For over 200 years, courts have been struggling to come up with an acceptable definition of business goodwill. Simon Wood explains the valuation options available
This article was first published in the September 2011 edition of Accounting and Business magazine.
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The valuation of goodwill assumed even greater importance with the advent of the corporate intangible fixed assets regime from 1 April 2002, which in many cases enables a newly incorporated business to claim a tax deduction on the amortisation of goodwill.
What is goodwill?
The definition of goodwill has been addressed by the courts over a considerable period of time. As early as 1810, the courts defined goodwill as 'nothing but the probability that the old customers will resort to the old place'.
In the case of Re Commissioners of the Inland Revenue v Muller & Co Margarine (1901), Lord MacNaughten spoke of goodwill as follows: '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 has also been defined as the ability to earn 'super profits', ie profits above the usual return on the money invested in the business.
The practice of valuating goodwill is probably best described as part art, part science and goodwill valuations, although often presented as a precise calculation, will be down to what a willing buyer is prepared to pay and a willing seller is prepared to accept.
However, a number of different approaches have developed in calculating the value of goodwill:
- Whole company approach;
- Simple multiple approach;
- Turnover approach; and
- Discounted cashflow approach
Let us look at each of the above approaches in turn.
Whole company approach
Perhaps the most common approach in valuing goodwill is to be found by valuing the entirety of a company or business and then deducting the tangible and other intangible assets. The residual value can then be termed goodwill. Examples of intangible assets other than goodwill are licences, brands, trade names, quotas, patents, copyright, franchises and trademarks.
"Based on a multiple applied to maintainable profits... known as the price/earnings (P/E) ratio."
Normally, the whole company valuation approach will be based on a multiple applied to maintainable profits (gross of any owner's/director's remuneration), known as the price/earnings (P/E) ratio.
Where this computation gives a value greater than the adjusted net asset value, then the excess is deemed to be goodwill; whereas if less than net assets, then the implication is that there is no, or negative, goodwill. Assets within the balance sheet should be included in the calculation at market value
P/E ratios will vary from industry to industry and from business to business, with a growing business with strong margins being at the top end of the scale, while businesses showing poor or declining turnover and weak margins would be at the bottom end.
Sector-specific P/E ratios may be obtained from sources such as the Financial Times and the London Business School Risk Measurement Service. When looking at company-specific P/E ratios, this can be obtained from the source financial information.
Example 1 - Whole company approach:
- Small machine tool company with a wide variety of customers, established for many years and with much repeat business.
- Turnover stable and growing steadily at GBP 10 million, as is profit after tax of GBP 400,000.
- No one-off or exceptional items in the accounts and directors' fees at a commercial rate for the services provided.
- Net assets GBP 500,000, but original commercial premises in the accounts for many years at GBP 100,000 have a current market value of GBP 1.1m.
- Research shows an appropriately adjusted P/E ratio is 5.
- When using the whole company approach, other factors may need adjustment, the more common of which include: Assets not contributing to the business profitability may need to be removed; for example, premises let out. Any income from non-trading activities (such as rent from let premises) will need to be removed.
- The company may have surplus cash that needs to be accounted for, as will the interest on the cash.
Simple multiple approach
In a simple straightforward business, it may be possible to ascertain a valuation of goodwill by applying a simple multiple to maintainable profits before any form of owner's/director's remuneration. The level of turnover multiple is subjective and will depend on the quality and nature of the client and growth and margins. The better the growth and margins, the better the multiple is likely to be.
- Small limited company selling products via the internet; established and stable with a website, trading name and broad customer base and repeat business. Business is growing at five per cent per annum.
- Turnover GBP 2m and pre-tax profits (after directors' fees of GBP 50,000) of GBP 50,000.
- Business operated from home and computer equipment is the principal asset in net assets of GBP 20,000.
The turnover approach would normally be used in valuing businesses where a profit-based approach is less appropriate - typically a professional practice (eg lawyers, architects, accountants). Often a turnover-based valuation will be based on recurring fees rather than overall turnover.
"normally... used in valuing... professional practice[s] (eg lawyers, architects, accountants)"
Typical multiples for this type of valuation range between 0.5 and 1.5, although they can range from 0.25 to 2.5. Again, these multiples are subjective and will depend on factors such as growth and margins.
- Non-quoted corporate recovery business; well established with a strong client base and growing strongly.
- Three principals and with rented premises.
- Turnover GBP1,500,000. Making industry-standard margins.
Research shows quoted comparators trading at about 1.3 x turnover.
Discounted cashflow approach
The discounted cashflow approach can also be used where cashflow is a key factor, eg the hotel industry.
Personal and corporate goodwill
In certain types of business, the nature of the goodwill is such that it does not attach to the business itself, but to the person of the owner/director. In certain trades, the personality of the owner is crucial - for example, a chef in a small restaurant.
Unless the chef is famous (in which case the name and concept can perhaps be franchised or otherwise leveraged), it is likely that much of the goodwill in the small restaurant will die with the change of ownership.
In these circumstances, it is difficult for the goodwill to be transferred or sold if the business is disposed of. In the case of a business being incorporated and goodwill being transferred to the company, HMRC would also seek to identify any personal goodwill being transferred and restrict accordingly.
Simon Wood is a technical adviser at ACCA UK