Handbook of Business Valuation

By Thomas L. West; Jeffrey D. Jones | Go to book overview

CHAPTER SIXTEEN
The Excess Earnings Method

S. CHRIS SUMMERS

The Excess Earnings Method, often called the formula approach, is perhaps the most commonly used business valuation technique in existence. However, the method has received a great deal of criticism from valuation professionals over the years. The reason for its wide usage is probably its apparent simplicity. The reason it has received so much criticism is certainly the unconscionable range of valuation results produced by its misapplication.

The Excess Earnings Method originated in 1920 with the publication of Appeals and Review Memorandum 34 by the U.S. Department of the Treasury. In 1968, the Internal Revenue Service updated the method in Revenue Ruling 68-609.' In part the ruling states:

The “formula” approach should not be used if there is better evidence
available from which the value of intangibles can be determined. If
the assets of a going business are sold upon the basis of a rate of cap-
italization that can be substantiated as being realistic, though it is not
within the range of figures indicated here as the ones ordinarily to be
adopted, the same rate of capitalization should be used in determin-
ing the value of the intangibles.

Accordingly, the “formula” approach may be used for determin-
ing the fair market value of intangible assets of a business only if there
is no better basis therefore available.

With such a guarded endorsement by the IRS, it is not surprising that valuation professionals have not wholeheartedly embraced the

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