Valuing Goodwill
Valuing goodwill can be a tricky one, and it’s likely a bit misunderstood. However, it’s one of those important components in the valuation of a business that simply can’t be overlooked. In this article, we’ll look at some of the essential components of goodwill so that you can get a better understanding of how goodwill works and how to calculate it if you’re in the process of or planning to sell your business.
What is Goodwill?
Before we begin explaining how goodwill is valued, we need to understand what it is. Goodwill is an intangible asset arising as a result of brand name, reputation, customer loyalty, location, and similar factors NOT able to be separately identified. For example, an intangible asset that can be separately identified is a patent because it can be licensed to a third party and individually valued, while a customer’s loyalty can’t be separately identified since it’s not sellable. Goodwill is effectively the collective of non-separately identifiable assets.
In simple accounting terms, goodwill entails that portion of a business’ enterprise value greater than the net value of all assets and liabilities of a company.
Goodwill = Enterprise Value – Net Value of its Assets and Liabilities
Example for Valuing Goodwill
A portion of Coca-Cola’s goodwill arises from their brand recognition and brand association to positive experiences, which translates into people buying more than just the product, generating cash flows for the company. If you’re to think about buying the Coca-Cola company, you would be buying so much more than just a recipe for a soda (Coca-Cola is available in more parts of the world than there is clean drinking water).
Importance of Goodwill for a Business
Goodwill ultimately increases the value of your company—the idea being that you want to create and develop these “non-tangible” assets, making your company more unique and, therefore, valuable.
Goodwill Calculation
Valuation practices calculate the enterprise value via the income approach, market approach, and/or asset approach (whichever is applicable), after which the net value of its assets and liabilities is subtracted from the enterprise value, and the result is the goodwill.
Goodwill = Enterprise Value – Net Value of its Assets and Liabilities
As an example, let’s say that company A has:
Assets value = $5 million
Liabilities value = $1 million
Net value of the company’s assets and liabilities = Assets – Liabilities = $4 million.
Now say that the enterprise value of the same company is $8 million, then:
Company A’s goodwill = Enterprise Value ($8 million) – Net Value of Assets and Liabilities ($4 million) = $4 million
Valuing Goodwill and Other Intangible Assets
Intangible assets other than goodwill are assets that can be separately identifiable and commercially transferable (i.e., a patent, customer relationships, a trade name, an internal software, etc.).
One of the most common mistakes that people make when valuing goodwill is ignoring intangible assets not yet accounted for in the company’s balance sheet. Intangible assets other than goodwill can be hard to value, and normally they are only recognized in a business’ balance sheet if they have a significant value or if a company purchased a business that has amortizable intangible assets that can help reduce its tax liabilities.
The main difference between goodwill and other intangible assets is that the first is not commercially transferable (i.e., a business’ reputation can’t be separated and sold, and therefore goodwill arises from it. On the other hand, a company’s trademark can be licensed to a third party, and therefore it’s an identifiable intangible asset and not goodwill.
As you can see, goodwill is an important component of a business, and one that helps increase your business’ value. If you’re preparing to sell your business, be sure to understand the concept of valuing goodwill, as it can be a material portion from the price you’ll receive
