The Excess Earnings Method- Should It Be Put out to Pasture in Equitable Distribution Cases?

Introduction. Historically, accountants in a local community, many of whom lacked any formal training in valuation, have prepared the majority of divorce valuations. Since the excess earnings method is simple and easy to understand, many tended to use this method. Over time as this method was frequently used it became the ones judges understood and saw used over and over again, leading to its institutionalization as one of a number George Hawkins of accepted methods. This does not mean it is a good or valid method. This article will explain the method and give a simplified example of its use. It will then summarize the significant problems with the method and the many leaps of faith required to use it. It is hoped that this article can be an agent of change to enlighten those who must review valuations, whether in or out of court, to the method’s serious flaws and illustrate why other better methods are available and why the excess earnings method should never be used. It is a faulty and intellectually bankrupt valuation model that leads to unreliable estimates of value. The method has largely fallen out of favor in the valuation field among sophisticated valuators. The only appraisers that continue to use it are those who don’t know better, are ignorant of modern valuation methodologies, or, in the worst case, use the model because it can be easily manipulated to give a value that benefits a client’s desired outcome. The latter reason is advocacy and is totally unacceptable since appraisers must be unbiased. Overview of the Excess Earnings Method. The excess earnings (“formula method”) method, as originally described in IRS Appeals and Review Memorandum 34, was developed at the onset of Prohibition as a way to determine the value of distilleries for the purposes of compensating the brewer for the loss in value of their company. Later reaffirmed by IRS Revenue Ruling 68-609 (in 1968), it is really a hybrid of the cost (where value is based on a company’s assets) and income valuation (where value is based on the present worth, in today’s dollars, of a company’s anticipated future earnings or cash flows) approaches. This is because it involves the determination of the portion of a company’s earnings that may be assumed separately to be the result of its tangible and intangible assets of the practice. Intangible assets are also referred to collectively as goodwill, and include assets such as the name, reputation, a skilled and trained workforce and other similar items. The Method, Step-by-Step. The method involves the multiplication of the market value of the company’s net tangible assets by a percentage annual rate of return these assets might reasonably be required to earn. This results in the annual portion of the company’s earnings that are theoretically attributable to its tangible assets. These earnings that are derived from the tangible assets are then deducted from the company’s total earnings to give that portion of the earnings that are leftover and theoretically stem from the company’s intangible assets (also known as goodwill). By dividing these earnings from intangibles by a capitalization rate applicable to intangibles, the total intangible value (or goodwill value) of the business is