How do you worth goodwill?
When you want to buy or sell a company, its value is more than the assets it holds. One of the intangible assets that need to be valued is goodwill – the magic sauce that gives one company a higher valuation than another that appears to be similar.
Goodwill is the value someone is willing to pay for a company in excess of the value of their assets. This includes the strength of a company’s brand, customer databases, and the aspects of a company that add value to the buyer.
For most companies, the value of goodwill is tied to current and future earnings. What are the company’s future profits and can this profitability be increased? This is sometimes referred to as a “super win”.
How do you value goodwill?
When calculating goodwill, your accountant typically starts working on the company’s income statements within the last three years. Some adjustments may be required to arrive at the profits for the goodwill calculation, sometimes referred to as average recoverable profits.
The most common adjustment involves making payments to the owner or manager in excess of a reasonable salary for the job they do.
Once you have the average recoverable income, you also need to figure out the value for money, which is common for the industry you are investing in.
As a rough rule of thumb, most private companies offer about half the price-performance ratio of listed companies in the same branch or branch. The company valuation is “earning times multiple”, whereby the goodwill represents the difference between this and the fair value of the assets.
Goodwill can work both ways
One word of caution: it’s also important to note that goodwill can work either way. Negative goodwill is when the consideration paid for the assets is less than the assets acquired. Items like off-balance sheet debt, pension obligations and future earnings that may not be as high as expected could push valuations down and into negative territory.
Although ratings are often presented as precise calculations, they must be viewed with caution. In the end, a company is only worth what a willing buyer is willing to pay and what a willing seller is willing to accept.
Once a goodwill valuation has been established and net worth reported, the next thing you should do is view the sum of net assets and goodwill and find out if the company represents good value given its future earnings potential.
Goodwill is the magic ingredient when a company is bought for more than the net worth of its assets. The buyer has to consider how much money he can raise.
James Johnson is a director with Hiller Hopkins
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