Excess Earnings Method

The Excess Earnings Method (EEM) is a valuation approach that considers both tangible and intangible assets to determine the value of a business. Its main purpose is to assess the worth of intangible assets separately from physical assets.

Also referred to as the Treasury Method, the excess earnings method originated in the 1920s and is commonly used for privately-owned companies that generate excess cash flows from intangible assets. It is particularly useful in valuing business goodwill. However, it is important to note that there are certain challenges and considerations when using an excess earnings method calculator for valuation purposes.

Key Takeaways                                                               

• The excess earnings method (EEM) is a business valuation approach that combines the value of tangible assets with intangible assets.
• The concept of EEM originated in the 1920s in the US, proposed by the Treasury in the Appeals and Review Memorandum Number 34. It was further updated by the IRS in 1968.
• The EEM formula involves calculating the net earnings for intangible assets, dividing it by the capitalization rate, and adding the value of net tangible assets to determine the total value of the business.
• Despite its historical popularity, many large capitalization firms do not commonly utilize the excess earnings method in their valuation processes.

The Excess Earnings Method, or the formula method, allows private firms to perform a business valuation. It consists of net tangible assets and net intangible assets. In addition, even the cash flows play a vital role in the calculation. In short, it is a hybrid approach combining asset values with the cash flows to determine the enterprise value. 

The capitalized excess earnings method is a hybrid of the income and asset valuation approach. Here, the fair value of fixed assets and working capital are relevant. So, when the tangible assets get added to the intangible assets, it results in the total business value. But, in this process, the values of net intangible assets are not counted. Instead, after calculation, the excess earnings get divided by a capitalization rate. This rate further helps determine the value of intangibles like goodwill and patents. Ultimately, both the values (tangible and intangible assets) are clubbed together. 

Despite single-period calculation, even multiple years are accessible. In some models, the data can be historical for at least five to seven years. However, if the firm selects many years, it falls under the multi-period excess earnings method (MPEEM). Yet the calculation remains the same; only the cash flows columns increase. It looks like the DCF (Discounted Cash Flow) model, but changes occur. Majorly, the capitalized excess earnings method considers both assets. However, the multi-period excess earnings method only accounts for cash flows from intangible assets. In short, the present cash flow value is attributed to the non-fixed assets. 

The excess earnings method became popular during the 1920s in the United States. The US Treasury Department released a memorandum as described in the Appeals and Review Memorandum Number 34. However, prior, between 1920 to 1933, alcoholic beverages were banned in the country. During this period, the breweries and distilleries faced huge losses. As a result, they could not value their goodwill. So, in 1968, the IRS updated the capitalized excess earnings method in Ruling 68-609. 

Let us look at the formula of the excess earnings method calculator to comprehend the concept better:

Value of Business = Net Tangible Assets (NTA) Value + Excess Earnings / Capitalization Rate

Let us look at the examples of excess earnings method calculation using the above-explained formula:

Example #1

Let's consider a company with net tangible assets valued at $500,000. The fair rate of return on these assets is determined to be 8%. The company's total normalized earnings are estimated to be $80,000.

Earnings on Tangible Assets: $500,000 * 8% = $40,000

Excess Earnings: $80,000 - $40,000 = $40,000

Assuming an appropriate capitalization rate of 10%:

Value of Business: $500,000 (NTA) + $40,000 (Excess Earnings) / 10% = $900,000

Therefore, the value of the business using the Excess Earnings Method (EEM) in this example is $900,000.

Example #2

Let's consider the case of Hyzon Motors Inc., an automobile manufacturer that recently released its first quarterly results. According to their Form 10-Q/A from March 2023, the company has a capital structure consisting solely of single-class equity. Two primary equity valuation models are employed in valuing the company: the comparable sales method and the excess earnings method. Both methods are equally utilized to determine the enterprise value of Hyzon Motors Inc.

Hyzon Motors Inc. can gain valuable insights into its enterprise value by employing comparable sales and excess earnings methods. These methods consider various factors such as industry comparables, earnings potential, and tangible assets to arrive at a comprehensive valuation. Ultimately, using these equity valuation models provides a robust framework for assessing the company's worth in the market.

Although this method gained popularity in the mid-20th century, it had certain disadvantages. Let us look at some of the challenges during the process:

• Subjective Variables: The method involves subjective variables, such as estimating adjusted net tangible assets, capitalization rate, and return rates for different assets. The subjective nature of these variables can make the computation challenging for firms.
• Last Resort Option: While the IRS(Internal Revenue Services) initially proposed the excess earnings method, it is now a last resort option. The method is appropriate only if a proper valuation basis is unavailable.
• Difficulty in Segregation: Separating earnings derived from tangible assets and other factors, such as land, labor, and capital, can be difficult. This lack of segregation poses a challenge in accurately determining the value of intangible assets.
• Limited Application: The method is less commonly used by sophisticated and larger firms, leading to its limited application. Many businesses and industry experts have criticized the method due to its limitations and complexities.

In summary, the excess earnings method faces challenges related to subjective variables, limited applicability, segregation difficulties, and status as a last-resort option.