Capitalized Excess Earnings and Rules of Thumb

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Capitalized Excess Earnings and Rules of Thumb

• Galbraith, EBD 481 Fall, 09

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CAPITALIZED EARNINGS

• Compute Cap-rate (approximation of Present value
  under two conditions)
• constant cash flows (constant growth)
• Nlarge
• Apply to last periods earnings
• Often use an average of several past periods,
  weighted to more recent
• Appropriate for stable firms

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Formulas for Capitalized Earnings
D1 PV0 --------------
Dr - g
Where g is constant growth
D0(1 g) PV0 --------------
Dr - g
OR
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CAPITALIZED EXCESS EARNINGS

• Values goodwill
• Used in Professional Practice Valuation, etc.
• Only technique that uses balance sheet plus
  income statement
• 5-step process
• compute normal return on assets (ROA)
• compute normal (expected earnings)
• compute excess earnings
• compute value of excess earnings (cap rate)
• compute value of company (value of excess
  earnings plus net tangible assets)
• NTA is difference between tangible assets and
  liabilities
• Note the difference in ROA to compute normal
  return on assets, but NTA to compute value of firm

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GOODWILL

• Three basic types of goodwill
• Institutional Goodwill
• 15-25 risk
• Organizational Goodwill
• 25-35 risk
• Personal Goodwill
• 35-75 risk
• Use weighted average of different classes of
  goodwill
• ask the principal what influences customers to
  buy from business)

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Rules of Thumb

• Ad hoc but commonly used formulas
• Non theoretical
• Specific to particular industries
• May be self fulfilling prophesies
• http//businessbookpress.com/catalog/b901.htm