Goodwill Valuation

[Kathleen Reynolds]

#2820

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Determines a business value using the Goodwill approach. The Goodwill approach is a combination of two other approaches: the Adjusted Book Value approach and the Capitalization of Earnings approach. It determines a business value by adding the “goodwill” value to the average value of the firm’s total business value.

A closely held business often earns more income than could be expected from the mere employment of capital invested by shareholders. The additional income is a result of an intangible value in the business.

A business’ goodwill value is estimated by capitalizing the “earnings attributable to intangibles.” In other words, the additional profits produced by the firm’s goodwill are divided by an appropriate rate. The goodwill value is then added to book value to determine the total business value.

A firm’s goodwill includes the following elements: business location and reputation; public recognition of the company name; customers and prospects; management skills; sales, operations, and accounting skills; employee ethics; and competition. Goodwill does not include the portion of profits attributable to the corporation’s ownership of patents, copyrights, formulas, or trademarks. Such items are intangible, but they are also identifiable.

Goodwill value should be used in conjunction with other valuation methods and not as the only method of valuing a business.

Entering Data

1. Average Annual Earnings Enter the average amount of earnings made annually by the business. Earnings should be averaged over a representative period (such as the past five years) and weighted, if necessary.
2. Estimated Capitalization Rate Enter the estimated capitalization rate. This value is the amount by which the earnings from intangible assets will be divided to arrive at the goodwill value.
3. Average Annual Asset Value Enter the average annual adjusted book value of the business’ assets.
4. Rate of Return on Tangible Assets Enter the rate of return on the business’ tangible assets.

Results

The calculation results show the company’s return and earnings from tangible assets, earnings from intangible assets, goodwill value, and total business value. Results are displayed for the rate of return specified at the Rate of Return input, and for four additional rates.

To calculate these values, the calculation multiplies the average annual asset value by the rate of return to arrive at the “earnings from tangible assets.” This value is than subtracted from the average annual earnings to arrive at the “earnings from intangible assets.” These numbers are then capitalized (divided) by the capitalization rate to determine the “goodwill value.” The final calculation, the “total business value,” is the sum of each of the goodwill values and the average annual asset value.

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