Goodwill Calculator

The Goodwill Calculator is used to compute the value of Goodwill, an intangible but quantifiable asset, in several ways. Goodwill is the present value of the future above-average earnings of a business. (Note: The above-average earnings vary from industry to industry).

APPLICATION

The existence of Goodwill is useful in valuation when selling a business for a price that is in excess of the fair market value of the net assets in the business. Goodwill comes in various forms including reputation, commercial secrets, brand name, customer lists and so on.

Techniques of Determining Goodwill

The value of Goodwill of a business can be determined in several ways. Here, four primary techniques are employed based on:

1. A multiple of the average earnings
   The average earnings of the company during the past 3 to 6 years is computed and projected into the future.  This projection often does not go so far into the future because the economic conditions may change rapidly.
2. The capitalized value of the extra earnings
   The capitalized value of the extra earnings power of a company is the amount which will yield a rate of return that is considered normal for similar kinds of businesses. The assumption here is that extra earnings will accrue indefinitely into the future.
3. A multiple of the extra earnings
   This is a modification of No.2 given that the presence of accrued earnings over a long period of time may not be traceable to a condition prevalent at the time of acquisition. One way of modifying this is to have a specific time period e.g. 5 or 8 years, during which extra earnings will continue. Goodwill may be determined as a multiple of the extra earnings by the specific number of future years (The multiplier).
4. An arbitrary goodwill agreement:
   A mutual agreement is settled on through negotiations between a willing seller and a willing buyer.

EXAMPLES

1. Goodwill Based on a multiple of the average earnings
James paid an amount of money for a business that included goodwill valued at 3 years of the company's average earnings for the preceding 4 years. The earnings for the preceding 4 years were $78,000 for the first year, $98000 for the second year, $104000 for the third year and $120000 in the fourth year. Find the value placed on goodwill.
Solution: First, find the average net income:

$78000 + $98000 + $104000 + $120000 = $400000
$400000 / 4 = $100,000 average net income
Then, find the value of goodwill by multiplying: Average Earnings ($100000) x Multiplier (3) = $300,000

However, this method ignores the concept of extra earnings as the basis for estimating the value of goodwill.

2. Goodwill Based on the Capitalized Value of the Extra Earnings
Techso Corporation financial records indicate that its average annual net income is $28,000 and the owner's investment (net worth) in the company is $260,000. The normal rate of return on capital invested in similar businesses is 10%. Find the value of goodwill by capitalizing the extra earnings at the same rate of return.

Solution:
Net worth ($260,000); Average annual net income ($28,000)
Normal earnings for industry ($260,000 x 10%) = $26,000
Extra earnings ($28,000 - $26,000) = $2000

Find the value of goodwill by capitalizing the extra earnings by 10% i.e. Extra earnings ($2000) / Normal rate of return (10%)  = $20,000

3. Goodwill Based on a Multiple of the Extra Earnings
Techso Corporation financial records reveal that its average annual net income is $28,000 and the investment in the company is $260,000. The normal rate of return on capital invested in similar businesses is 10%. Assuming that the extra earnings will continue for 3 years in the future, find the value of goodwill.

Solution:
Net worth ($260,000); Average annual net income ($28,000)
Normal earnings for industry ($260,000 x 10%) = $26,000
Extra earnings ($28,000 - $26,000) = $2000

Find the value of goodwill by multiplying Extra earnings ($2000) by Multiplier (3)  = $6,000

4. Arbitrary Value of Goodwill

An apparent arbitrary value of goodwill can be added to corporate valuation of a company.  In this case, it is not a function of the company's revenue or earnings.  It is more intangible.  Often an arbitrary goodwill value is placed on the value of a company base on the acquiring company's perceived future value of investment due to factors such as the belief that company's synergy will provide an earnings multiplier or the market penetration of the company where the acquiring company believes that the cost to penetrate the market is worth a much higher multiple.

Sycamore Associates has large footprint with a specific government agency that is believed to have substantially increasing budgets over the next decade.  To acquire Sycamore Associates, an arbitrary value of goodwill is embedded in the corporate buy-out offer.  This goodwill can not be defended by either revenue or earnings, but by a belief that market penetration with the agency would take too long and cost too much in the short-term horizon.

REFERENCES

Loyce C.G. Business Mathematics. A College Course. South-Western Publishing Co.USA.

Elvin Mirzayev (2014). How to Calculate Goodwill. http://www.investopedia.com/articles/investing/112814/how-calculate-goodwill.asp. Retrieved April 30, 2015.