Excess earnings method: how the rates of return affect the business value

If you are valuing an established business the capitalized excess earnings method is an excellent choice to determine the value of business goodwill. However, use care when specifying the rates of return as your results may vary considerably.

The method uses not one but two rates of return to calculate the valuation results. One is the rate of return on the business’ net tangible assets. The other is actually the capitalization rate used to calculate the value of business goodwill from earnings.

Depending on your valuation scenario the choices of these rates can make a surprisingly big difference. To demonstrate, we select the following inputs for the excess earnings valuation:

• Annual business earnings (net cash flow): $100,000
• Expected earnings growth rate, per year: 5%
• Cash on hand: $10,000
• Accounts receivable: $5,000
• Inventory: $25,000
• Other current assets: $2,000
• Property and equipment: $30,000
• Other fixed assets: $2,000
• Rate of return on net tangible assets: 30%
• Accounts payable: $3,000
• Other current liabilities: $1,000

Under the above assumptions we get these results:

• Value of business goodwill: $331,800
• Total business value: $401,800

Now let’s see how the results change if we assume a 20% growth in annual business earnings:

• Value of business goodwill: $948,000
• Total business value: $1,018,000

The difference is remarkable. A closer look shows that most of the business value increase is due to goodwill. The cap rate used to calculate it is the difference between the fair rate of return on net tangible assets and the earnings growth rate. This is the business cap rate and it went from 25% (30% – 5%) in the initial scenario down to just 10% for the second calculation.

In simple terms, we expect the business earnings to grow at 4 times the initial rate. Without changing the other inputs this means that the company is expected to growth much more rapidly while facing the same level of business risk.

If you are an investor, you basically assume that the management has figured out a way of generating much better earnings while keeping the risk the same. This is a big strategic difference and it shows in the much greater business value result.

Note that the excess earnings method depends to a great extent on your choices for the rates of return. In the calculations above we used the overall company discount rate and cap rate. You can see how the discount rate is typically calculated for a business using the build up formula. The cap rate then is just the difference between the discount rate and the earnings growth percentage per year.

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