Multi-Period Excess Earnings Method

The Multi-period Excess Earnings Method (MPEEM) refers to a valuation methodology utilized in determining the value and goodwill of intangible assets based on their future cash flow generation. Its primary purpose is the valuation of goodwill and intangible assets owned by businesses.

It is done by discounting the current value of excess earnings by the asset. It helps businesses conduct acquisition, dispute resolution, and financial reporting. Moreover, it finds use in determining the value of those intangibles which are challenging to observe in a market. Accountants, financial analysts, and appraisers mostly use it for its impact and importance of intangibles.

Key Takeaways                                                               

• The Multi-period Excess Earnings Method (MPEEM) is a valuation approach that considers the ability of intangible assets to generate future cash flow to assess their worth and goodwill.
• It is commonly employed in business valuation, mainly when intangible assets significantly generate future earnings.
• The MPEEM method estimates the current value of expected future cash flows from intangible assets. By, identifying, collecting financial information, calculating useful life, calculating excess earnings, forecasting excess earnings, discounting future payments, and finding residual values.

The multi-period excess earnings method is a valuation technique used to estimate the value of a business or an intangible asset over a specific projection period. Therefore, this method comprises forecasting future cash flows produced by these assets to determine the return on tangible assets. Thus, this valuation method is beneficial when valuing businesses with significant intangible assets or projecting earnings growth beyond a few years.

As a result, any amount above the average return on tangible assets gives excess earnings. Thus, it leads to their capitalization using an appropriate rate. Companies commonly employ this method when attributing a significant portion of their value to intangible factors such, as brand reputation, customer relationships, patents, or proprietary technology.

The firm estimates the overall net cash flows produced by its business operations. Subsequently, it divides these net cash flows into portions created by tangible and intangible assets, such as customer relations. After obtaining the earnings of the intangible assets, MPEEM offers to estimate the value of the intangible assets.

However, it's essential to recognize that the accuracy and reliability of the multi-period excess earnings method depend on the quality of the assumptions, projections, and discount rates used. Therefore, conducting sensitivity analyses and using appropriate discount rates based on the business's risk profile is critical to producing robust valuation results. Besides, like any valuation method, this method also requires making assumptions and forecasts. So it's crucial to use reliable data and apply sound financial judgment when utilizing this approach.

Companies deploy the MPEEM method to estimate the current value of expected future cash flows that could be generated by intangible assets. Hence, the below steps would help determine the MPEEM of intangible assets:

• Identification of intangible assets: First, identify the intangible asset for valuation, like a customer list, patent, trademark, etc.
• Collection of financial information: Second, collect full details of the entity or business owning that intangible asset, like its expenses, taxes, revenue, etc.
• Measure the valuable life: To determine the time until intangible assets will add revenue to the firm, companies must calculate the useful life of these assets.
• Calculate the excess earnings: To obtain the extra profits of intangible assets, companies must calculate the fourth earnings beyond the standard return on assets.
• Forecasting of excess earnings: Fifth, companies must project the future excess earnings of the intangible asset during its useful life by using assumptions concerning profit margins and future revenue growth that may affect the earning capacity of the intangible asset
• Consider uncertainty and risk: Sixth, companies must factor in all the uncertainty and risk factors, such as regulatory changes, competition, technological advancements, and market conditions, into the intangible asset.
• Discount the future earnings: Companies must calculate the present value by using the discount rate.
• Find the residual values: Companies must estimate the residual value at the end of the useful period of the intangible asset to determine the anticipated value of the asset from projected excess earnings.
• Adding up the present values: Finally, companies must total all the current values obtained for all projected excess earnings plus the residual values to obtain the net estimated value of the intangible asset.

Let us use a couple of examples to understand the concept of the topic.

Example #1

Suppose, Data Bricks, is a technology start-up in the US. Initially, it was perceived as a one-time success story due to its exceptional performance in its first quarter. However, upon applying the multi-periodic excess earning method, analysts found that the company had consistently surpassed market expectations for several consecutive quarters, indicating sustained growth potential. This led to increased investor interest and a surge in the company's stock value.

This method is poised to reshape how financial analysts and investors evaluate companies. Thereby, it paves the way for more accurate valuations and informed investment decisions.

Example #2

Consider the hypothetical case of Next Era Energy Corp., a leading player in the renewable energy sector. It released its financial results for the past four quarters, revealing a remarkable trend of multi-periodic excess earnings. The company reported earnings that consistently exceeded market expectations, demonstrating strong growth and performance across various business segments.

The firm achieved $7 million in earnings in the first quarter, surpassing expectations, as it was projected to earn $5 million. The positive trend continued in the second quarter, with actual earnings of $9 million, exceeding the expected $8 million.

In the third quarter, analysts predicted earnings of $11 million, but the sector again outperformed, recording $14 million in revenues. Thus, the company concluded the year with a stellar fourth quarter, reporting $18 million in earnings, surpassing the projected $16 million. The revelation of this method sparked enthusiasm among investors, leading to a surge in Next Era Energy's stock price.

Moreover, analysts are now closely monitoring the firm's future growth prospects and expect increased investor interest in the company's potential for sustained success in the renewable energy sector.

Based on the facts at hand, the following table lists the possible benefits and drawbacks of applying the Multi-period Excess Earnings Method (MPEEM) to value intangible assets: