A buyer offers you exactly what your balance sheet says the business is worth — every dollar of equipment, inventory, and receivables, minus every liability — and not a cent more. If you have spent twenty years building a reputation that keeps customers coming back, that offer quietly asks you to hand over the most valuable thing you own for free. The excess earnings method exists to price exactly what book value misses: the earnings your business produces above a fair return on its tangible assets, and the goodwill those extra earnings imply. It is also the method the IRS reaches for when it suspects value is hiding somewhere, so understanding it protects you whether you are selling, gifting shares, or defending a return.
The Idea in One Paragraph
Every valuation approach has to answer the same question: how much of this company's earnings come from the stuff you could sell at auction, and how much come from everything else — the brand, the customer list, the trained crew, the location, the systems? The excess earnings method answers it by splitting your earnings into two streams. The first stream is the return your tangible assets would earn on their own, called the capital charge. Everything left over is excess earnings, attributed to intangible assets. Capitalize that leftover stream into a lump sum and you have goodwill; add it to your tangible asset value and you have the business. One formula does the splitting, a second does the capitalizing, and the argument is almost always about the two rates those formulas need.
Where the Method Comes From: Prohibition, Breweries, and ARM 34
This method was not designed for you. In 1920, the U.S. Treasury Department needed a way to compensate breweries and distilleries for the goodwill that Prohibition was about to destroy, and it published Appeals and Review Memorandum No. 34 — ARM 34 — with the answer. The memorandum's logic was plain: goodwill shows up as earnings above a fair return on net tangible assets, and the value of goodwill rests on that excess. For a century now, appraisers have applied Prohibition-era loss math to operating businesses, which tells you something about both the method's durability and its rough edges.
Two later rulings shaped how it is used today. Revenue Ruling 59-60, issued in 1959, is the foundational guidance for valuing closely held stock for estate and gift tax purposes, and it remains the single most cited piece of valuation literature. Revenue Ruling 68-609 then gave the excess earnings calculation its modern formula and suggested capitalizing excess earnings at roughly 15 to 20 percent, with higher rates for riskier businesses. ARM 34 itself had never defined a rate at all. Note the caveat that travels with the ruling: the method should not be used when better evidence of intangible value is available. The IRS handed appraisers this tool and in the same breath told them to prefer anything better.
The Five Steps, With the Formulas
Appraisers following the method work through the same sequence. Each step has one judgment call that can move the answer more than all the arithmetic combined.
Step 1: Value the adjusted net tangible assets
Start with the fair market value of everything tangible — cash, receivables, inventory, equipment, real estate used in the business — and subtract all liabilities. Then adjust: revalue assets carried at stale book amounts, strip out non-operating assets such as the rental duplex titled in the company name, and remove intangibles already sitting on the balance sheet from a past acquisition. The result is adjusted net tangible assets, the only part of the conclusion anchored to things you could touch.
The judgment call is what counts as operating. Every asset you leave in raises the capital charge in Step 2 and shrinks goodwill; every asset you pull out does the reverse. An appraiser who never asks which assets actually produce the earnings is manufacturing goodwill out of inattention.
Step 2: Compute the capital charge
Multiply the adjusted net tangible assets by a fair rate of return — the return an investor would expect from those assets given their risk and liquidity, often in the 8 to 10 percent range for an ordinary small business:
Excess earnings = Normalized earnings − (Net tangible assets × Fair rate of return)
The product is the capital charge: the slice of your earnings credited to the tangible assets. There is no published table of correct rates, which is the method's original sin — ARM 34 defined none, and a century of practice has produced conventions rather than data. Industry benchmarks and risk-free rates plus a premium are the usual starting points, but two appraisers can defend different rates for the same asset base with equal confidence.
Step 3: Normalize total earnings
Estimate what the business truly earns in a normal year. That means adjusting reported profit for everything that does not reflect ongoing economics: restating the owner's compensation to a market salary, removing one-time legal settlements and insurance windfalls, smoothing unusually good or bad years by weighting several years of results, and repricing related-party rent and supplier deals to arm's length. Small-business books almost always need this surgery, because the tax return was optimized for taxes, not for truth about earning power.
The judgment call is the add-back list. Every normalization is negotiable, and in a dispute each side's expert produces a different normalized number from the same general ledger. Clean books do not eliminate the argument, but they shrink the room it has to roam.
Step 4: Subtract to find excess earnings
Excess earnings are what remains after the capital charge comes out of normalized earnings. These are the earnings attributed to goodwill, brand, customer relationships, and every other intangible working alongside the tangible assets. If the capital charge equals or exceeds normalized earnings, there are no excess earnings and — in the economic sense the method measures — no goodwill.
Step 5: Capitalize the excess and add it up
Convert the annual excess stream into a lump sum by dividing by a capitalization rate:
Goodwill = Excess earnings / Capitalization rate
Business value = Net tangible assets + Goodwill
The cap rate for excess earnings runs higher than the return on tangibles — 15 to 25 percent or more — because earnings from intangibles are riskier and less durable than returns on equipment and receivables. A customer list can walk away; a lathe cannot. Revenue Ruling 68-609's 15 to 20 percent band is the conventional starting point, with speculative or unstable earnings pushed higher. Then add the resulting goodwill to the net tangible assets from Step 1, and finally add back the non-operating assets you stripped out. That total is the indicated business value.
A Worked Example With Small-Business Numbers
Say you own a profitable specialty contracting shop. After adjustments, your net tangible assets are $200,000 and your normalized annual earnings are $70,000. The appraiser assigns an 8 percent fair return to the tangibles and a 20 percent cap rate to the excess.
