How Does Goodwill Increase a Company's Value?

What Is Goodwill and How Does It Increase Corporate Value?

Business goodwill is an intangible asset owned by and associated with the operation of a company. Goodwill is the premium that is paid when a business is acquired. If a business is acquired for more than its book value, the acquiring business is paying for intangible items such as intellectual property, brand recognition, skilled labor, and customer loyalty.

Understanding Goodwill and Its Effects on Corporate Value

Factors such as proprietary or intellectual property and brand recognition are reflected in goodwill. While goodwill is not easily quantifiable, it can be calculated by taking the purchase price of a company and subtracting the difference between the fair market value of the assets and liabilities. In fact, companies are required to record the value of goodwill on their financial statements and record any impairments. While intangible assets typically have a finite useful life, goodwill is considered indefinite.

The presence of goodwill implies that a company's value is greater than its combined raw assets. The effect of goodwill on a company's value is better understood by learning the factors that create business goodwill. The three factors in the creation of a company's goodwill include its going concern value, excess business income, and the expectation of future economic benefits.

1. The going concern value indicates that the company can produce income by applying existing capital (equipment, employees, management, and resources) effectively.
2. The excess business income implies that a company is earning additional income due to the presence of its goodwill.
3. The overall value further increases when expectations for economic growth are added to the equation. A company is expected to attract new customers and create more products, resulting in combined wealth.

How Business Goodwill Is Determined

A business's goodwill is caluculated by subtracting the fair market value of the tangible assets from the total business value. Business goodwill is also determined by the capital surplus earnings method, which calculates the fair market value of the business assets, determines the fair rate of return on said assets, and subtracts the return from the company's total earnings. The resulting excess earnings are considered the goodwill of the company.

Example of a Goodwill Calculation

Company A acquires company B for $4 million. Company B has assets equaling $2.8 million and liabilities equaling $400,000. The net assets of Company B are $2.8 million minus $400,000, which equals $2.4 million.

Goodwill equals $1,600,000, or $4 million minus $2.4 million.

Thus, company A paid $1,600,000 premium above the company’s net assets to acquire its assets, which add to its earning power. The goodwill account is located in the assets section of the balance sheet.