What is goodwill?
The stuff that makes a company worth more than the sum of its parts
I wrote yesterday (and not very clearly, reading again) about how the problem with an asset-based valuation of a company is goodwill. Accurate valuation of the tangible assets can be tricky, but it’s possible. It’s the difference between the book value and the market or acquisition value - what the goodwill of the business should be - that is so hard to analyse.
I always puzzle about what this stuff called goodwill is. You might break it down like this:
(1) Tangible assets undervalued on the balance sheet - e.g. land or investments held at historic cost. Not really goodwill.
(2) Intangible assets, definable and created by investment, but not measured on the balance sheet. Examples include brands, as a result of advertising, intellectual property rights, software etc
(3) Contracts. For example, if I agree to buy 1m barrels of oil at $50, and the price rises to $100, that contract has a positive value. More generally, all the contractual relationships of a company have a value, which fluctuates according to market conditions. A contract could give rise to negative goodwill, if I have an obligation to sell lower than my cost of production.
(4) None of the above. This is the really interesting category. Imagine that I open a restaurant. I start with zero goodwill. But over time people pass the restaurant and remember where it is - that is goodwill. It may get included in guidebooks - that is goodwill. It will build up a base of repeat diners - that is goodwill. And they may recommend it to friends - that is also goodwill.
It gets even more complicated. Say I have a Japanese restaurant in a town of 50,000 people. It can only support one Japanese restaurant. Therefore, just by opening the restaurant, I will discourage another entrepreneur from doing the same. I’ve acquired a local monopoly that will make my restaurant more profitable - in asset terms, that is goodwill.
It gives rise to a number of fascinating questions and propositions:
- Will goodwill keep rising automatically over time as more people get to know my restaurant? I.e. is an old business always worth more than a new business?
- If someone else opens a new restaurant next door, their goodwill will go up, and mine will go down. If I have goodwill does that always mean negative goodwill for somebody else?
- How is it possible to maximise the goodwill in a business?
- And, most important for a financial analyst, is there any way to value it?
Comments
2 Responses to “What is goodwill?”
Leave a Reply
-
Find It
-
Subscribe by RSS
-
Disclaimer & Risk Warning
This website is about my investments and opinions on shares. It does not constitute advice and you should not rely on any material in this website to make, or refrain from making, any decision or take, or refrain from taking, any action. Where I have positions in a share I mention I will disclose them. Rogue Analyst is not authorised under the Financial Services and Markets Act 2000.
-
Recently Written
-
Categories
-
Monthly Archives
-
Blogroll
-
Admin
[…] I used the example of a Japanese restaurant to try and show how the goodwill value of a new business builds over time. “Imagine that I […]
Hallo Rogue Analyst,
I’m intrigued by your `Goodwill’ desciptions. Clearly in trying to establish the intrinsic value of a business, goodwill has a fundamental, albeit intangible, value. The shareprice fall today of Severfield Rowen (SFR) for example, looks way overdone, especially when set against its fundamentals (e.g. ROCE: 35% and Price/sales 0.7) and the `goodwill’ of its successful structural engineering business. Benjamin Graham’s `Mr Market’ is having one of his manic depressive `fits’ today.
Just for the record I’m a network marketer which uses the this `goodwill’ factor in order to move product/services, in my case I’m spreading `health & wellness’ across the world….just thought I’d mention that in passing! I also have my own (quiet) value blog: http://journals.aol.co.uk/spcdesign/BargainIssue
Regards JL