AAML Article & What’s Really Wrong with the Excess Earnings Method?

November 03, 2006 | Complex Financial Issues, Divorce, Legal Perspective

Icon for author Brian Vertz Brian Vertz

The recent edition of the Journal of the American Academy of Matrimonial Lawyers contains an interesting article describing various approaches to personal and enterprise goodwill. There is a handy list of which states consider goodwill (both types) to be separate property, which states consider goodwill to be marital property, and which states distinguish between the two types of goodwill.

The third section of the article describes five different valuation approaches and how goodwill might be computed in each of those approaches.

In describing the valuation methods, the author praises the excess earnings method and its cousin, the Treasury method, as superior to the other methods “invented by biased experts for the purposes of . . . giving larger values to businesses.” This phrase was quoted from a leading divorce treatise by Brett R. Turner, entitled Equitable Distribution of Property.

It is a terrific book, and I keep a copy in my law firm’s library, but on this topic, I think it is wrong. The excess earnings approach and Treasury approach are generally regarded by the valuation community as theoretically weak and flawed. These were among the first methods developed by valuation experts in the 1920’s, but were left behind long ago. Unfortunately, these seem to be the most prevalent methods in divorce litigation.

In the article, the author cites one court’s criticism of the excess earnings method, in which a Maryland court complained of “double counting.” The Maryland court claimed that the excess earnings method was flawed because it regarded the owner’s future compensation both as income and as part of the value of the business. Turner, in his book, correctly noted that this criticism is unjustified. There is no double dip because the owner’s compensation is excluded from the excess earnings which are capitalized in the business valuation. To avoid the double dip in alimony and child support determinations, the court should exclude any business income that exceeds the owners’ compensation as used in the business valuation.

There is a double dip in the excess earnings method, however. The value which is calculated in most divorce cases is a going concern value, which assumes that the business will continue to operate and generate profits in perpetuity. The tangible assets of a business – its receivables, inventories, equipment, supplies – all will be consumed and replaced, over and over, in the production of an earnings stream over an infinite period of time. Nothing lasts forever. There is no residual value.

But the excess earnings approach carves out a separate value for the hard assets and adds that value to the capitalized earnings stream of a going concern business. That is a double dip.

Another problem with the excess earnings approach is the capitalization rate. The most common method of an appropriate capitalization rate, which measures the risk of certain investments
compared to other investments, is called the Ibbotson build-up method. The risk-free rate, which is generally equal to the yield on long-term government bonds, is added to an equity risk premium, a size premium, an industry risk premium, and a specific company premium. All but one of those elements is published annually in a statistical study by Ibbotson Associates.

The result of an Ibbotson build-up calculation is called an after-tax net cash flow discount rate, which is easily converted to an after-tax net cash flow capitalization rate. Several more steps are required to convert this rate into an after-tax intangible capitalization rate, which is used in the excess earnings method. The conversion from a net cash flow capitalization rate to an intangible capitalization rate involves additional levels of subjectivity, so the excess earnings approach is actually more subjective than other methods of valuation (not less subjective, as suggested by Turner).

In his discussion of the Treasury method, Turner exaggerates the level of acceptance this method enjoys outside of divorce cases. I doubt that the excess earnings method is prevalent in IRS valuations. That was once true, in the days of Prohibition when it was the only recognized method, but it is not true today. NACVA teaches that the excess earnings approach should not be used outside of divorce cases, and in those cases, only because it is widely accepted by the courts.

Perhaps it is time for us to present better valuation methods to the divorce courts and point out the flaws of the excess earnings method. I chafe when I hear divorce lawyers accuse valuation experts of tailoring their opinions to their clients’ expectations (see note 41 of the AAML article). Why should we believe they are less ethical than we?

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