Good­will in valu­a­tion

Finweek English Edition - - IN­SIDE - FI­NANCE FOR EN­TREPRENEURS BY GARETH OCHSE

Good­will sounds like some­thing sim­ple to un­der­stand but i n my deal-mak­ing busi­ness it comes up i n al­most ev­ery trans­ac­tion, and in­vari­ably I f ind that part of each trans­ac­tion in­volves ex­plain­ing good­will to the par­tic­i­pants. Good­will is of­ten a key part of the value be­ing trans­ferred and de­serves proper un­der­stand­ing.

LET’S RE­CAP HOW WE MEA­SURE THE VALUE OF A BUSI­NESS, THEN WE’LL SEE WHERE GOOD­WILL FITS IN AND HOW WE TREAT IT DUR­ING TRANS­AC­TIONS AND AF­TER­WARDS:

The core prin­ci­ple be­hind valu­ing any fi­nan­cial in­stru­ment is that its fi­nan­cial value to­day is the value of its ex­pected f uture cash f lows, dis­counted back to to­day by a rate that ref lects the risk to the cap­i­tal em­ployed in gen­er­at­ing those f uture re­turns. This ap­proach ( known as t he

‘ in­come’

ap­proach) works just as well for in­di­vid­ual stocks as it does for the mar­ket in­dex. It also works when valu­ing any busi­ness and we use the dis­counted cash f low (DCF) method to cal­cu­late it.

A BUSI­NESS ALSO HAS A BOOK

(OR ‘NET AS­SET’) VALUE: this is the to­tal fair mar­ket value of its as­sets less all its li­a­bil­i­ties. That’s not its real value – it’s merely an ac­count­ing con­struct that shows the value of as­sets ver­sus li­a­bil­i­ties at a par­tic­u­lar point in time. Although widely used as a proxy for val­u­a­tions (par­tic­u­larly in BEE trans­ac­tions), it’s rarely the case that the book value of a busi­ness ref lects its ac­tual f inan­cial value. It’s the value of what a busi­ness has achieved to date, rather than the value of what it yet to come.

THEN THERE I S STRATE­GIC VALUE: a busi­ness might be worth more to you than to me be­cause you can do more with it. You might be able to sell your prod­ucts to new cus­tomers and new prod­ucts to your cus­tomers. You could cut costs. You could block a com­peti­tor from en­ter- ing your mar­ket, and so on. Quite of­ten the strate­gic value of a busi­ness is higher than the fi­nan­cial value of the busi­ness. That’s why one gen­er­ally makes the most money when you sell your busi­ness to an­other in­dus­try player, rather than a purely fi­nan­cial in­vestor. It’s also why one of­ten sees two in­dus­try ri­vals duke it out when a smaller in­dus­try player comes on to the mar­ket.

When a busi­ness pays more than book value for an­other busi­ness then the dif­fer­ence be­tween price paid and book value is recorded as ‘good­will’.

You can de­scribe good­will in terms of the ‘strate­gic’ or ‘ fi­nan­cial’ valu­a­tion pre­mium over book value, or you can think of it as the value of all the in­tan­gi­bles of the busi­ness – its brand, man­age­ment team, in­ter­nal con­trols, track record, cus­tomer re­la­tion­ships, and so on. In other words, all the el­e­ments that sug­gest that the fu­ture value of the

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