World Class Mergers & Acquisitions  |  For Companies $5 Million to $100 Million in Revenue

How Is Goodwill Determined in Valuing a Business?

In the real world of buying and selling businesses, some businesses have a very large component of goodwill, while others have little or none.  The concept of goodwill is confusing to most business owners, and many hold serious misconceptions about how goodwill comes into play in valuing their business.  If fact, many business owners believe that goodwill is somehow calculated from the years they’ve been in business, the cumulative effect of all their advertising, their long-term customer relationships, etc., which is then added to the value of all their tangible assets to arrive at the total value of their business.

Let’s begin by reviewing two fundamental principles of business valuation.  The first principle is that the fair market value of any ongoing business is fundamentally driven by the expected value of its future cash flows.  This is what the buyer is willing to pay money for, i.e., the right to own the business’ cash flow into the future.  This may seem odd – or even counterintuitive – since so much time and attention is invested in gathering and analyzing historic cash flows.  It may appear to the business owner that the value of his/her business is being determined by its past cash flows, but in reality, analyzing the recent past is perhaps the best ways to truly understand the proven, cash flow generating capacity of the business, and its predictability, volatility, and cyclicality, as well as the likelihood that it will continue into the foreseeable future.

The second fundamental principle of business valuation is that the minimum value of any ongoing business – even one that is currently losing money — is at the fair market value of its tangible assets.  Even if the owner decides to close the business, he/she should be able to collect the current accounts receivable and sell the inventory, equipment and other tangible assets at their current market value, depending upon how quickly it must be liquidated.

Goodwill is the accounting term given to the excess value of a business’ future cash flow over the value of its tangible assets.  Consequently, businesses which are losing money, or only marginally profitable, may only be worth the market value of their tangible assets, and have zero goodwill.  In contrast, businesses that are profitable and earning a good to excellent return on their invested assets, will likely be worth much more than the fair market value of their tangible assets, and thus have very substantial goodwill.

If you know of a business owner who’s thinking of selling or buying a business and who might benefit from a free, confidential, consultation with us, have them contact me at mertel@legacyadvisorsgroup.com

By: Mike Ertel, Transworld M&A Advisors