Goodwill in valuation
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
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