Why worry about goodwill?

The mysterious stuff that underlies most of the stockmarket’s value

OK, so the accounting definition is simple enough: goodwill is the difference between the acquisition price for a company (or its market value) and the value of its assets.

But the question that often bothers me is what this weird, intangible stuff called goodwill actually is? How do you value it? Does it depreciate over time? And if I have more of it does that mean that someone else has less? I’m going to ramble about the subject (ignoring a lot of very good academic research) this week.

This is the problem I want to address. The standard way to value of a company is to estimate the discounted present value of its future cashflows i.e. the value in today’s money of all the cash that the company will pay out in the future.

The trouble with this approach is that future cashflows have no anchor. The only way to estimate them is to assume that profits grow at some rate over time - which is what investment bank analysts usually do - but this is a pretty poor guide to reality. CFROI analysis tries to get around this by relating future cashflows to capital invested.

Another way to look at it is that the discounted present value of a company’s cashflows should also be equal to the present value of its assets, if those assets are correctly defined: a company’s cashflows are simply the return on its assets. If it were possible to value a company’s assets correctly, it should be an attractive way to value the whole company.

The problem is that so much of what a company is worth is goodwill - the stuff that is not captured on the balance sheet - and is therefore hard to measure.

I’ll write a bit more tomorrow about what that stuff might be. In the meantime, if you can recommend good links or research on the subject, it’d be much appreciated.

January 7, 2008 | Filed Under Valuation

 

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One Response to “Why worry about goodwill?”

  1. What is goodwill? : The Rogue Analyst on January 8th, 2008 6:21 pm

    […] wrote yesterday (and not very clearly, reading again) about how the problem with an asset-based valuation of a […]

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