March 13, 2016

What is Goodwill, and how to quantify its value

Like any 21st century adult, if you are trying to research something, you head to Google. And the result is of googling the word ‘goodwill’ is….

  1. Friendly, helpful or cooperative feelings or attitude,
  2. The established reputation of a business regarded as a quantifiable asset and calculated as part of its value when it is sold.

Apart from the fact that we all like to be friendly and helpful, the interesting part about googling of the definition of a word is the assertion that it is quantifiable and that it is part of value when sold.

After just having reviewed a valuation report (someone else’s, single expert in a family law proceedings) where it is asserted the value of goodwill is the value of the business derived after capitalising passive business profit, using a multiple incorporating risk, (nothing wrong with this so far), but after simply deducting the value of plant and equipment ignoring all other business assets and liabilities.

In the book, The Valuation of Businesses, Shares and Other Equities by Wayne Lonergan when using the Capitalisation of Future Maintainable Profits method he states;

“As with other earnings or cash based valuation methods, the value of any surplus assets should be added to the value obtained by capitalising FMP to estimate the total value of the company or entity being valued”.

In other words, the value of a business using the Capitalisation of Future Maintainable Profits method incorporates all business assets and liabilities and the quantifiable derived value for goodwill is the excess value over and above net tangible business assets. The valuation report I just reviewed was wrong.

But is it this simple? Anyone owning a business ultimately dreams about an exit strategy (sitting on a beach listening to waves crashing on the sand) and wishes to maximise value (goodwill) when the business is sold. The key to this as asserted in the google definition is that goodwill is (ultimately) calculated as part of business value when it is sold. So any derived value for goodwill (and ultimately business value) needs to take into account the proposed purchaser of the business (there may be synergies or economies of scale) and also take into account the purpose of the valuation.

It is, for example, arguable that the current value of an accounting business  can be either:

  1. The value of business profits Capitalised (using the Capitalisation of Future Maintainable Profits method) or,
  2. Cents in the dollar of fee base using an industry norm assuming the fee base will be sold to another accounting firm that will benefit from economies of scale.

And under each of these methods the derived value for goodwill is often very different. So where does that leave us?

  1. If you are looking to sell your business you are without a doubt looking to maximise the value of goodwill. You should therefore look to possible purchasers such as competitors who will benefit from economies of scale and therefore pay more for it,
  2. For people like me who are often asked to quantify the value of goodwill, for example to be used in court proceedings, take care to understand the purpose of the report. If you are assessing an experts report seek advice regarding whether the report seems reasonable.

The business and financial environments are both dynamic and unpredictable making valuation increasingly challenging. Our forensic accountants are experts in their field, and provide you with a properly considered valuation report. Please contact our forensic team on 1800 246 801 if you are seeking further advice regarding business valuations.

Article written by Ross Mottershead, Director – Forensics, New South Wales.

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