What goodwill is and how a valuation works it out

The short answer, explained

Goodwill is the value of a business as a going concern over and above the things that can be separately identified and valued: plant and equipment, stock, debtors less creditors, and identifiable intangibles such as registered trade marks or contracts. It reflects the customers, location, systems, staff and reputation that make the business earn more than its assets alone would.

In a valuation, goodwill is not calculated on its own. The valuer first values the business as a whole, usually from its earnings, and then subtracts the identifiable net assets. What remains is goodwill. The accounting standard for business acquisitions uses the same logic: AASB 3 measures goodwill as the excess of the consideration over the net identifiable assets acquired and liabilities assumed.

Why goodwill is a residual

A buyer pays for the earnings the business is expected to produce. Those earnings come from using all the assets together. The ATO ruling on goodwill, TR 1999/16, summarising the High Court in FC of T v Murry, describes goodwill as attaching to the whole business rather than to each separate asset, and records the court's view that the value of a profitable business can be measured as the difference between the present value of its expected earnings and the fair value of its identifiable net assets.

Two consequences follow:

• There is no separate goodwill formula. A rule such as "goodwill equals one year's profit" is not a valuation method. The business is valued first; goodwill is what that value implies.
• Goodwill must not be added on top. If the business has been valued from its earnings, the goodwill is already inside that figure. Adding a goodwill amount to an earnings-based value counts the same earnings twice.

What changes the size of goodwill

Because goodwill is the residual, anything that moves the whole-business value or the asset values moves goodwill:

• Maintainable earnings. Higher, more reliable earnings support a higher whole-business value and so more goodwill. Earnings have to be normalised first, for example by charging a market salary for a working owner; see normalising a working owner's salary.
• The capitalisation rate or discount rate. A riskier business is valued at a higher rate, which lowers the whole-business value and the goodwill. You can see the effect with the capitalised earnings sensitivity tool.
• Asset values. If the plant is revalued upwards and the whole-business value does not change, goodwill falls by the same amount. The total is unchanged; only the split moves.
• What would transfer to a buyer. Earnings that depend on the owner personally may not pass to a new owner, which reduces the whole-business value and so the goodwill.

Personal and business goodwill, briefly

Some of the value of an owner-run business may depend on the owner's own skill, licence or relationships. TR 1999/16 notes that when a sole practitioner sells, the part of goodwill coming from their personality, reputation or skills is not transferable, while other sources of goodwill can continue to draw customers. Where the line falls can change a valuation materially. Oliver Group, the Valuo practice for restructures, tax and buyouts, sets out how valuers separate the two in personal vs transferable goodwill.

Worked example: goodwill as the residual

This example is hypothetical. The figures are round numbers chosen to show the steps.

A business is valued from its normalised earnings at $1,200,000 on a cash-free, debt-free basis with normal working capital.

Check: $250,000 + $180,000 + $70,000 = $500,000, and $1,200,000 less $500,000 = $700,000.

Now suppose the plant is valued at $300,000 instead of $250,000 and the earnings are unchanged. Identifiable net assets become $550,000 and goodwill becomes $650,000. The business is still worth $1,200,000.

When goodwill is nil. Suppose instead the normalised earnings support a whole-business value of only $420,000 while the identifiable net assets are still $500,000. The earnings do not justify the assets, so there is no goodwill. The valuation then turns to what the assets would realise, which is the subject of valuing an asset-heavy business.

Limitations

• Goodwill for capital gains tax follows the legal meaning applied by the ATO in TR 1999/16, which the ruling notes can differ from the accounting view, particularly for a business that is not profitable. Tax questions about goodwill belong with a tax adviser.
• The split between goodwill and identifiable intangibles depends on what can be separately identified and valued, which varies by business.
• Family law and some agreements may use a different standard of value, which can change how owner-dependent goodwill is treated.
• The example values all of a business. A part interest raises separate questions; see is a minority shareholding worth its percentage.

Next steps

• Ask your accountant for normalised earnings and an up-to-date asset register before discussing goodwill.
• If someone quotes a goodwill figure, ask how the whole-business value behind it was worked out.
• If the business depends heavily on you personally, read the Oliver Group article on personal goodwill and raise it early with your valuer.
• Test how sensitive the residual is to the capitalisation rate with the capitalised earnings sensitivity tool.

General educational information, not financial, tax or legal advice. Worked examples are hypothetical and do not value a real business. A valuation depends on its purpose, the evidence and the agreed scope.