First the capital charge: $200,000 × 8% = $16,000 of your earnings credited to the tangible assets. Subtract from normalized earnings: $70,000 − $16,000 = $54,000 in excess earnings. Capitalize: $54,000 / 20% = $270,000 of goodwill. Add it back: $200,000 + $270,000 = $470,000 indicated business value.
Notice how much weight the intangibles carry — well over half the conclusion — even though nothing on the balance sheet names them. Now change one input: raise the cap rate to 25 percent and goodwill falls to $216,000; raise the tangible return to 10 percent and the capital charge takes another $4,000 bite out of the excess first. Small rate movements swing the answer by tens of thousands of dollars, which is why every step below about disputing rates matters more than the arithmetic.
When the Answer Looks Wrong
Because the method is so rate-sensitive, it regularly produces results that surprise the owner. Two patterns account for most of them.
Zero or negative goodwill in a business that feels valuable. If the asset base is heavy — expensive equipment, owned real estate, inventory bought at peak prices — the capital charge can swallow normalized earnings whole, leaving nothing to capitalize. The same thing happens when the required return is set high. Before accepting that your life's work has no goodwill, examine the inputs the way a reviewer would: are all the counted assets actually used to produce the earnings, or is idle equipment and an overvalued building inflating the charge? Does the return rate truly match the risk of these assets, or was it borrowed from a very different business? Removing one non-operating property from the asset base can conjure six figures of goodwill back into existence, which says less about the property than about the method.
Goodwill that dwarfs the tangible business. Service firms and professional practices with few assets and strong earnings produce enormous excess almost by construction — a $30,000 asset base throwing off $200,000 in normalized earnings implies goodwill near $1 million at a 20 percent cap rate. Sometimes that is real: the client relationships genuinely are the business. But it is also where personal goodwill hides. If the earnings follow you out the door when you retire — the patients who trust one dentist, the clients who hire one lawyer — a buyer cannot purchase them, and in a divorce or sale the distinction between enterprise goodwill and personal goodwill decides what is actually transferable. An excess earnings conclusion that never addresses whose goodwill it found is unfinished.
Why Many Appraisers Distrust It
Sophisticated valuation professionals use this method reluctantly, and the criticisms are worth knowing before you pay for — or argue against — a report built on it.
First, the split is artificial. Tangible and intangible assets do not earn money separately; they earn it together, as a system. Crediting the equipment with a standalone return and handing the leftovers to goodwill is a modeling convenience, not an observed fact, and no market data tells you what either rate should be. Discount and cap rates under the income approach can at least be built from observable market inputs; the excess earnings method's two rates are conventions defended by assertion.
Second, the inputs are underspecified. The rulings never pinned down which earnings measure to use — pre-tax or after-tax, one year or weighted average, which adjustments are legitimate — so experts facing the same books produce different excess figures and both cite the same authority. That subjectivity is why practitioners call it a method of last resort and why studies of its conclusions find they rarely track what markets actually pay.
Third, the method's own sponsor distrusts it. Revenue Ruling 68-609 says plainly not to use it when better evidence exists, and the IRS has challenged excess earnings conclusions in Tax Court for resting on unsupported rate choices. A method the IRS both endorses and attacks is a method whose results depend entirely on who is wielding it.
None of this makes the method useless. It makes it a rough instrument that demands corroboration — which is exactly how careful appraisers treat it, as one indication weighed alongside income and market approaches rather than a standalone verdict.
When It Still Gets Used
Despite the flaws, the method survives in specific niches where its simplicity outweighs its imprecision. Small businesses and professional practices — medical and dental offices, law and accounting firms — are the classic setting, because modest tangible assets beside strong earnings make goodwill the dominant component and there are rarely good market comparables for a three-dentist practice. Divorce and estate cases use it heavily, partly from tradition and partly because some courts expect to see it. Buy-sell agreements sometimes name it as the pricing mechanism for a departing partner's shares. And even appraisers who lead with a discounted cash flow will run an excess earnings calculation as a sanity check: if the two indications disagree wildly, one of them has a bad input worth finding.
If you encounter the method in any of these settings, ask three questions before accepting the number. Which assets were excluded from the tangible base, and why? What justifies each of the two rates — a cited source, or professional judgment alone? And does the goodwill conclusion separate enterprise value a buyer could own from personal value that walks out with the owner? The answers tell you whether you received analysis or arithmetic.
What This Means for Your Books
Both of the method's independent inputs come straight from your records: the adjusted net tangible assets from the balance sheet, and normalized earnings from years of profit and loss. An appraiser can only adjust what your books identify, so structure now what you will need to prove later. Keep operating and non-operating assets in separate accounts from the day each arrives — the rental duplex and the personal vehicle titled to the company should never share an account with the equipment that earns revenue:
2026-01-01 open Assets:Fixed:Equipment:Operating
2026-01-01 open Assets:Nonoperating:Rental-Duplex
2026-01-01 open Assets:Nonoperating:Personal-AutoDo the same on the earnings side: book one-time items to distinct sub-accounts such as Income:Nonrecurring:Legal-Settlement instead of burying a windfall in general revenue, and split owner compensation so the market-rate portion is visible without reconstruction. When the appraiser asks for three years of add-backs, you hand over account histories; when the other side challenges them, each traces to dated postings. The docs walk through account design and queries if you are setting this structure up, and Fava renders the trend behind your normalized margins well. None of this changes your tax return — it changes what you can prove about your economics, which is what every rate in this method gets applied to.
Your Last Useful Step
Pull your most recent balance sheet and income statement and run the rough version yourself: net tangible assets times 8 percent, subtracted from a normalized earnings figure you compute honestly, capitalized at 20 percent. If the implied goodwill surprises you in either direction, you now know which input to interrogate first — the asset base, the earnings adjustments, or the rates. Bring that skepticism to any appraisal you commission or contest, and demand the corroborating method the IRS itself says should come first.
