Capitalized Excess Earnings
Greg A. Raffaele CPA CVA FCPA
Family law attorneys are familiar with the Capitalized Excess Earnings (or Capitalized Excess Cash Flow) method to value the tangible and intangible assets and goodwill1 of a company. The formula2 itself is simple, but is often misused and misunderstood partly because earnings and cash flow are rarely synonymous (see table below). Which then is more appropriate: earnings or cash flow? Many valuation analysts believe that cash flow is the best proxy for a company’s (economic) benefit stream. However, other benefit streams, such as net income (earnings) are often used.3
The difference in benefit streams used may produce wide differences in the valuation of a company and its equity. To illustrate this point, my recent valuation of Company X produced a valuation range of its equity from zero to $521,500 using four different benefit streams. Which benefit stream is correct? It depends on the purpose of the valuation. For family law attorneys, the gross cash flow is more appropriate because it is closer to the owner’s discretionary cash flow. For gift and estate attorneys, the equity capital net free cash flow is more appropriate because it is the “free cash” available to the owner after allowances for working capital (cash needed to liquidate ongoing obligations) and capital expenditures (cash needed to replace plant and equipment) are made. Both benefit streams assume that a reasonable salary is paid to the owner.
The problem with using the gross cash flow is that it ignores the reality of operating a business, which is probably the source of the in-spouse’s compensation. Paying too much for the business will leave less cash for the business, which may affect the profitability and the going concern of the business. The solution: In a mediation or collaboration, I would recommend a negotiation range between $320,000 and $420,000 because it is within 15% of the average normalized value of $364,000. In my experience, reasonable people can successfully negotiate within this range.
| Value (3) | ||||
| Economic Benefit Stream | LFY 2006 (1) | Normalized (2) | LFY 2006 | Normalized |
| Sales | $3,000,000 | $2,800,000 | ||
| Net Earnings | $43,000 | $69,000 | $129,000 | $207,000 (8) |
| Gross Cash Flow (4) | $61,000 | $149,000 | $213,500 | $521,500 (8) |
| Operating Cash Flow (5) | $106,000 | $117,000 | $371,000 | $409,500 (8) |
| Operating Cash Flow (6) | $47,000 | $136,000 | $164,500 | $476,000 (8) |
| Equity Capital Net Free Cash Flow (7) | ($19,000) | $59,000 | $0 | $206,500 (8) |
| Average | $219,500 | $364,100 (8) | ||
(1) Latest Full Year. Company X is on a calendar year.
(2) Weighted Average. Adjusted for the business cycle of Company X over four years.
(3) Different multiples for different benefit streams. Ignores value of net tangible assets for ease of illustration.
(4) Formula: Net earnings adjusted for depreciation.
(5) Historical Cash Flow Statement: Net earnings adjusted for depreciation and working capital.
(6) Formula: Net earnings adjusted for depreciation and working capital.
(7) Formula: Net earnings adjusted for depreciation, working capital, capital expenditures and net borrowings.(8) Value of Company X's equity.
1Intangible assets and goodwill are not synonymous. Intangible assets can be identified and separated from goodwill. Goodwill may be enterprise or personal (professional). Personal goodwill is subject to the daily efforts of the owner.
2Formula: Earnings (or Cash Flow) in Excess of Return on Tangible Assets Divided Return on Intangible Assets and Goodwill Plus Net Tangible Assets.
3Financial Valuation, Applications and Models, 2nd Edition (2006).
Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.
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