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Excess Earning Method
This method is similar to the capitalization method described above. The difference is that it splits off return on assets from other earning (the excess earnings). For example, let's suppose Joe's Ice Cream Shop has tangible assets of $50,000. Further let's suppose that Joe pays himself a very reasonable market value salary-- the same amount that he would have to pay a competent manager to do his job. After paying the salary Joe's business has earnings of $120,000.
The $50,000 in assets that will be included in the sale include items such as freezers, inventory, and store fixtures. The buyer's expects to be able to obtain a bank loan for the $50,000 fair market value, secured by those assets at 8%. The rate used in calculations is usually adjusted up by 2-3% from the rate that the bank charges, so we'll use a rate of 10% in this example.
This $6,000 excess earning number is typically multiplied by a factor of 1 to 6 based on such subjective factors as the level of risk involved in the business, the attractiveness of the business and the industry, competitiveness, and growth potential. The higher the factor used, the higher the estimate of the business will be. An average number is 3. That is, a business that is judged to be very average in terms of the level of risk involved, the attractiveness of the business, the industry, competitiveness, and growth potential would use three as a multiplier. The actual factor used is a mix of opinion, comparison to others in the industry, and industry outlook.
We have built a free valuation calculator located at www.freevaluationsonline.com it will ask a series of questions to determine an appropriate multiple for your business. A more detailed analysis, that accounts for many more of the non-financial factors that affect the value of a business is available at EzValuation.
Let's suppose that Joe's business is a bit better than average in these factors and assign a multiplier of 4. Therefore, the value of this business can be determined as follows:
| Fair market value of tangible equipment | $50,000 |
| Total Earnings | $120,000 |
| Minus carrying cost of Tangible assets $50,000X10%= | -$5,000 |
| Excess Earnings | $115,000 |
| Value of excess earnings $115,000X4= | $460,000 |
| Estimated Total Value | $460,000 |
*An alternative approach to using a rate 2 to 3 points above the current bank rate for a small business loan, or about 5 points above the current prime rate is to find an industry appropriate rate for return on assets.
The capitalization methods work for businesses that derive their income primarily from tangible assets such as a utility (gas or electric company). In the case of most small businesses that earn only a small part of their revenues from tangible assets, the excess earning method is probably a better method to use.
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