Page 48 - FINAL CFA II SLIDES JUNE 2019 DAY 8

LOS 33.f: Calculate the value of a READING 33: PRIVATE COMPANYVALUATION
private company using free cash flow,
capitalized cash flow, and/or excess
earnings methods. MODULE 33.2: INCOME-BASED VALUATION

The Excess Earnings Method
Excess earnings are firm earnings minus the earnings required to provide the required rate of return on working capital and fixed
assets. The value of intangible assets can be estimated as the present value of the (growing) stream of excess earnings (using
the excess earnings and the growing perpetuity formula from the CCM. This value for the intangible assets is added to the values
of working capital and fixed assets to arrive at firm value.
The excess earnings method (EEM) is used infrequently but can be used for small firms when their intangible assets are
significant. However, the required return for working capital and fixed assets is subject to estimation error.

EXAMPLE: Given the following figures, calculate the value of the firm using the EEM.

Step 1: Calculate the required return for working capital and fixed assets.

• working capital: $300,000 × 6% = $18,000
• fixed assets: $1,000,000 × 10% = $100,000

Step 2: Calculate the excess earnings.
excess earnings = $130,000 − $18,000 − $100,000 = $12,000

Step 3: Value the intangible assets.
value of intangible assets = ($12,000 × 1.05) / (0.14 − 0.05) = $140,000

Step 4: Sum the asset values.
firm value = $300,000 + $1,000,000 + $140,000 = $1,440,000