"A faulty and intellectually bankrupt valuation model that leads to unreliable estimates of value"
George B Hawkins ASA, CFA
“It is the most widely used and misused of all methods for valuing small businesses and professional practices.”
“The most inappropriately applied method of valuation today”
Zachary M. Sharkey CFA, CPA, ABV
The above comments are emblematic of how the excess earnings method has come to be viewed by some of the most experienced appraisers within the business valuation community today. However, as the Excess Earnings Method has lost favor among the most knowledgeable business valuators, it has simultaneously emerged as a best practices technique in the valuation of special purpose real estate properties that typically involve a business enterprise component.
Originally developed by the US Treasury Department in 1920 for the purpose of providing a formula to be used in determining the proper amount of compensation for the owners of breweries and distilleries for the loss of goodwill that resulted from prohibition, the simplicity of the methodology became popular among early business valuators.
Historically, local accountants, many of whom lacked any formal training in valuation, prepared the majority of small and mid-sized business valuations. Despite the fact that this methodology was developed with the intent to value only the intangible assets of a business, and not the whole business, the simplicity of the approach made its use widely attractive for both.
Over time, this approach was frequently used, or misused, to value entire businesses. Additionally, as a result of its common usage, and because it was easy to understand, it became the approach that many judges recognized and preferred.
By 1968, the IRS recognized that this approach was being misapplied in practice and issued Revenue Ruling 68-609, which stated in part “the (excess earnings) approach may be used only if there is no better basis available for estimating the value of intangible assets.” However, despite that ruling, and the fact that there are frequently better methods to apply in valuing a business, the approach continues to be used by many valuation analysts.
Fundamentally, the problem with the methodology is the inability to reliably divide the earnings of the business between the tangibles and intangibles due to a lack of support. This problem is compounded by the fact that there is no empirical data to support the rates of return on the net tangible and identifiable intangible assets. The inherent subjectivity associated with this method has lead to its frequent misapplication.
Errors in its application are frequently committed due to a lack of understanding of the theoretical background of the method. However, the method is also readily subject to manipulation and has frequently been used with the primary intent to support a value that benefits a clients desired outcome.
It is widely recognized that business valuation of closely-held companies is both an art and a science. However, as the business valuation industry has matured, there have been increasing numbers of highly educated valuators with finance and economics backgrounds. At the same time, there has been more effort to increase the quantitative and empirically measurable elements of valuations, versus the inherent subjectivity of the art component.
The fact that the Excess Earnings Method is so easily and so often misapplied, and the fact that many of the underlying assumptions that belie the use of this approach cannot be empirically supported, does not fit with the industry’s evolving demand for more defensible and intellectually honest valuations.
In an article titled “Closely Held Business Valuations: “The uninformed Use of the ‘Excess Earnings/Formula Method,” Jeffrey Fox, ASA, indicated that “to mechanically cite the excess earnings, formula method as the authority for closely held business valuation will leave an appraiser very vulnerable to criticism”.
Excess Earnings Method Defined
The Excess Earnings Method is a hybrid between the income and asset approaches. Fundamentally, this valuation technique recognizes that each type of asset within a business can be valued by capitalizing the earnings applicable to that asset; intangible assets are present only to the extent that there are excess earnings beyond what is necessary to support the cash flow requirements of the tangible assets.
The Excess Earnings Method can be defined as follows:
“A specific way of determining a value indication of a business, business ownership interest, or security determined as the sum of (a) the value of the assets derived by capitalizing excess earnings and (b) the value of the selected asset base. Also frequently used to value intangible assets”.
The Excess Earnings Method for Real Estate-Centered Enterprises
As the Excess Earnings Method has lost favor among the most knowledgeable business valuators, it has simultaneously emerged as a best practices technique in the valuation of special purpose real estate properties that typically involve a business enterprise component.
The first presentation of the Excess Earnings Method as it relates to real estate is believed to have been a 1953 Appraisal Journal article by George Schmutz “Valuation of Intangible Property” which demonstrated the use of an excess earnings method for allocating the assets of an operating farm.
Subsequently, T. Alvin Mobley, III, in an October 1997 article “Defining and Allocating Going-Concern Value Components”, an important and influential article presented a strong case for the use of this methodology for allocating the component assets of a real estate-centered going concern. This article was later reprinted within the first edition of the Appraisal Institute’s “A Business Enterprise Value Anthology”, compiled and edited by David C. Lennhoff, MAI, CRE, for allocating values to the appropriate assets in 2001.
Long before, however, the US Department of Housing & Urban Development, one of the primary lenders associated with the financing of nursing homes and senior care properties, wrestled with and has long recognized that these properties consisted of real estate, FF&E and an intangible business value component. James K. Tellatin, MAI, an authority on the appraisal of senior facilities, has indicated that HUD had a policy dating back to the 1970’s, if not earlier, that required as a jurisdictional exception that appraisers allocate 15% to 25% of a going-concern’s net operating income to proprietary earnings. This allocation to proprietary earnings effectively accounted, albeit crudely, for the business enterprise value of the going concern.
Additional examples of the approaches emerging use and acceptance for special purposed real estate properties include the Appraisal Institute book, Analysis and Valuation of Golf Courses and Country Clubs, where Arthur Gimmy uses the cost approach and the excess earnings method, though he references it as the “excess profits technique.”
Similarly, Stephen Rushmore incorporated aspects of the excess earnings model in his 2004 article “Why the ‘Rushmore Approach’ Is a Better Method for Valuing the Real Property Component of a Hotel. James Tellatin, MAI includes the excess earnings model in another Appraisal Institute text, The Appraisal of Nursing Facilities. Robert Bainbridge similarly emphasizes the excess earnings model in Convenience Store and Retail Fuel Properties.
