Goodwill: Definition and Calculation
Most business owners and executives recognize that goodwill is an important concept in business valuation and the buying or selling of a business, also as KYC and video identification to provide secured buying place for customers. Not as well understood is the meaning of goodwill, its calculation and tremendous importance in buy/sell negotiations, particularly for medium and small businesses.
Here is a rather common sense definition of goodwill from the CICBV: Goodwill– that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.
While true, and conceptually easy to understand, this definition does little to practically assist a valuator or vendor. What is the value of your name and reputation?
We prefer this definition: goodwill is the ability of the combined tangible assets of the business to earn an above normal economic return. In other words, the whole is worth more than the sum of the parts (1+1 may equal 3).
The intrinsic value of any business can be thought of as the sum of the value of its tangible assets plus goodwill. Intrinsic value can be calculated using various methodologies, such as by capitalizing (applying a multiple to) earnings. Goodwill is the difference between the intrinsic value of the business and the stand-alone value of its tangible assets.
For example, a small manufacturing company may have tangible assets, including net working capital, equipment and real estate, with a combined going concern value of $6.0 million and maintainable earnings of $1.0 million. Assuming a 10 times earnings multiple is appropriate (for this example only), the intrinsic value of the business is $10.0 million ($1.0 million x 10). Its goodwill is $4.0 million ($10.0 million – $6.0 million).
Understanding goodwill is very important for many reasons. In valuation theory, for example, the implied amount of goodwill may be a limiting factor on the calculated value of the company. When selling a business, the amount of goodwill is often a difficult part of the negotiation (whether or not expressed in those terms) and a limiting factor on price and payment.
See our next post for more on how goodwill impacts the purchase and sale of medium and small businesses.
Posted by Scott Sinclair, Range Advisors
Our passion is to support business owners in pursuit of their dreams.
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