Business Worth – How Do You Calculate Goodwill?

Business Worth – How Do You Calculate Goodwill?

Investing, or buying into a business could by some, be compared to getting married; what are you taking on and what baggage is being brought into the relationship! In the case of buying a business, this means finding out the value of any goodwill if assets are transferred at their market value! Therefore, it’s wise to acquire at least some working expertise related to calculating goodwill when buying a business.

Goodwill Valuation When Buying A Business

There are a variety of definitions of the term “goodwill”, as there are various methods of calculating goodwill in a sale, excluding the assets and liabilities which compose the net assets. A popular and preferred by many, perception of “business goodwill” is the ability to make extreme profits, beyond the normal return on the investment.

Business sellers and buyers have different approaches to the valuation of goodwill.  The seller will likely inflate goodwill due mainly to his or her emotional attachment to the business whereas the buyer is likely to deflate its value.  Goodwill, being an intangible asset, is not easily identified or measured. It is what attracts customers to continually patronize a certain business. It helps a business to earn more profits in the future.  It can be any or all of the following: customer lists and relationships, brand name and logo recognition, business connections, reputation, trademarks, patents, inventions, employees and their skills, and vendor relationships. All these intangible but very valuable assets contribute to a business’s worth.

Goodwill Purchase Price Fair Market Value of Net Assets of the Business

Wikipedia defines Goodwill as “the value of an entity over and above the value of its assets”.  If you have to put a monetary value on goodwill, it is the amount you pay in acquiring a business that is in excess of the fair market value of its net assets.

Goodwill = Purchase Price – Fair Market Value of Net Assets of the Business

Once the value of goodwill is established, this is listed as an asset (aside from the tangible assets) in the business’s balance sheet.

Below are some popular methods of goodwill valuation.

Goodwill Valuation When Buying A Business

Goodwill Calculation:  How to Calculate Goodwill

1.  Net Asset Method

Add up the fair market value of all tangible assets of the business and subtract this from the purchase price to determine the value of goodwill.

Goodwill = Purchase Price – Fair Market Value of Net Assets of the Business

2.  Average Profit Method

Calculate the average profit from previous years and multiply this figure with the number of purchase years.  Purchase years is defined as the number of years required for a business to yield its purchase price.

Goodwill = Average Profit X Number of Purchase Years

3.  Super Profit Method

You obtain Super Profit when the actual profit is more than the expected or normal profit of a business.  In this method, you calculate the normal profit with the normal rate on investment.  Then calculate Super Profit using the following formula:

Super Profit = Actual Profit – Normal Profit

Or Super Profit = Average Profit – Normal Profit

And Goodwill = Super Profit X Number of Purchase Years

In calculating goodwill in a sale you could begin with:

  • Reviewing the profit and loss accounts of your potential asset, for the past 3 years.
  • Make certain adjustments needed to determine the “goodwill”, or average sustainable earnings calculation.
  • Use a general format, by adjusting payments to the owner, or other person in charge of the business, based on sums paid over and above a reasonable work-related salary.

An example of this would be an assessment of the net assets, less liabilities of $200,000, with the average investment return for that particular industry being 8%. This is founded on the base rate of the bank, with an allowance added for the risk factor; a normal return could be expected of $16,000.

Therefore, calculating goodwill when buying a business on this basis could be:

  • Determined by the business consistently performing with a net profit of $20,000, with excess payments of $4,000.
  • Working on the premise of the average price earnings ratio for this industry being “10”, the “goodwill” factor would be assessed at $40,000, or $4,000 multiplied ten times.

Selling Goodwill in a Business

  • The figure related to selling goodwill in a business, is gained from the average sustainable earnings of that business and earnings/price quotient usual in that particular industry.
  • An average assessment is provided by the earnings/price quotient for the majority of privately owned businesses, being about 50% that, of publicly quoted companies, in a comparable business segment.

Valuations, despite generally presented with meticulous calculations, should however, be viewed with a degree of caution. Therefore, before making any for of decision, enlist the help of a qualified professional, who has proven experience in how to calculate goodwill in selling businesses.

4.  Market Value Method

Study records of comparative business sales data in the area and industry similar to the business for sale to get the market value or cash basis purchase price of the business.  Subtract the total value of all assets from this amount to calculate the value of goodwill.

Goodwill = Cash Basis Purchase Price – Total Assets Value

Capitalization of Average Profit Method or Simply Capitalization Method

5.  Capitalization of Average Profit Method or simply Capitalization Method

In this method, you calculate capitalized value of the business by using the following formula:

Capitalized Value of the Company = Average Profit or Normal Profit X 100/Normal Rate of Return

Net Assets = Total Assets – External Liabilities

Goodwill is the difference between the total capitalized value of the business and the net assets.

Goodwill = Capitalized Value – Net Assets

The end result in any type of negotiation and the worth of an entity is always founded on a buyer who is willing to pay, what a willing seller is prepared to accept. However, also to be considered is the question of raising financing. It is not unusual for selling goodwill in a business to be agreed by a seller at a figure with the net assets deducted. This aspect is then reserved to be valued more precisely.

On the “goodwill” valuation being determined, with the net assets listed and agreed, the total sum of the net assets and goodwill should be reviewed. A decision should then be made regarding whether, after taking all aspects into account, this business offers good value for potential earnings and profit in the future.

Think of the future income or potential earnings of the business when calculating goodwill.  Value goodwill high is there is a high probability that the business will continue to profit in the future.  On the other hand, goodwill is valued low if the projected future earnings are less than in previous years.  Goodwill keeps bringing the customers to the business.

Seek a professional such as a Certified Public Accountant (CPA) or a Certified Valuation Analyst (CVA) to help you in business valuation and its tax implications. Which calculation method will you use to get the best valuation of business goodwill?

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