Valuing goodwill in a business
Accounting for goodwill has always been one of the more controversial issues faced by accountants for many years and I covered the issue concerning goodwill and intangible assets in an earlier article which addressed the accounting requirements for goodwill (as well as intangible assets).
Many accountants will associate goodwill as being the value inherent in the business due to a built upon reputation or the value attributed to a well-known brand or company name. Lord MacNaghten in the case of Commissioners of Inland Revenue v Muller & Co Margarine (1901) AC215 defined goodwill as follows – he said:
“What is goodwill? It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation and connection of the business. It is the attractive force which brings in custom. It is the one thing which distinguishes an old established business from a new business at its first start. Goodwill is composed as a variety of elements. It differs in its composition in different trades and in different businesses in the same trade. One element pay preponderate here, and other there.”
Lord MacNaghten merely defined goodwill in his summing up, which is one thing. The challenge for accountants is how such goodwill is valued.
Valuation techniques
There are various techniques associated with the valuation of goodwill which can be split into the three most common:
1. Simple multiple approach
2. Turnover approach
3. Whole company approach
Simple multiple approach
The simple multiple approach is more appropriate for small, straight-forward businesses (typically owner-managed businesses). In a nutshell the way this works is to apply a multiple to sustainable profits before management/owners’ remuneration.
The range of multiples used in the calculation of goodwill usually vary between 1 and 5. Typically where a business is showing strong growth and is experiencing high levels of profitability, the multiples used will be at the higher end of the scale. On the flip side, if a business is in decline, the multiples used will typically be at the lower end.
Illustration
Company A Limited is a husband and wife run company. The following information is relevant:
- The company operates in the publication of e-books through a website.
- The company has witnessed steady growth over the last few years and have started to see an increased number of subscribers to their products.
- Turnover for the last financial year amounted to £1 million and profit before taxation is £70,000 after directors salaries of £30,000.
- Net assets are very low with computer equipment being the only real assets owned by the company as the business is operated from a converted garage at the marital home. Net assets amount to £15,000.
The couple have asked you to value the goodwill in their business and provide them with a business valuation.
£70,000 pre-tax profit plus £30,000 remuneration results in profit of £100,000. If you opt for a multiple at the lowest end of the scale (1), this will give rise to goodwill of £100,000. Add to this the net assets of the business of £15,000 and this will give a business valuation of £115,000.
Turnover approach
This method is commonly used in a professional practice (such as when an accountancy or solicitors’ practice is being sold). Multiples are then applied to these fees which are usually between 0.5 and 1.5 – though of course such ranges are often subjective and will depend on various factors such as the quality of the clients, financial health of the business and historical trends. As with the simple multiple approach, a business that is experiencing a higher level of growth will often have a higher multiple applied to it – this can sometimes be as high as 2.5 for a business that is experiencing a high degree of profitability and growth and as low as 0.25 for a business in decline.
When such businesses are being sold it is not uncommon to apply a multiple for a company in the same industry/profession that is quoted and to then discount this multiple back to take account of the smaller size of such a business as can be illustrated as follows:
Illustration
A firm of accountants consists of four partners and is an independent practice and not listed on any stock market. The practice has been in existence for several years, is well-established with a good client base. Two of the partners are relatively young and over the last six years have been driving the practice forward and have been successful in gaining a number of lucrative clients. The firm currently rents its offices from an unconnected third party commercial lettings agency. Financial facts are as follows:
- Turnover is approximately £2.5 million
- Margins are standard
- The corporate financiers have estimated that quoted firms are currently trading at 1.4 x turnover
The partners have asked for a valuation of the goodwill attributable to the firm.
The valuation is calculated as £2.5m turnover multiplied by 1.0 = £2.5m goodwill. You have to discount back the 1.4 multiple as this applies to a firm that is listed on a stock market. The four-partner firm above is not listed and relies on the partners as well as a lack of assets, hence the multiple selected is 1.0.
Whole company approach
This is generally a very common approach to valuing goodwill. It works by valuing the entire business and then deducting tangible/intangible assets to find the residual amount which is the goodwill.
In a nutshell, the whole company approach works by basing the valuation on a multiple that is applied to sustainable profit. Where this results in a valuation that is less than the adjusted net asset value, the assumption is that there is little (or even no) goodwill inherent in the business. The calculation uses a P/E ratio which is basically the relationship between after-tax profits of a business and its capitalised value. P/E ratios are often adjusted to take into account any ‘one-off’ items such as one-off bonus payments to directors or other exceptional items.
Illustration
A company makes post-tax profits of £200,000 and is sold for £1.5 million. The P/E ratio is calculated as (£1.5m / £200,000) 7.5.
An important point also to emphasise is that assets contained within a company’s balance sheet will need to be valued at fair value, where applicable and not at the lower of cost and net realisable value which is the method often used when the balance sheet itself is constructed.
Illustration
A company is in the plant and machinery hire business and has been established for several years and has an extremely strong customer base that place a significant amount of repeat business.
The company’s turnover is around £15 million and post-tax profit have remained stable at £800,000 per annum. There are no exceptional items and the company’s balance sheet shows net assets of £600,000 including its building which was purchased for £100,000 several years ago and has an open market value at today’s prices of £1.2 million.
The company’s external accountants have arrived at an adjusted P/E ratio of 6.
The directors of the company are considering selling the business and have asked for a valuation to be placed on the company’s goodwill.
Valuation:
Post-tax profit £800,000 x 6 £4,800,000
Net assets £600,000
Gain on property £1,100,000 £1,700,000
Goodwill £3,100,000
In this scenario the property uplift gives rise to a material difference in the goodwill valuation. Other factors that may also give rise to a difference in the goodwill valuation could include assets that are let out to third parties (hence do not contribute to the profitability of the business) and any surplus cash that may need accounting for.
Conclusion
Goodwill is (probably) one of the most controversial and subjective areas of accountancy and has the potential to lend itself to a whole host of misdemeanours. This article has concentrated on simplified valuations of goodwill, but these often become more complex in real-life situations.
Category: Accounting and standards
