A Comparison of the Earnings Capitalization and the Excess Earnings Models in the Valuation of Closely-Held Businesses
Mastracchio, Nicholas J., Lippitt, Jeffrey W., Journal of Small Business Management
Closely-held businesses are valued for many tax, legal, and business reasons. Recent growth in the use of employee retirement plans that invest in the common stock of the sponsoring closely-held company (Employee Stock Ownership Plans(1)) has resulted in the need for annual valuations of these companies for compliance with U.S. tax and pension regulations (Pratt 1993). These plans require annual valuations to determine the market value of the stock donated to the plan and to determine the price to be paid to retiring employees. Litigation is another reason for valuations. Many jurisdictions have adopted equitable distribution laws requiring businesses that are owned by one spouse to be treated as marital property and valued in connection with divorce actions. This is an important and growing cause for valuations (Pratt 1993). Legislation and case law protecting minority interest shareholders require corporations to repurchase shares of oppressed minority shareholders at an appraised fair value. Currently, all states in the U.S. except for West Virginia provide this type of relief to minority shareholders (Pratt 1993). These requirements, in addition to continuing needs in the areas of financial planning, estate and gift taxation, and actual transfers of ownership, have resulted in a large and growing demand for the valuation of closely-held businesses.
There is a variety of models available for valuing small businesses. In choosing the appropriate models in any particular situation, an appraiser must make judgments regarding which models will most accurately predict market value. Little empirical guidance is available in the literature to assist in this judgment. This paper presents the results of an empirical test comparing two of the most commonly used models - the earnings capitalization model and the excess earnings model. (In addition to these models, there are the discounted cash flows model, models based on assets such as net asset value and liquidation value, and models that consider comparable sales of the same or similar companies(2).) The second section of this paper discusses the underlying concepts of two of the most widely used valuation models. The third section describes previous empirical work. The fourth section describes the test used to compare the applicability of the excess earnings model to the earnings capitalization model, and the final section summarizes the results and conclusions reached.
The objective of a valuation of a business is to estimate its fair market value, that is, "the price at which the property would change hands between a willing buyer and willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts" (IRS Revenue Ruling, 59-60). For publicly-traded companies, the fair market value is demonstrated in market transactions. However, since there is no market for closely-held companies, some other method of estimating the value is necessary. Two commonly used models for valuing small businesses are those based upon the present value of future benefits. Three other models often considered by appraisers are discounted cash flows, earnings capitalization, and excess earnings.
Small business literature provides strong theoretical support for the Discounted Cash Flow (DCF) model (Carland and White 1980; Lloyd and Hand 1982; Burns and Walker 1991). However, the DCF model has only limited usage in practice. Carland and White suggest that the infrequent use of the DCF model is due to its complexity. Pratt (1993) argues that its infrequent use is due to the difficulty in estimating future cash flows. Lippitt and Mastracchio (1993) examine the relationship between DCF and Earnings Capitalization (EC) and demonstrate that in many situations the models result in similar values if the treatment of capital assets under the EC model is modified using estimates that are readily available from within the historical cost accounting system. While enjoying less theoretical support, the earnings capitalization and the excess earnings models are frequently used in the actual valuation of small businesses (Pratt 1993). These models are often viewed as alternative approaches for the same valuation.
Both the earnings capitalization model and the excess earnings model estimate the value of business assets by taking the present value of the expected income associated with the assets. In both models, the adjusted accounting earnings of the firm are used as a surrogate for future economic earnings. Accounting earnings must be adjusted to reflect economic values, including adjustments such as accelerated depreciation methods, inventory valuation methods, and related party transactions.(3) The earnings capitalization model is based on the assumption that the future earnings are homogenous with respect to risk, and the model applies a single discount rate to all future earnings. The excess earnings model is based on the assumption that the future earnings are heterogeneous with respect to risk, and it separates the earnings into two risk classes, applying a different capitalization rate to each class(4).
The capitalization rate is one of the most difficult factors to understand and implement (Pratt 1993). The appraiser either looks to publicly-traded firms or attempts to build a rate by considering the riskless rate and the risks involved in the business being valued. Capitalization rates are often developed from a direct comparison with publicly-traded firms. In this context, for the homogeneity assumption of the EC model to be valid, all assets employed in the industry must have the same level of risk, or all firms in the industry must hold assets with different risk levels in the same proportion. If the homogeneity assumption is incorrect, that is, if future earnings are in fact heterogeneous with respect to risk, there is reason to suspect that the separation of the future earnings stream into separate risk components for valuation purposes will lead to better results, because the risk level of an individual firm will reflect the …
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Publication information: Article title: A Comparison of the Earnings Capitalization and the Excess Earnings Models in the Valuation of Closely-Held Businesses. Contributors: Mastracchio, Nicholas J. - Author, Lippitt, Jeffrey W. - Author. Journal title: Journal of Small Business Management. Volume: 34. Issue: 1 Publication date: January 1996. Page number: 1+. © 2002 Journal of Small Business Management. COPYRIGHT 1996 Gale Group.
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