What is Goodwill?
Goodwill is an intangible asset that is associated with the purchase of one company by another. Specifically, goodwill is the portion of the purchase price that is higher than the sum of the net fair value of all of the assets purchased in the acquisition and the liabilities assumed in the process. The value of a company’s brand name, solid customer base, good customer relations, good employee relations, and proprietary technology represent some reasons why goodwill exists.
How to Calculate Goodwill
To calculate goodwill, we should take the purchase price of a company and subtract the fair market value of identifiable assets and liabilities.
Goodwill = P−(A+L)
P = Purchase price of the target company
A = Fair market value of assets
L = Fair market value of liabilities
Types of Goodwill
There are two distinct types:
Purchased: Purchased goodwill is the difference between the value paid for an enterprise as a going concern and the sum of its assets less the sum of its liabilities, each item of which has been separately identified and valued.
Inherent: It is the value of the business in excess of the fair value of its separable net assets. It is referred to as internally generated goodwill, and it arises over a period of time due to the good reputation of a business. It can also be called as self generated or non-purchased goodwill.
For example, suppose you are selling an outstanding product or providing excellent service consistently. In that case, there is a high chance of an increase in goodwill.
Example of Goodwill
If the fair value of Company ABC’s assets minus liabilities is $12 billion, and a company purchases Company ABC for $15 billion, the premium value following the acquisition is $3 billion. This $3 billion will be included on the acquirer’s balance sheet as goodwill.
As a real-life example, consider the T-Mobile and Sprint merger announced in early 2018. The deal was valued at $35.85 billion as of March 31, 2018, per an S-4 filing. The fair value of the assets was $78.34 billion and the fair value of the liabilities was $45.56 billion. The difference between the assets and liabilities is $32.78 billion. Thus, goodwill for the deal would be recognized as $3.07 billion ($35.85 – $32.78), the amount over the difference between the fair value of the assets and liabilities.
How Is Goodwill Used in Investing?
Evaluating goodwill is a challenging but critical skill for many investors. After all, when reading a company’s balance sheet, it can be very difficult to tell whether the goodwill it claims to hold is in fact justified. For example, a company might claim that its goodwill is based on the brand recognition and customer loyalty of the company it acquired.
When analyzing a company’s balance sheet, investors will therefore scrutinize what is behind its stated goodwill in order to determine whether that goodwill may need to be written off in the future. In some cases, the opposite can also occur, with investors believing that the true value of a company’s goodwill is greater than that stated on its balance sheet.