a reasonable proxy for some items, but others may need to be adjusted.
For example, the book value of inventory may include obsolete or missing items. Fixed assets that have been fully depreciated may continue to provide value. And real estate recorded years earlier at historic cost may require an appraisal.
Tangible assets generate returns of 8% to 10%, according to Rev. Rul. 68-609. Valuators decide what’s appropriate for the subject company, based on its perceived risk and industry guidelines, if available. Then they multiply the rate of return by the value of net tangible assets.
To illustrate: Suppose a business expects to achieve a 10% return on $2 million of net tangible assets. That’s $200,000. If the company’s annual earnings historically have averaged $800,000, its excess earnings from intangible assets would equal $600,000 ($800,000 normalized earnings minus $200,000 return on assets).
Impute intangible value
The next step is to value the intangibles. Rev. Rul. 68-609 recommends using a 15% to 20% return, depending on risk levels. The ruling provides no guidance about the type of earnings to use, however.
Continuing with our example and assuming a 15% return, the value of intangibles would be $4 million ($600,000 divided by 15%). There’s no specific empirical evidence on which to base this rate of return. Instead, valuators use professional judgment.
The last step is to combine the value of tangible and intangible assets. In our example, the company’s value would be $6 million ($2 million of net tangible assets plus $4 million of intangibles).
An appraiser can also calculate the overall rate of return on assets to use as a sanity check. That requires dividing the company’s normalized earnings by its value. For example, $800,000 divided by $6 million equates to an overall return on assets of about 13%.
Like any appraisal technique, the excess earnings method is only as reliable as its underlying assumptions. A valuation professional can help you apply this method correctly and avoid potential pitfalls.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.