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## 5.2.4 Excess Earnings Method

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 68-609, 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 68-609, 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 65-192, 1965-2 C.B. 259 and Revenue Ruling 65-193, 1965-2 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 pre-tax 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).

Student paper

For a discussion of goodwill valuation methodology in the context of an equitable distribution of a dental practice, see Caroline Finch, Measuring Goodwill in a Dental Practice in the Context of Equitable Distribution.

 5.2.3 Applying DCF Formulas 5.3 Stock Valuation - Market Method