The Return of a Classic: The Excess Earnings Method Works in the Marketplace

By: Joseph LaPray and William C. Herber

The practice of valuing an enterprise based upon its excess earnings is not a conceptually dubious appraisal technique, it is an everyday tool used by many businesses and investors. The excess earnings method was first used in the 1920's to estimate the value of intangibles lost when liquor manufacturers were shut down by Prohibition. Although the approach originally appeared in the U.S. Treasury Department's Appeals Review Memorandum (ARM) #34, the government later became guarded about the idea and issued Revenue Ruling 68-609 which states that the approach "...may be used for determining the fair market value of intangible assets of a business only if there is no better basis therefore available."

One possible explanation for the government's caution could be carelessness in the application of the Excess Earnings Approach. For example, ARM-34 used a rate of return of 8% for the net tangible assets of low-risk companies, and a recommended excess earnings capitalization rate of 15% to determine the value of intangibles. When explicit capitalization rates were stated in the memorandum, it was easy to apply them in cases where they were inappropriate. Carelessness in determining the value of tangible assets (for example, simply using book values rather than market values) could also result in unrealistic conclusions. The IRS has clarified its position by stating that the appropriate capitalization rates are dependent upon the pertinent facts of each case.

Appraisers who find themselves applying the excess earnings method need not feel apprehensive. Variations of the excess earnings method are used by the likes of CSX, AT&T, Coca-Cola, Briggs & Stratton and many other companies in their everyday operations. Each of these companies calculates excess earnings from their operations to measure financial performance and make investment decisions. One currently popular variation of excess earnings is "Economic Value Added" or EVA, a term trademarked by the New York consulting firm of Stern Stewart & Co. Earlier generations may have known the same concept as "economic profit," which was described by the eminent British economist Alfred Marshall (1842-1924) and taught as a matter of course in microeconomics classes.

EVA is simply a company 5 net operating profit after taxes and after deducting the cost of capital (calculated as: weighted average cost of capital x total capital invested in the business). If a positive number remains after deducting the cost of capital from after tax net operating profits, the company's operations have created capital; if the number is negative, the company has consumed capital. For example, assume that a company has a net operating profit after taxes of $1,000,000; a capital structure with 67% equity and 33% debt; a cost of debt of 6.9% and a cost of equity (determined using the Capital Asset Pricing Model) of 14.5%; and total invested capital of $8,000,000, the company's EVA would then be calculated as follows:

In the above example, the economic value added was $40,000. In other words, the capital invested in the operation generated additional capital, or new wealth (excess earnings) of $40,000.

Even if the IRS is cautious about the use of excess earnings or EVA, investors like it enough to use it in their decision making. As noted in articles in Fortune, Industry Week and other popular publications, EVA is useful for helping managers measure the performance of individual operating units within companies. If their net operating income does not exceed the cost of the capital invested in the unit, there is no wealth being created by the operation. EVA is also used to measure the performance of managers and employees, i.e., by tying incentive pay to capital formation. Another use of EVA is to estimate whether a proposed capital investment will be profitable enough to justify itself. In general, EVA focuses attention on the essential element of any business; stewardship of capital. EVA helps to answer the questions; Where should capital resources be invested? Who is doing a good job of capital stewardship? Are our present investments consuming or producing wealth?

The September 20, 1993 issue of Fortune magazine quoted James Meenan, chief financial officer of AT&T's long-distance business: "We calculated our EVA back to 1984 and found an almost perfect correlation with stock price." While it is doubtful that investors deliberately set out to calculate the EVA for every publicly traded stock, the market may be sensitive to the thing that EVA is attempting to measure, capital formation. Coca-Cola reportedly used EVA to determine that the money it had invested in businesses such as instant tea, plastic cutlery and wine was not as productive as money invested in the soft-drink business. As a result of this analysis, the company decided to get out of some of its non-soft drink businesses. CSX used EVA to determine that its intermodal business had to shape up or close down. Briggs & Stratton used EVA to decide that it should no longer make its largest engines. Generally speaking, when EVA rises so do stock prices.

The Excess Earnings Approach calculation used by appraisers is similar to the EVA calculation in that both methods attempt to measure the profits remaining after deducting a return on capital investments. Both the Excess Earnings Approach and EVA start with the earnings generated by the enterprise, deduct the cost of capital (amount invested x rate of return) and determine if there is anything left over to represent capital formation. One difference in the two methods is in the calculation of earnings. Starting with normalized earnings (depending on the circumstances this may or may not be net cash flow after actual capital replacement costs), the excess earnings calculation then deducts the returns which the company could earn from its tangible assets. Returns on assets are determined by taking the market values for each of the company's operating assets (if a computer has a book value of ~,000 but would only sell for $500 in the second hand market, the $500 value is used) and multiplying each of these assets by an appropriate rate of return (cash and like assets are low risk assets and would earn a lower rate of return than highly specialized machinery which might be difficult to sell). After deducting the market rate of return on the market value of the company's assets, the remaining number is the company's excess earnings. Because the returns on all of the company's tangible assets have already been accounted for, the remaining earnings must have been generated by another kind of asset, an intangible asset. If there are any excess earnings, the excess earnings method capitalizes those earnings at an appropriate rate to reflect their riskiness and the resulting quotient is the estimated value of the company's intangible assets. Adding the value of the intangible assets to the previously determined market values of tangible assets provides the total value of all of a company's assets and is one way to appraise the value of the entire company.

A sample Excess Earnings Approach calculation is presented below. To be sure, there are some differences between EVA and the excess earnings method used by appraisers. Cost of capital in EVA relates to a company's total invested capital times the weighted average cost of that capital and is applied at the same rate to all assets. Appraisers using the excess earnings method may apply different rates of return to different components of a company's assets depending on their riskiness and other factors (however, the weighted average return for each of the assets should equal the required return for the total enterprise). Some of the problems common to application of the excess earnings method are shared by EVA, such as determining the cost of capital in addition to the rate of return on the capital.

Far from a relic of Prohibition, the excess earnings method can be seen as a variation of EVA, an analytical tool widely used by investors and managers. Use of EVA is proof of the conceptual validity of excess earnings calculations as a measure of a company's value. Business appraisers can perform an excess earnings calculation on an entire business enterprise or any of its individual component parts to determine which operations are contributing to capital creation and which are not worth the investment of resources. As the popularity of EVA demonstrates, the Excess Earnings Approach is an appraisal approach whose time has come again.

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