In 2011, Franz Ross and Adam Alesi advocated the use of this methodology as a best practice when appraising going concerns. More recently, published in Spring 2014 Brock Rule, MAI wrote “Restaurant Valuation” which provided a step by step analysis of this methodology, and noting within this important article:
“According to the Uniform Standards of Professional Appraisal Practice, appraisers must “be aware of, understand, and correctly employ those recognized methods and techniques that are necessary to produce a credible appraisal.” The excess earnings method is the “recognized method” for valuing restaurants.”
Then, in 2016, Laurence A. Hirsh, MAI includes a thorough discussion of the excess earnings method and incorporates it into his text: "Golf Property Analysis: A Modern Approach"
The Fork in the Road
The theory that BEV is present in some properties is almost universally accepted today, though the issues of The Appraisal Journal from the 1990s indicate that this was then a controversial topic.
One aspect that clearly fueled the debate in the past about the existence of BEV within these properties, however, are the divergent points of view and the multitude of appraisal purposes. Property tax appeals are frequently contentious, with assessors encouraged by the municipalities in which they work to maintain high assessments. However, because personal and intangible values are not taxable, taxpayers benefit from allocating higher percentages of the overall going concern value to those assets.
Similarly, lenders frequently want to lend either exclusively on the real estate, or they charge higher interest rates for the loan component associated with non-realty based assets. Therefore, borrowers and their advocates frequently encourage appraisers to minimize the non-realty components of the allocation. As a result, sometimes very creative, as well as heated arguments have made to dispute even the existence of BEV in appraisals of these property types.
Although many appraisers have long recognized that a successful business operation has value beyond the value of the real estate and personal property, Franz Ross noted that one of the reasons that there have been strenuous disagreement between BEV proponents and naysayers is probably because each group is partly right. By its nature, BEV is present only to the degree that it contributes to value beyond the real estate and the personal property. Therefore, only the more profitable special-purpose properties will effectively include more than a nominal degree of business enterprise value.
In analyzing the income associated real estate-centered enterprises, it must be recognized that each dollar generated by the enterprise effectively lies along a continuum between land, which typically represents the safest component of the income stream, and excess earnings associated with the incremental value of the business concern.
As noted by Ross, what is certain is that the last dollar of net EBITDAR received is the first dollar to evaporate in a downturn. The second-to-last dollar is slightly more likely to be earned again.
It is also possible for the market value of the real estate to exceed the going-concern value of the overall business. This situation would suggest that the business operation should be discontinued in favor of simply maximizing the use of the real estate this scenario too, is not uncommon. Since the client would not know this without an appraisal of the real estate, it is obvious that in some cases a going-concern appraisal needs to be supplemented with a real estate valuation.
So, Which Is It... Is the Excess Earnings Method Hero... or Goat?
According to Gary Trugman in the 4th Ed. Of Understanding Business Valuation, It is commonly accepted in the appraisal community that a business valued as a going concern will generally be appraised based on the earnings or cash flow capacity of the business. Only in limited circumstances would primary weight be afforded to an asset-based approach. The excess earnings method places a great emphasis on net asset values to determine the value of the intangibles.
Mr. Trugman also states on the previous page of the text that "if used correctly, the excess earnings method can be a good method to use. However, the answer is only as good as the information that the valuation analyst uses to calculate it."
With good reason, the business valuation community at large has recognized the many flaws associated with the use of this methodology with respect to the majority of business valuations, The excess earnings method places great emphasis on the net asset values of the business to derive intangible values - even when the net asset values represent a small percentage of the overall value being appraised and oftentimes can not readily or accurately be valued.
As the business valuation industry has matured, it has recognized that a properly developed income approach tends to provide a far more robust and supportable value conclusion that can withstand scrutiny.
In contrast, the appraisal of real estate centered going concern properties, often special purpose properties, has represented a vexing problem for the real estate appraisal industry. An article written by David C. Lennhoff in 2013 "Separating the Real Property from the Tangible and Intangible Personalty in Appraisals" published in The Practical Real Estate Lawyer states,
Usually, estimating the value of real property is fairly straightforward. The appraiser capitalizes the rent for the real property, estimates a depreciated cost of the improvements and adds the site value, or makes a direct comparison to sales of similar real property. These are the three traditional approaches to value identified in nearly every real property appraisal text or course. Sometimes, however, the appraiser is not able to get directly to the real property rent or sales price. In these situations, the valuation of just the real property can get messy. Hotels, regional malls, night clubs, health care facilities—to name just a few—are property types that illustrate the problem. The real property component of these properties is often tightly bundled with other assets, such as tangible and intangible personal property and monetary assets.
Developers don’t build hotels or nursing homes, as a rule, then put the buildings up for rent or sale. Instead, the revenue and sales price represent the total assets of the business. When these property types are the subject of a valuation of just their real property component—in real property tax assessment or condemnation, for example—then the appraiser is forced to begin with the revenue or sales price of the total assets and remove from it that portion attributable to the non-real property components. “If only tangible assets are subject to property taxation, then the value of monetary and intangible assets must be extracted as a first step.” (Gordon V. Smith and Russell L. Parr, Valuation of Intellectual Property and Intangible Assets, 3rd ed. [John Wiley and Sons, 2000], 443.) The need to conduct an allocation is not subject to debate. How the allocation is accomplished, however, can be controversial.
When considering the classic three approaches to value in the consideration of real estate centered enterprises, the cost approach typically yields the least reliable indication of value since these properties are purchased with the intent of realizing future profits. The reproduction cost often bears little relation to the investment value of one of these properties.
The market or sales approach often provides empirical evidence of value for other comparable going-concern properties, however, is often less reliable for isolating just the real estate value since sales of vacant or non-operating properties frequently represent failed businesses or distress situations.