The Excess Earnings Method is a common method used to value intangible assets. What is the method and how is it applied? This article provides an overview of these matters.
What is the Excess Earnings Method?
The Excess Earnings Method is classified as an income valuation approach by the International Valuation Standards, meaning that the method involves converting future cash flows to a current single value.
This method applies a value to intangible assets after excluding the proportion of cash flows attributable to other assets which are required to generate those cash flows. For example, if an intangible asset is one component of a broader business, this method would require that the cash flows only directly derived by virtue of the business holding the intangible assets be identified and used as the basis for conducting a valuation calculation.
The Excess Earnings Method can be applied with reference to several periods of forecasted cash flows or a single period of forecasted cash flows, with the latter more common owing to the significant difficulties that can arise in accurately forecasting business and intangible asset related cash flows into the future.
How is the Excess Earnings Method Applied?
The Excess Earnings Method has multiple steps in its application, which are summarised as follows:
- Forecasting future cash flows and expenses to be derived from the subject intangible asset and other assets which contribute to the generation of cash flows;
- Identify what assets assist the intangible assets to derive cash flows (often referred to as the contributory assets);
- Determine the appropriate rate of return on each contributory asset based on an assessment of the risk associated with that asset;
- In each forecast period, deduct the required returns on contributory assets from the forecast profit to arrive at the excess earnings attributable to only the subject intangible asset, and;
- Determine the appropriate discount rate for the subject intangible asset and present value or capitalise the excess earnings.
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Groves & Partners are expert business transaction advisors and valuers, with significant experience in valuing intangible assets including through application of the Excess Earnings Method.