This method, sometimes known as the
"formula method", is a hybrid that combines
cost and income approaches. Earnings are separated
into those derived from
 tangible assets
 intangible assets (name, reputation, quality
of personnel)
Steps in "excess earnings"
method. Under the excess earnings method,
the market value of net tangible assets is multiplied
by a rate of return appropriate to these assets
to calculate earnings attributable to tangible
assets. Then this earnings figure is deducted
from total earnings to calculate an earnings figure
attributable to intangible assets. Then these
"intangible" earnings are divided by
a capitalization rate for intangibles to calculate
an estimated value for the intangibles. Valuators
sometimes use this method to estimate "goodwill."
This method, described in Rev
Ruling 68609, is said to be conceptually
easier for lay persons to understand and is frequently
used by courts in equitable distribution cases.
The IRS, however, has said it should be used only
as a last resort when other better methods are
unavailable.
(1) Determine the average net
earnings, excluding reasonable compensation
or the owner or partner, of the business for
not less than five years. Abnormal years,
whether above or below average, should be
eliminated. 
(2) Determine the average annual
value of the tangible assets used in the business
for a representative number of years before
the valuation date. Tangible assets include
accounts and bills receivable in excess of
bills and accounts payable. 
(3) Determine a fair percentage
return on tangible assets computed in (2).
This should normally be the industry average
or, if unknown, an 8% to 10% rate of return
may be used. 
(4) Deduct (3) from (1). This
is the amount of average earnings attributable
to goodwill or excess earnings. 
(5) Capitalize the average
earnings attributable to goodwill or excess
earnings computed in (4) using an appropriate
capitalization rate. This is the fair market
value of goodwill or intangibles. (The capitalization
rate for intangibles should be between 15%
to 20%  a multiplier of 6.6 to 5.0). 
What rates of return? According
to Revenue Ruling 68609, the reasonable return
and the rate of capitalizing excess earnings depend
on the nature of the business, how stable or hazardous
it is, and other factors. Low rates of return
(8% on tangibles and 15% capitalization rate)
should be used for small risk businesses with
stable and regular earnings; the 10% rate of return
and 20% capitalization for high risk business.
See Revenue
Ruling 65192, 19652 C.B. 259 and Revenue
Ruling 65193, 19652 C.B. 370. 
Example
Alina divorces Bert, who claims half the value
of Alina's medical practice. She claims that he
is not entitled to the future earnings of the
practice, which will be due to her own efforts.
What is the value of the medical practice that
Bert is entitled to share?
Assume that over the last 5 years:
 the tangible business assets have averaged
$200,000
 net earnings have averaged $350,000 per year
 annual draws by Alina have been $300,000 per
year
Assume that the tangible business assets (office
space, supplies, equipment) a fair return of 10%
and assume that goodwill is capitalized at a rate
of 20%.
Answer. Under most modern
equitable distribution statutes, Bert is entitled
to half the value of the practice as of the date
of their separation. The tangible assets have a
value of $200,000 and the goodwill a value of $150,000
under the "excess earnings" formula determined
as follows:
(1) Average Earnings
(Normalized) 
$50,000 
(2) Average Tangible Assets

$200,000 
(3) Fair return (10%)
on tangible assets 
$20,000 
(4) Average earnings
attributable to goodwill or excess earnings
(1) minus (3) 
$30,000 
(5) Capitalized average
earnings attributable to goodwill at 20%
(multiply by 5 to get the value of goodwill) 
$150,000 
(6) Add (2) and (5) for
total value of corporation 
$350,000 
Notice that this assumes Bert is not entitled
to a capitalization of earnings in an equitable
distribution, since future earnings are not considered
a marital asset  Alina will earn them after
their separation. The "excess earnings"
method allows for the valuation of intangible
assets.

Critique. It's
hard to believe that this is more understandable
than capitalizing earnings! What do you think?
Illustration
A company has pretax income of $120,000
and net tangible assets (adjusted to market)
of $280,000. Assuming a rate of return on
the net tangible assets is 10% and the rate
on intangibles is 25%, what is the company's
value?
Answer: There are four
steps 
 Calculate the portion of earnings attributable
to tangible assets. Multiply these assets'
required return (10%) by their market
value ($280,000) = $28,000
 Calculate the portion of earnings attributable
to intangible assets. Subtract the earnings
attributable to tangibles ($28,000) from
company's total earnings ($100,000) =
$62,000
 Calculate intangible value. Divide earnings
attributable to intangibles ($62,000)
by their rate of return (.25) = $244,000
 Calculate total assets. Add value of
net tangible assets ($280,000) to calculated
intangible assets ($244,000) = $524,000.
The key is estimating rates of return on
the tangible and intangible assets. 

Example
For an example of the "excess returns method
applied in an equitable distribution, see Smith
v. Smith, The court valued the Charlotte Motor
Speedway by adding 
 the net value of the facilities (based on
appraisal)
 the capitalized excess earnings realized by
current operations
 the company's book value, excluding the appraised
value of its facilities
As the court explained, excess earnings are "the
net income from operations in excess of a normal
return on value from a net lease of the real property
owned by Charlotte Motor Speedway, Inc. (CMS),
or, stated differently, the amount by which expected
net income from operations would exceed the expected
rental income."
See also Barth H. Goldberg, Valuation of Divorce
Assets, §; 6.6 (1984); 2 John P. McCahey,
Valuation and Distribution of Marital Property,
§; 22.08(2) (1993). 