The Capitalization of Earnings versus Capitalization of Excess Earnings Methods

The capitalization of earnings method is an approach acknowledged by the IRS that converts a single income data point to an indication of value. It can be applied to historical, current, or expected income, as represented by earnings, EBIT, EBITDA, free cash flows to equity or invested capital. This method assumes all of the assets of the subject company, tangible and intangible are indistinguishable operating parts of a single enterprise. Ideally, this approach works in valuing profitable businesses where the investor seeks returns over and above a reasonable compensation; it works best for businesses that are not capital intensive.

I’ve used the capitalization of earnings method primarily in valuing professional services firms, which lack robust projections. I’ve only used this method for tax or Fair Market Value projects. According to Pratt, Reilly and Schweihs, in their book Valuing Small Businesses and Professional Practices, the value indication provided by the capitalization of earnings method is fair market value, where the capitalized economic income, and the capitalization rate reflect the condition of the subject company on a stand-alone basis, rather than with built-in synergies peculiar to a particular investor or market participant.

For me, one of the biggest challenges in valuing a company using the capitalization of earnings method is choosing whether to value the company on an enterprise or equity basis. It’s a little easier to apply the method to free cash flows to equity. Specifically, the equity approach remains consistent with the data most often found on long-term growth assumptions, used to devise capitalization rates. Generally, the industry research we find provides long-term growth assumptions applied to growth in equity, rather than invested capital. This point is particularly relevant in calculating a capitalization rate, using a discount rate minus long-term expected growth. So what’s the best growth rate to imply, and what’s the basis for a long-term growth rate?

If I’ve got Invested Capital in the numerator, divided by the sum of the discount rate (WACC) minus a growth rate (i.e. the capitalization rate), I’ll come up with wildly different results than the output by using free cash flows to equity, divided by the sum of an equity hurdle rate minus the growth rate. In other words, the outcome is more sensitive to the growth rate applied to invested capital than applied to equity. This is true because the discount rate applied to invested capital (WACC) is lower than an equity hurdle rate.

Tax courts have generally rejected a CAPM or WACC as inappropriate in valuing closely-held businesses (Furman v. Commr., T.C. Memo 1998-157, Hendrickson v. Commr., T.C. Memo 1999-278). The Court in Furman specifically stated: “we do not believe that CAPM and WACC are the proper analytical tools to value a small, closely held corporation with little possibility of going public. CAPM is a financial model intended to explain the behavior of publicly traded securities that has been subjected to empirical validation using only historical data of the two largest U.S. stock markets.” That leaves us with a build-up method, wherein we have to consider expected inflation as an upward adjustment to the calculated discount rate, and simultaneously reduce our long-term growth rate to reflect the impact of expected inflation.

Now, we’re left some remaining challenges, like determining whether or not we’re evaluating income the investor has the ability to control; are we coming up with a control or minority interest? If it’s control we’re after, we have to normalize earnings to factor-in compensation to owners/operators. The compensation should be consistent with what we’d expect to see in the market for similar services. Now, we need to come up with a discount/capitalization rate that’s consistent with the earnings we’re evaluating. Then consider the extent to which we weight prior year earnings, for example an equally weighted average of all prior years, or a weighted average emphasizing the most recent year?

Remember, we can use a proxy of historical, current or estimated future earnings. Is the ideal data-point best represented by the most recent year’s income, or some variation of prior year earnings?

The capitalization of earnings method is not to be confused with the capitalization of excess earnings method, which is best utilized for the purpose of allocating total value between intangible and tangible assets. The capitalization of excess earnings method uses an income and an asset approach to arrive at the total value of a privately held business. This method relies on the assumption that the total value of a business is the sum of adjusted net assets, and the value of intangible assets. The capitalization of excess earnings is considered a reasonable method of valuing closely-held businesses, and is often referred to as the Treasury method or IRS method, because it was originally blessed by the Treasury Department, and later codified in Revenue Ruling 68-609.

The value computed under the capitalization of excess earnings method is generally close to the value derived by the capitalization of earnings method. The capitalization of excess earnings approach is widely criticized but used regularly in certain circumstances, such as (1) divorce cases, where personal goodwill is considered a personal rather than marital asset; (2) conversions from C corporations to S corporations; and (3) other situations where tangible and intangible values need to be recognized separately. In a nutshell an appraiser must determine:

  1. Average annual earnings (adjusted for appropriate owner compensation and perquisites as above)
  2. Average fair market values of the tangible and intangible assets of the business (3 to 5 years)
  3. Appropriate rates of return on the various assets (tangible and intangible) of business- need to determine rate of returns separately
  4. Appropriate capitalization rate to apply to “excess earnings” Normally higher than equity rate
    • Subtract expected normal dollar returns on assets from total average annual earnings
    • Capitalize excess earnings
    • Add value of tangible assets to capitalized excess earnings for total value of business