One method is called the excess earnings approach. Using
this approach, the total earning power that the company commands is
computed. The next step is to calculate "normal earnings" by
determining the normal rate of return on assets in that industry. The difference between what the firm earns and
what is normal in the industry is referred to as the excess earning
power. This extra earning power indicates that there are
unidentifiable values (intangible assets) that provide this
increased earning power. Finding the value of goodwill then is a
matter of discounting these excess future earnings to the
present.
This approach appears to be a systematic and logical
way of determining goodwill. However, each factor necessary to
compute a value under this approach is subject to question.
Generally, the problems relate to getting answers to the following
questions:

What is a
normal rate of return?


How does one
determine the future earnings?


What discount
rate should be applied to the excess
earnings?


Over what
period should the excess earnings be
discounted?

Finding a Normal Rate of return
Determining the normal rate of return for tangible and
identifiable intangible assets requires analysis of companies
similar to the enterprise in question. An industry average may be
determined by examining annual reports or data from statistical
services. Suppose that a rate of 15% is decided as normal for a
concern such as Tractorling (as discussed in the text). In this
case, the normal earnings are calculated in the following manner.
Illustration 1:

Calculation of Normal
Earnings




Determining Future Earnings
The starting point for determining future earnings is
normally the past earnings of the enterprise. Although estimates of
future earnings are needed, the past often provides useful
information concerning the enterprise's future earnings potential.
Past earningsgenerally 3 to 6 yearsare also useful because
estimates of the future are usually overly optimistic; the hard
facts of previous periods bring a sobering reality to the
negotiations.
Tractorling's net earnings for the last 5 years are as
follows:
Illustration 2:

Calculation of Average
Earnings




The average net earnings for the last 5 years is
$75,000 or a rate of return of approximately 21.4% on the current
value of the assets excluding goodwill ($75,000 ÷ $350,000). Before
we go further, however, we need to know whether $75,000 is
representative of the future earnings of this enterprise.
Often past earnings of a company to be acquired need
to be evaluated on the basis of the acquirer's own accounting
procedures. Suppose, that in determining earnings power,
MultiDiversified measures earnings in relation to a FIFO inventory
valuation figure rather than LIFO, which Tractorling employs, and
that the use of LIFO reduced Tractorling's net income by $2,000 per
year. In addition, Tractorling uses accelerated depreciation while
MultiDiversified uses straightline. As a result, Tractorling's
earnings were lower by $3,000.
Also, assets discovered on examination that might
affect the earnings flow should be considered. Patent costs not
previously recorded should be amortized, say, at the rate of $1,000
per period. Finally because the estimate of the future earnings is
what we are attempting to determine, some items, like the
extraordinary gain of $25,000, probably should not be considered. An
analysis can now be made as follows:
Illustration 3:

Calculation of Adjusted Net
Earnings




The excess earnings would be determined to be $21,500
($74,000  $52,500).
Choosing a Discount Rate to Apply to Excess
Earnings
Determining the discount rate is a fairly subjective
estimate. The lower
the discount rate, the higher the value of the goodwill and vice
versa. To illustrate, assume that the excess earnings are
$21,500 and that these earnings will continue indefinitely. If the
excess earnings are capitalized at, say, a rate of 25% in
perpetuity, the results are:
Illustration 4:

Capitalization of Excess
Earnings at 25% in
Perpetuity




If the excess earnings are capitalized in perpetuity
at a somewhat lower rate, say 15%, a much higher goodwill figure
results.
Illustration 5:

Capitalization of Excess
Earnings at 15% in
Perpetuity




Because the continuance of excess profits is
uncertain, a conservative rate (higher than the normal rate) is
usually employed. Factors that are considered in determining the
rate are the stability of past earnings, the speculative nature of
the business, and general economic conditions.
Choosing a Discounting Period for Excess
Earnings
Determining the period over which excess earnings will
exist is perhaps the most difficult problem associated with
computing goodwill. If it is assumed that the excess earnings will
last indefinitely, then goodwill is $143,333 as computed in the
previous section (assuming a rate of 15%).
Another method of computing goodwill that gives the
same answer, using the normal return of 15%, is to discount the
total average earnings of the company and subtract the fair market
value of the net identifiable assets as shown in Illustration 6.
Illustration 6:

Capitalization of Average
Earnings Less Fair Value of Net
Assets




Frequently, however, the excess earnings are assumed
to last a limited number of years, say 10, and then it is necessary
to discount these earnings only over that time. Assume that
MultiDiversified believes that the excess earnings of Tractorling
will last 10 years and, because of the uncertainty surrounding this
earning power, uses 25% as an appropriate rate of return. The
present value of an annuity of $21,500 ($74,000  $52,500)
discounted at 25% for 10 years is $76,766. That is the amount that MultiDiversified
should be willing to pay above the fair value of net identifiable
assets.
The fair value of Tractorling's assets (rather
than historical cost) is used to compute the normal profit,
because fair value is closer to the true value of the
company's assets exclusive of
goodwill.

The present value of an annuity of one dollar
received in a steady stream for 10 years in the future
discounted at 25% is 3.57050 (3.57050 × $21,500 =
$76,766).

One article lists three "assetbased approaches"
(tangible net worth, adjusted book value, and pricebook value
ratio methods) and three "earningsbased approaches"
(capitalization of earnings, capitalization of excess
earnings, and discounted cash flow methods) as the popular
methods for valuing closely held businesses. See Warren Rissin
and Ronald Zulli, "Valuation of a Closely Held Business," The
Journal of Accountancy, June 1988, pp.
3844.

Tim Metz, "Deciding How Much a Company Is Worth
Often Depends on Whose Side You're On," The Wall Street
Journal, March 18,
1981.

