Originally formulated by the IRS in 1920 to value distillaries seized by the government during prohibition, this old ghost still haunts the courts today.  It is essentially an attempt to separate and value the intangible assets of a company.  That is,  to calculate the worth of a company above and beyond the market value of its tangible assets.  Although the process can get messy, it essentially uses the following method:

a)  Determine the income produced by assets using a ‘normal’ rate of return. 

b)  Determine a ‘normalized’ anticipated income using historical income. (Normalized simply means omitting unusual events, such as the sale of discontinued operations and using the average of the most recent years – methods can vary but the goal is to determine what ‘normal’ income can be expected from the business in the future).

Subtract a) from b) and divide by a capitalization rate to arrive at the ‘value’ of the intangibles

Add this amount to the market value of the tangible assets to arrive at a final valuation.

What’s wrong with this picture?  Let me count the ways:

How do you determine a ‘normal’ rate of return on assets?  In manufacturing, you might find a sufficient amount of data to take a swing at this but even in this sector, you’re assuming a homogeneity among companies that might have existed in 1920 but has long since evaporated.

In service industries, most assets are not income producing – employees are.  How do you take this difference into account?  For example, a high end attorney’s office might have $200,000 worth of furniture, fixtures, and build-outs – how do you determine a rate of return on these ‘tangible’ assets?

How do you determine a reasonable capitalization rate?  That is, what returns do other similar companies generate on their excess earnings? (think of excess earnings as anything over the amounts produced by tangible assets).  This rate is extremely significant.  For example, if you have $100,000 of excess earnings and you use a 10% capitalization rate, that would mean $1 million added to the worth of the assets for a sales price.  Conversely if you use a 50% capitalization rate, you would only add $200,000.

The truth is, there is just too much subjectivity inherent in this method.  Even the IRS has debunked it:

From the IRS Appellate Conferee Valuation Training Program:

“To attempt to segregate value based on earnings as between normal income and that induced by whatever goodwill or other intangible assets the business may possess, is to aspire to a higher degree of clairvoyance than has yet been demonstrated as obtainable  by mere man”

Ouch! Furthermore, this method is so subjective, that it has been abused by unscrupulous business valuators in court contested properties to manufacture an artifically high or low valuation – depending upon whose ox is being gored. The IRS further stated, in Revenue Ruling 68-609:

“The ‘formula’ approach may be used for determing the fair market value of intangible assets of a business only if there is no better basis therefor available”

It should be noted that this method is still used in some court cases and there are many business brokers who still support this method.  I am not one of them.