Capitalized Excess Earnings or Cash Flow

Family law attorneys are familiar with the Capitalized Excess Earnings (or Capitalized Excess Cash Flow) method to value the tangible and intangible assets and goodwill of a company. The formula itself, though simple, is often misused and misunderstood partly because earnings (on an accrual basis) and cash flow are rarely synonymous. Which then is more appropriate: earnings or cash flow? While earnings (net income) are often used, many valuation analysts believe that cash flow is the best proxy for a company’s economic benefit stream since cash from profits (and not just cash-less profits) is the objective ALL businesses.  However, even within cash flow as a benefit stream, there differences.

The difference in cash flow benefit streams used may produce wide differences in the valuation of a company and its equity, which is the marital asset. My recent valuation of Company X produced a valuation range that was a few hundred thousand dollars apart using two cash flow benefit streams: cash flow after owner’s reasonable compensation and net free cash flow to equity. Which benefit stream is correct? It depends on the purpose of the valuation.

For family law attorneys, a valuation using the cash flow after the owner is paid a reasonable compensation (hereon “gross cash flow”) is more appropriate. For gift and estate attorneys, a valuation using the net free cash flow to equity (hereon “free cash flow”) is more appropriate because it is the “free” or available cash after allowances are made for (1) working capital (cash needed to liquidate ongoing obligations); (2) capital expenditures (cash needed to replace plant and equipment); and (3) the owner’s reasonable salary. The first two allowances, however, are not made in divorce valuations.

The “conceptual” problem with using the gross cash flow is that it ignores the reality of operating a business, which is probably the source of the in-spouse’s income (and therefore the out-spouse’s alimony or maintenance). Paying too much for the business will leave less cash for the business, which may affect the profitability and the going concern of the business. By using gross cash flow would be similar to “killing the goose that lays the golden egg”. There may not be a solution in divorce litigation (unless you could reasonably use a lower valuation multiple for the gross cash flow).  However, in a divorce mediation or collaboration, I would recommend a negotiation range within 20% (plus or minus) of the average values using gross cash flow and free cash flow.  From my experience, reasonable people can successfully negotiate within this range.

Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

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