What Is Goodwill? – Definition
Goodwill is reported in financial statements only if its valuation can be supported by a transaction involving the purchase of a firm. However, the existence of this unidentifiable asset should not be ignored by the potential buyer or seller in negotiating the amount to be paid for the firm. Even though the estimated numbers do not appear in the balance sheet, an accountant can be involved as a consultant to the buyer or seller in estimating the value of the firm. The estimate is typically based upon projections of future benefits to be received by the purchaser.
Valuation of Goodwill
Future benefits can be defined as the earnings generated during the assets’ lives. Some methods of valuing a firm use compound interest techniques to discount future earnings. However, these approaches are inappropriate because earnings do not represent future fund flows. That is, depreciation and similar expenses reduce earnings but not funds. Present value techniques are based on an assumption that the future amounts to be discounted are equal to a return of the investment plus a return on the investment.
Earnings, however, represent only the return on the investment. Therefore, a more appropriate measure of future benefits is fund flows which can be computed by adding non-fund expenses to earnings. This amount is provided for past periods on the SCFP.
There are two different approaches to estimating the value of a firm. First, the business can be treated as a single unit, the value of which is determined by the present value of future fund flows. Second, the value of the business can be estimated by aggregating the values of the individual assets and liabilities, including identifiable and unidentifiable components.
Entire Firm Valuation Approach
Because there usually are no well-established market values for entire firms, estimation of the value of a business is perhaps best determined by discounting its future fund flows using the buyer’s minimum desired rate of return. An estimate of the value of goodwill can be made by subtracting the value of identifiable assets from the present value of the entire firm; however, the main purpose of the analysis is to determine the firm’s value, not the goodwill. The following example illustrates this method.
Example (How to Estimate Goodwill)
Suppose that the management of Sample Company is considering the purchase of ABC Company. According to the best estimates available, the future net fund flows from the purchased company would be as follows:
If the Sample Company managers seek a 12 percent rate of return, the present value of the future fund flow is found as follows (rounded to the nearest million dollars):
This indicates that the entire firm is worth approximately $71,000,000 to Sample Company. The amount of goodwill is estimated to be $71,000,000 less the fair values of the assets less the liabilities. If, for example, the market value of the firm is estimated to be $48,000,000, the goodwill is approximately $23,000,000. This number, however, should not be confused with the number that will actually be recorded by Sample Company for goodwill.
That amount will be the difference between the total actually paid and the fair value of the identifiable assets and liabilities. If Sample’s offer of $50,500,000 cash and assumption of $4,000,000 of liabilities is accepted, this entry would be recorded:
A frequently used shortcut approach to approximating the value of a firm is capitalization of earnings. This approach estimates the value of the business by assuming that earnings are achieved at a specified rate of return on the firm’s assets. If the earnings and desired rate of return are known, the investment can be computed using the following formula:
Income = Investment x Rate of return
Investment = Income / Rate of return
For example, assume that the average annual earnings for ABC Company have been $7,800,000 and future earnings are expected to remain at that level. If the desired rate of return is 12 percent, the value of a firm that would generate $7,800,000 of earnings each year would be:
Investment = $7,800,000 / .12 = $65,000,000
This method is frequently used because it is easy to apply. However, it does not allow for uneven future cash flows or a limited life of the investment. The discounted fund flow approach is conceptually superior, but the capitalization of earnings approach may yield satisfactory results.
Valuation of Components Approach
A different approach to finding a firms’ value aggregates the estimates of values for its individual components, including identifiable and unidentifiable assets and liabilities to be assumed.
The advantage of using a components approach as opposed to valuing the entire firm as one present value is the ability to use different discount rates for each component. Many accountants feel it is appropriate to use different discount rates to reflect what they believe are different levels of risk for each component. Future flows for liabilities to be assumed are generally known, and they can be discounted at the current market rate of borrowing.
Future flows from identifiable assets can frequently be estimated with fairly high reliability, but they are not as definite as the flows for legal liabilities. For example, the flows from rent revenue to be received on a building can be estimated but are somewhat uncertain. Discounting these flows with a higher rate (to reflect the increased uncertainty) will result in a more conservative estimate of the building’s value.
Fund flow estimates for unidentifiable assets are much less certain than either of the other components. For example, if a firm has above normal flows due to the excellence of its management. As a result, an even higher discount rate should be used to obtain a more conservative estimate of goodwill value.
The values of identifiable assets and liabilities can be established using the present value techniques described earlier. When no funds flow pattern can be projected for an identifiable asset, a value often can be determined by referring to an established market for that asset. However, there is no established separate market for goodwill, and, therefore, it must be determined differently.
Relying on the definition of goodwill as that asset that produces above normal fund flows, a direct approach for estimating goodwill computes the present value of future excess fund flows. These above normal flows are often defined as the amount in excess of the fund flows needed to provide the desired rate of return on the identifiable assets net of liabilities.
Using the information presented earlier for Sample Company, normal fund flows on the assets net of liabilities other than goodwill are the amounts that would yield a present value equal to their fair value of $48,000,000 when discounted at 12 percent. Thus, the operating flows attributable to normal earnings are computed as follows:
Excess fund flows in each year would be $3,100,000 ($9,250,000 — $6,150,000). If those flows are discounted with a rate of 12 percent, the result is goodwill of $23,000,000, the same amount as computed under the entire firm valuation approach. If a higher rate of 20 percent is used to reflect the higher degree of uncertainty, a more conservative amount is ($3,100,000 X PA 20%) or $15,000,000 (rounded).
A shortcut method that is frequently used to approximate goodwill is the capitalization of excess earnings. Under this approach, the first step is to separate total earnings into normal and excess earnings according to the average income experience of firms in the industry. Then, the excess earnings are capitalized at a higher rate to reflect the uncertainty of the goodwill value.
For example, normal earnings based on the $48,000,000 of identifiable assets would be $5,760,000 ($48,000,000 X .12). If total earnings per year are projected to be $7,800,000, the excess earnings of $2,040,000 would then be capitalized at 20 percent (or some rate greater than 12 percent) to determine the amount of goodwill. The computation is shown below:
Goodwill = Excess earnings / .20
Goodwill = $2,040,000 / .20 = $10,200,000
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.