Expanded Discussion: Valuing Goodwill

Explain various approaches to valuing goodwill.


In the text, we discuss the generally accepted method of measuring and recording goodwill as the excess of cost over fair value of the identifiable net assets acquired in a business acquisition. Accountants are frequently asked to participate in the valuation of businesses as part of a planned business acquisition.

To determine the purchase price for a business and the resulting goodwill is a difficult and inexact process. As indicated, it is often possible to determine the fair value of identifiable assets. But how does a buyer value intangible factors like good management, good credit rating, and so on?

Excess Earnings Approach
Other Methods of Valuation
Exercises

Excess Earnings Approach

One method is called the excess earnings approach. Using this approach, the total earning power that the company commands is computed. The next step is to calculate "normal earnings" by determining the normal rate of return on assets in that industry. The difference between what the firm earns and what is normal in the industry is referred to as the excess earning power. This extra earning power indicates that there are unidentifiable values (intangible assets) that provide this increased earning power. Finding the value of goodwill then is a matter of discounting these excess future earnings to the present.

This approach appears to be a systematic and logical way of determining goodwill. However, each factor necessary to compute a value under this approach is subject to question. Generally, the problems relate to getting answers to the following questions:

What is a normal rate of return?
How does one determine the future earnings?
What discount rate should be applied to the excess earnings?
Over what period should the excess earnings be discounted?

Finding a Normal Rate of return

Determining the normal rate of return for tangible and identifiable intangible assets requires analysis of companies similar to the enterprise in question. An industry average may be determined by examining annual reports or data from statistical services. Suppose that a rate of 15% is decided as normal for a concern such as Tractorling (as discussed in the text). In this case, the normal earnings are calculated in the following manner.

Illustration 1:

Calculation of Normal Earnings

Determining Future Earnings

The starting point for determining future earnings is normally the past earnings of the enterprise. Although estimates of future earnings are needed, the past often provides useful information concerning the enterprise's future earnings potential. Past earnings-generally 3 to 6 years-are also useful because estimates of the future are usually overly optimistic; the hard facts of previous periods bring a sobering reality to the negotiations.

Tractorling's net earnings for the last 5 years are as follows:

Illustration 2:

Calculation of Average Earnings

The average net earnings for the last 5 years is $75,000 or a rate of return of approximately 21.4% on the current value of the assets excluding goodwill ($75,000 ÷ $350,000). Before we go further, however, we need to know whether $75,000 is representative of the future earnings of this enterprise.

Often past earnings of a company to be acquired need to be evaluated on the basis of the acquirer's own accounting procedures. Suppose, that in determining earnings power, Multi-Diversified measures earnings in relation to a FIFO inventory valuation figure rather than LIFO, which Tractorling employs, and that the use of LIFO reduced Tractorling's net income by $2,000 per year. In addition, Tractorling uses accelerated depreciation while Multi-Diversified uses straight-line. As a result, Tractorling's earnings were lower by $3,000.

Also, assets discovered on examination that might affect the earnings flow should be considered. Patent costs not previously recorded should be amortized, say, at the rate of $1,000 per period. Finally because the estimate of the future earnings is what we are attempting to determine, some items, like the extraordinary gain of $25,000, probably should not be considered. An analysis can now be made as follows:

Illustration 3:

Calculation of Adjusted Net Earnings

The excess earnings would be determined to be $21,500 ($74,000 - $52,500).

Choosing a Discount Rate to Apply to Excess Earnings

Determining the discount rate is a fairly subjective estimate. The lower the discount rate, the higher the value of the goodwill and vice versa. To illustrate, assume that the excess earnings are $21,500 and that these earnings will continue indefinitely. If the excess earnings are capitalized at, say, a rate of 25% in perpetuity, the results are:

Illustration 4:

Capitalization of Excess Earnings at 25% in Perpetuity

If the excess earnings are capitalized in perpetuity at a somewhat lower rate, say 15%, a much higher goodwill figure results.

Illustration 5:

Capitalization of Excess Earnings at 15% in Perpetuity

Because the continuance of excess profits is uncertain, a conservative rate (higher than the normal rate) is usually employed. Factors that are considered in determining the rate are the stability of past earnings, the speculative nature of the business, and general economic conditions.

Choosing a Discounting Period for Excess Earnings

Determining the period over which excess earnings will exist is perhaps the most difficult problem associated with computing goodwill. If it is assumed that the excess earnings will last indefinitely, then goodwill is $143,333 as computed in the previous section (assuming a rate of 15%).

Another method of computing goodwill that gives the same answer, using the normal return of 15%, is to discount the total average earnings of the company and subtract the fair market value of the net identifiable assets as shown in Illustration 6.

Illustration 6:

Capitalization of Average Earnings Less Fair Value of Net Assets

Frequently, however, the excess earnings are assumed to last a limited number of years, say 10, and then it is necessary to discount these earnings only over that time. Assume that Multi-Diversified believes that the excess earnings of Tractorling will last 10 years and, because of the uncertainty surrounding this earning power, uses 25% as an appropriate rate of return. The present value of an annuity of $21,500 ($74,000 - $52,500) discounted at 25% for 10 years is $76,766. That is the amount that Multi-Diversified should be willing to pay above the fair value of net identifiable assets.

