The Multi-Period Excess Earnings Method (MPEEM)

 

                                The Multi-Period Excess Earnings Method (MPEEM)

The Multi-Period Excess Earnings Method (MPEEM) is a valuation approach used to estimate the fair value of intangible assets. It is a variation of the excess earnings method, which is used to determine the value of a business based on the expected future earnings that exceed a reasonable rate of return on the company's net tangible assets.

 

The MPEEM method involves estimating the cash flows that will be generated by the intangible asset over its useful life, and then calculating the present value of these cash flows. The cash flows are calculated by estimating the excess earnings that the intangible asset is expected to generate over and above a normal rate of return on tangible assets. This excess earnings are then projected over a number of periods into the future, using appropriate growth rates and discount rates.

 

To estimate the excess earnings, the MPEEM method involves a number of steps. First, the intangible asset's historical earnings are adjusted to remove any earnings attributable to tangible assets. This adjustment is made to reflect the fact that tangible assets have their own normal rate of return, which should be accounted for separately. Next, a reasonable rate of return on tangible assets is estimated, which is subtracted from the intangible asset's adjusted earnings to arrive at the excess earnings.

 

The excess earnings are then projected into the future, using a suitable growth rate, which takes into account the expected growth of the industry or market in which the intangible asset operates. Finally, the present value of the projected excess earnings is calculated, using a discount rate that reflects the risk associated with the intangible asset.

 

The MPEEM method is often used to value intangible assets such as patents, trademarks, customer relationships, and non-compete agreements. It is particularly useful when the intangible asset generates cash flows that are expected to be stable over a number of years. However, the MPEEM method does have some limitations, such as the need to make assumptions about future growth rates and discount rates, which can be difficult to estimate accurately.

 

 

Suppose a company owns a patent on a new technology that it expects to generate significant revenues over the next 10 years. The company wants to determine the fair value of the patent for accounting purposes. The MPEEM method could be used to value the patent as follows:

 

1. Estimate the excess earnings: The Company would begin by estimating the expected cash flows generated by the patent over the next 10 years. To calculate the excess earnings, the company would subtract a reasonable rate of return on tangible assets from the estimated cash flows. For example, if the company estimates that the patent will generate $1 million in cash flows each year over the next 10 years and the reasonable rate of return on tangible assets is 8%, the excess earnings would be $200,000 ($1 million - 8% x $12.5 million). Assuming $ 12.5 million total value of company’s tangible asset.

 

2. Project the excess earnings: The excess earnings would then be projected into the future, using a suitable growth rate. For example, if the company expects the industry to grow at a rate of 4% per year over the next 10 years, it might use a growth rate of 3% for the patent. The projected excess earnings over the next 10 years would be $2.3 million ($200,000 x (1.03)^10).

 

3. Calculate the present value of the excess earnings: The present value of the projected excess earnings would be calculated using a discount rate that reflects the risk associated with the patent. For example, if the company estimates that a suitable discount rate for the patent is 10%, the present value of the excess earnings over the next 10 years would be $1.5 million ($2.3 million / (1.10)^10).

 

4. Add the present value of the excess earnings to the value of tangible assets: Finally, the present value of the excess earnings would be added to the value of the company's tangible assets to arrive at the total value of the company. For example, if the company's tangible assets are worth $10 million, the total value of the company would be $11.5 million ($10 million + $1.5 million).

 

This is a simple example, and the actual calculations used in the MPEEM method can be much more complex depending on the specifics of the intangible asset and the company's circumstances. However, this example gives a general idea of how the MPEEM method can be used to value an intangible asset.