Valuation: Cash Flow Discounting-Based Methods: 3. Goodwill-Based Methods

Strategic Finance

Generally speaking, goodwill is the value that a company has above its book value or above the adjusted book value. Goodwill seeks to represent the value of the company’s intangible assets, which often do not appear on the balance sheet but which, however, contribute an advantage with respect to other companies operating in the industry (quality of the customer portfolio, industry leadership, brands, strategic alliances, etc.). The problem arises when one tries to determine its value, as there is no consensus regarding the methodology used to calculate it. Some of the methods used to value the goodwill give rise to the various valuation procedures described in this section.

These methods apply a mixed approach: on the one hand, they perform a static valuation of the company’s assets and, on the other hand, they tiy to quantify the value that the company will generate in the future. Basically, these methods seek to determine the company’s value by estimating the combined value of its assets plus a capital gain resulting from the value of its future earnings: they start by valuing the company’s assets and then add a quantity related with future earnings.

 

The Classic Valuation Method

This method states that a company’s value is equal to the value of its net assets (net substantial value) plus the value of its goodwill. In turn, the goodwill is valued as n times the company’s net income, or as a certain percentage of the turnover. According to this method, the formula that expresses a company’s value is:

 V = A + (n X B), or             V = A + (z x F)

 

Where: A = net asset value; n = coefficient between 1.5 and 3; B = net income; z = percentage of sales revenue; and F = turnover. The first formula is mainly used for industrial companies, while the second is commonly used for the retail trade. A variant of this method consists of using the cash flow instead of the net income.

 

The Simplified “Abbreviated Goodwill Income” Method or the Simplified UEC Method

According to this method, a company’s value is expressed by the following formula:

V = A + an (B – İA)

 Where:

A = corrected net assets or net substantial value. an = present value, at a rate t, of n annuities, with n between 5 and 8 years. B = net income for the previous year or that forecast for the coming year.

i = interest rate obtained by an alternative placement, which could be debentures, the return on equities, or the return on real estate investments (after tax). an (B – İA) = goodwill.

 

This formula could be explained in the following manner: the company’s value is the value of its adjusted net worth plus the value of the goodwill. The value of the goodwill is obtained by capitalizing, by application of a coefficient an, a “superprofit” that is equal to the difference between the net income and the investment of the net assets “A” at an interest rate “i” corresponding to the risk-free rate.

 

In the case of the company Alfa Inc., B = 26; A = 135. Let us assume that 5 years and 15% are used in the calculation of an, which would give an = 3.352. Let us also assume that i = 10%. With this hypothesis, the equity’s value would be: 135 + 3.352 (26 – 0.1 x 135) = 135 + 41.9 = 176.9 million dollars

 

Union of European Accounting Experts (UEC) Method

The company’s value according to this method is obtained from the following equation:

 

V = A + an (B – iV)     giving: V = [A + (an x B)] / (1 + iaj

 

For the UEC, a company’s total value is equal to the substantial value (or revalued net assets) plus the goodwill. This calculated by capitalizing at compound interest (using the factor aj a superprofit which is the profit less the flow obtained by investing at a risk-free rate i a capital equal to the company’s value V.

 

The difference between this method and the previous method lies in the value of the goodwill, which, in this case, is calculated from the value V we are looking for, while in the simplified method, it was calculated from the net assets A.

 

In the case of the company Alfa Inc., B = 26; A = 135, an = 3.352, i = 10%. With these assumptions, the equity’s value would be: (135 + 3.352 x 26) / (1 + 0.1 x 3.352) = 222.1 / 1.3352 = 166.8 million dollars.

 

UEC: This is the acronym of “Union of European Accounting Experts

 

Indirect Method

The formula for finding a company’s value according to this method is the following:

 

V = (A + B/i)/2, which can also be expressed as V = A + (B – iA)/2i

 

The rate i used is normally the interest rate paid on long-term Treasury bonds. As can be seen in the first expression, this method gives equal weight to the value of the net assets (substantial value) and the value of the return. This method has a large number of variants that are obtained by giving different weights to the substantial value and the earnings’ capitalization value.

 

Anglo-Saxon or Direct Method

 

This method’s formula is the following: V = A + (B – İA) / tm

 

In this case, the value of the goodwill is obtained by restating for an indefinite duration the value of the superprofit obtained by the company. This superprofit is the difference between the net income and what would be obtained from placing at the interest rate i, a capital equal to the value of the company’s assets. The rate tm is the interest rate earned on fixed-income securities multiplied by a coefficient between 1.25 and 1.5 to adjust for the risk. In the case of the company Alfa Inc., B = 26; A = 135, i = 10%. Let us assume that tm = 15%. With these assumptions, the equity’s value would be 218.3 million dollars.

 

Annual Profit Purchase Method

With this method, the following valuation formula is used: V = A + m (B – iA).

 

Here, the value of the goodwill is equal to a certain number of years of superprofits. The buyer is prepared to pay the seller the value of the net assets plus m years of super-profits. The number of years (m) normally used ranges between 3 and 5, and the interest rate (i) is the interest rate for long-term loans.

 

Sources:

– Standard& Poors, Valuation Consultants, LLC

– Fernandez, Pablo, `Company Valuation Methods, The Most Common Errors in Valuations`, Johanning, Lutz, `Risk Management ` class notes, Kellogg, Northwestern U.

– Istanbul Technical University, “business valuation” Seminar Series, Cem Sari, 2011

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