Other Methods of Valuation

A number of other methods of valuing goodwill exist. Some accountants fail to discount but simply multiply the excess earnings by the number of years they believe the excess earnings will continue. This approach, often referred to as the number of years method, is used to provide a rough measure for the goodwill factor. The approach has only the advantage of simplicity; it is sounder to recognize the discount factor.

An even simpler method is one that relies on multiples of average yearly earnings that are paid for other companies in the same industry. If Skyward Airlines was recently acquired for five times its average yearly earnings of $50 million, or $250 million, then Worldwide Airways, a close competitor, with $80 million in average yearly earnings would be worth $400 million.

Another method (similar to discounting excess earnings) is the discounted free cash flow method, which involves a projection of the acquired company's free cash flow over a long period, typically 10 or 20 years. The method first projects into the future a dozen or so important financial variables, including production, prices, noncash expenses (such as depreciation and amortization), taxes, and capital outlays, all adjusted for inflation. The objective is to determine the amount of cash that will accumulate over a specified number of years. The present value of the free cash flows is then computed. This amount represents the price to be paid for the business.

For example, if Magnaputer Company is expected to generate $1 million a year for 20 years, and the buyer's rate-of-return objective is 15%, the buyer would be willing to pay about $6.26 million for Magnaputer Company. (The present value of $1 million to be received for 20 years discounted at 15% is $6,259,330.)

In practice, prospective buyers use a variety of methods to produce a "valuation curve" or range of prices. But the actual price paid may be more a factor of the buyer's or seller's ego and horse-trading acumen.

Valuation of goodwill is at best a highly uncertain process. The estimated value of goodwill depends on a number of factors, all of which are extremely tenuous and subject to bargaining.

Explain various approaches to valuing goodwill. One method of valuing goodwill is the excess earnings approach. Using this approach, the total earning power that the company commands is computed. The next step is to calculate "normal earnings" by determining the normal rate of return on assets in that industry. The difference between what the firm earns and what is normal in the industry is referred to as the excess earning power. This excess earning power indicates that there are unidentifiable values that provide the increased earning power. Finding the value of goodwill then is a matter of discounting these excess future earnings to the present. The number of years method of valuing goodwill, which simply multiplies the excess earnings by the number of years of expected excess earnings, is used to provide a rough measure for the goodwill factor. A third method of valuing goodwill is the discounted free cash flow method, which projects the amount of cash that will accumulate over a specified number of years and then finds the present value of that amount as today's value of the firm.

Exercises

Exercise 1 (Compute Goodwill)

The net assets of Frankie Beverly Company excluding goodwill totals $800,000 and earnings for the last 5 years total $890,000. Included in the latter figure are extraordinary gains of $75,000, nonrecurring losses of $40,000, and sales commissions of $15,000. In developing a sales price for the business a 14% return on net worth is considered normal for the industry, and annual excess earnings are to be capitalized at 20% in arriving at goodwill.

Instructions

Compute estimated goodwill.

Exercise 2 (Compute Normal Earnings)

Cliff Barnes Petroleum Corporation's pretax accounting income for the year 2004 was $850,000 and included the following items:

Amortization of goodwill $ 60,000
Amortization of identifiable intangibles 57,000
Depreciation on building 80,000
Extraordinary losses 44,000
Extraordinary gains 150,000
Profit-sharing payments to employees 65,000

Ewing Oil Industries is seeking to purchase Cliff Barnes Petroleum Corporation. In attempting to measure Barnes' normal earnings for 2001, Ewing determines that the fair value of the building is triple the book value and that the remaining economic life is double that used by Barnes. Ewing would continue the profit-sharing payments to employees; such payments are based on income before depreciation and amortization.

Instructions

Compute the normal earnings (for purposes of computing goodwill) of Barnes Petroleum Corporation for the year 2004.

Exercise 3 (Compute Goodwill)

Net income figures for Maryland Company are as follows:

2000 - $64,000 2003 - $80,000
2001 - $50,000 2004 - $75,000
2002 - $81,000  

Tangible net assets of this company are appraised at $400,000 on December 31, 2004. This business is to be acquired by Annapolis Co. early in 2005.

Instructions

What amount should be paid for goodwill if:

  1. 14% is assumed to be a normal rate of return on net tangible assets, and average excess earnings for the last 5 years are to be capitalized at 25%?
  2. 12% is assumed to be a normal rate of return on net tangible assets, and payment is to be made for excess earnings for the last 4 years?

Exercise 4 (Compute Goodwill)

Virginia Corporation is interested in acquiring Richmond Plastics Company. It has determined that Richmond Company's excess earnings have averaged approximately $150,000 annually over the last 6 years. Richmond Company agrees with the computation of $150,000 as the approximate excess earnings and feels that such amount should be capitalized over an unlimited period at a 20% rate. Virginia Corporation feels that because of increased competition the excess earnings of Richmond Company will continue for 7 years at best and that a 15% discount rate is appropriate.

Instructions

  1. How far apart are the positions of these two parties?
  2. Is there really any difference in the two approaches used by the two parties in evaluating Richmond Company's goodwill? Explain.