In my article featured in the Fall 2016 KT Addition, I discussed the components of goodwill value. If you recall, they are the assets we can’t touch but undeniably generate value. A few examples include:
- Assembled Workforce
- Non-Compete Agreements
- Signed Customer Contracts
So, how do we calculate the value of these assets? It is more technical than just a guess. The calculation involves both the Income Approach and Asset Approach.
The Income Approach can be a simple mathematical equation with cash flows as the numerator and a capitalization rate or “risk factor” as the denominator. The assets included in the value derived by employing the Income Approach are anything used to generate cash flows, such as working capital (inventory plus accounts receivable less accounts payable), fixed assets and goodwill (assuming the subject company has goodwill value).
The Asset Approach can simply be the value the tangible assets (the assets that we can touch) would bring in an orderly liquidation (less any debts).
If the Income Approach produces a value greater than the value produced by employing the Asset Approach, the company has goodwill value equal to the difference.
In the example listed below, the value based on the Income Approach is $100,000. This is the value based on cash flows. Meanwhile, the value of the actual tangible assets sold net of any debts is $90,000. Therefore, in this example, the value of goodwill is $10,000. This implies that the cash flows support a value greater than simple liquidation of assets. Moreover, it means that the intangible assets owned by the company (assembled workforce, signed contracts, reputation, etc. as noted above) are needed to produce company cash flows.
|Value Based on Income Approach||$100,000|
|Less: Value Based on Asset Approach||$90,000|
So, how do we know what level of goodwill is normal for a particular company? It depends on the type of business. If we are referring to a small construction company that is awarded jobs based on the bidding process, such a firm usually has very little goodwill value—even if such firm is highly profitable. This is because its next job is not secured because of historical reputation of quality work, but rather because it simply has the lowest bid. In other words, the industry has very low “barriers to entry.” For example, a hypothetical buyer of such company would not be any further ahead by buying this going concern business. Rather, he/she could just as easily bought his/her own equipment and start bidding jobs. However, this type of company may have some goodwill because of an assembled workforce.
Another example of a company that would have very little or no goodwill value is a lawn mowing business. Lawn mowing requires no special skills, education or training to perform. Therefore, a hypothetical buyer would only pay for the value of the lawn mower(s) and accessories; however, it would be unlikely if he/she would pay a premium for the business. After all, there is no shortage of lawns to mow.
An example of a business that has a high level of goodwill value would be a “near monopoly” such as Apple. The only way to buy an iPhone or iPad is to buy from Apple. Yes, there are other smart phones available in the market but none are the glorified iPhone. Moreover, if your iTunes playlist is as big as mine, you wouldn’t want to start over with your music collection; it is simply cost prohibitive. In other words, I’m stuck. And in other more technical words, Apple has a tremendous level of goodwill because no one else can offer the iPhone:
- The goodwill value of Apple is transferrable, meaning that it does not reside in one person.
- The Apple products and processes are patented.
- The add-on features are Apple specific; they cannot be transferred to a non-Apple device.
- It is an internationally recognized product.
- Almost everyone is a potential Apple customer meaning the customer pool is seemingly endless.
- Software updates make the devices almost impossible to be obsolete. (Until the next big thing!)
As the worlds’ biggest company, it is doubtful anyone could buy the entire Company. But you can buy its shares. The value of goodwill is quantifiable. However, understanding of why an investor would pay a premium for the subject company, like Apple is key.
Do you or your clients have Business Valuation questions or needs? Contact the KTLLP Business Valuation Team.