Assets and Earnings Valuation

April 13, 2006

	Visited: 326
	Not rated
	Rate:

The excess earnings method of valuing a small business takes both assets and historical earnings into consideration, and is the method prescribed by the IRS for estate and gift tax situations when there's no other more appropriate method. It can also be used in appraising a business that's being put up for sale, although the IRS does not prescribe it for this situation. Since the IRS has sanctioned this method for at least some purposes, your appraiser may want to use it also, particularly if you're concerned about IRS scrutiny of your tax returns reporting the sale. You may sometimes see this method referred to as ARM 34, which is what the IRS calls it.

To use this method, you must first recast your historical financials to show how the business would have looked without the owner's excess salary and perks (that is, the amount over and above what a non-owner manager would have been paid), nonoperating or nonrecurring income/expenses, etc. For the income statement, a judgment call must be made as to whether you should look only at the last year's statement, or at some combination of statement results from the last three to five years (the most common combinations are a simple average, a weighted average that values the most recent years more heavily, or a trend line that factors in the percentage and direction of growth each year). The IRS prefers to see figures that represent a five-year average, which seems to be a reasonable approach.

For the balance sheet, use the most recent month's sheet, recast to reflect current market value. The starting point for the value of your business is the net value of your assets as shown on the recast balance sheet. But how much more should you get, based on the business's goodwill or intangible value?

Putting a price tag on goodwill. From your recast financials you can determine your historical annual earnings figure (generally, EBIT or earnings before interest and taxes). From this you'll subtract the portion of earnings that's attributable to your assets alone. Anything left over is the "excess earnings" — the portion that's attributable to the going-concern value of the business.

How do you determine the portion of earnings that are attributable to your assets? One way of looking at this is, if the assets were sold and the money invested at market rates, how much could you get? How much is the market paying for other investments of similar risks? This is one of many areas where the expertise of a professional business appraiser can be invaluable. For example, your appraiser might say that, in view of the risk involved in your particular business, your annual return from the current assets should be about 150 percent of the rate of a short-term government bond; your annual return from the long-term assets should be about 188 percent of the bond rate.

After you compute the expected returns from your assets, compare the total with your historical earnings figure. If the historical earnings figure is higher than the return from assets, the difference is called "excess earnings." The excess earnings can be divided by a capitalization ("cap") rate to arrive at their value. Although a professional appraiser will spend a good deal of time and effort determining the proper cap rate to use, in today's market it will generally be somewhere around 20 to 25 percent, or enough to recover your investment in four to five years.

For example, let's say that your recast balance sheet shows a net current asset value of $80,000, and a net long-term asset value of $200,000. So, the minimum or base price for your business should be $280,000 — the market value of your assets.

Now let's assume that your historical annual earnings figure is $150,000. How much of this earnings figure is attributable to the assets? You might calculate that under current market conditions the return on current assets should be $80,000 x 7.5% or $6,000, and your return on long-term assets should be $200,000 x 9.4% or $18,800. Thus, your total earnings attributable to your assets is $6,000 + $18,800 or $24,800. Subtracting this "asset return" figure from your total earnings, you arrive at an excess earnings amount of $125,200 ($150,000 - $24,800 = $125,200).

Using a cap. rate of 20 percent, the value of your excess earnings is $626,000. Add to this the current market value of your assets, and you arrive at a total price of $906,000 for the business ($626,000 + $280,000 = $906,000).