What is goodwill? Definition and meaning
Goodwill in the world of business, refers to the established reputation of a company as a quantifiable asset and calculated as part of its total value when it is taken over or sold. It is the vague and somewhat subjective excess value of a commercial enterprise or asset over its net worth. It is a vital component for increasing a company’s customer base and retaining existing clients. It also attracts investors and encourages stakeholders to forgive you if you make a mistake.
When a company is being acquired by another one for a premium value, that amount, above what it is believed to be truly worth – its book value – is known as goodwill.
Goodwill – an intangible asset – is the value of business’ brand name, good customer relations, extensive customer base, excellent employee relations and any proprietary technology or patents. These assets are not separately identifiable.
In a successful business, the whole is greater than the sum of the parts. The difference between the value of the whole and the sum of its parts is its goodwill. It is all about the nature of the business and the ethics and integrity with which people conduct their business. It is an honor that is impossible to imitate.
In a distress sale, when a business is acquired for less than its book value, the target company gains ‘negative goodwill’.
According to ipsosmori.com, most leading board directors in Britain’s top 100 corporations say that their company has at least a ‘fair amount’ of goodwill among their most important stakeholders – customers and employees.
Goodwill in accounting
If a company has a goodwill account, you can find it in the assets portion of its balance sheet.
It is reported on a company’s balance sheet as a non-current asset. US corporations have no longer had to amortize the recorded amount since 2001. Even so, the amount of goodwill is subject to an impairment test at least every twelve months.
It does not include identifiable assets which can be sold separately or divided from the commercial entity and licensed, rented, transferred, sold, or exchanged.
The task of maintaining goodwill and mutual understanding between a company, its customers and the rest of the general public is usually undertaken by the Public Relations or Marketing department.
According to ssr.com, if it is determined that any exists, total goodwill may be separated into personal and enterprise components. In order to determine whether it is attributable to that of an enterprise or a particular person, an investigation into its source is required.
The pricing of goodwill
Goodwill is extremely difficult to price, however, it does make a commercial enterprise more valuable.
For example, the drinks company Coca-Cola – which has been around since 1886, makes a popular product based on a secret formula, and is generally perceived positively by the general public – has a lot of goodwill.
A small competitor that has only been around since the turn of the century, specializes in unusual soda flavors, and recently had to face a scandal over a contaminated batch, would have considerably less goodwill than Coca-Cola.
Give that its components have subjective values, there is a considerable risk that a predatory company might overvalue goodwill in an acquisition.
For the stockholders of the acquiring company, this overvaluation would be very bad news, because they would probably see their share values decline when the company later needs to write down the intangible asset. This is exactly what happened in the AOL-Time Warner merger in 2001.
What creates business goodwill?
There are several factors that contribute to the creation of this intangible asset, such as:
- Expectation of future economic benefits: the owners of a company believe that it has additional value because they think it will continue creating new products and services, attracting new customers, and merging with other businesses.
- Excess business income: implies the existence of earnings in excess of a fair return on all the other business assets. The belief is that this extra income is due to goodwill.
- Going concern value: the existence of business assets ready for use in generating income. The value is created because the company can effectively apply its financial resources & equipment, manpower, and management to generate economic benefits for its owners.
Types of goodwill
- Institutional Goodwill – this is related to the company, its position in the marketplace, and how well it serves its customers.
- Professional Practice Goodwill – this relates to professional practices such as engineers, accountants, lawyers, doctors, architects. This type has two components:
- Practitioner Goodwill – this is related to the reputation and skill of the individual professional.
- Practice Goodwill – arises from the practice itself, its track record, institutional reputation, location, and operating procedures.
The Old English word Godes Willan meaning ‘state of wishing well to another’ dates back to 13th century Britain. In its modern business-English sense, the term did not appear until the 1570s with the meaning ‘degree of favor enjoyed through patronage of customers.’
In non-business English, the term means helpful and friendly feelings, as in: “Releasing half the hostages was seen as a gesture of goodwill by the terrorists.”
According to gurufocus.com, the Coca-Cola Company’s goodwill value for the quarter that ended in September 2016 was $10,865 million ($10.865 billion), compared to $11,357 million ($11.357 billion), i.e. over the twelve-month period it declined. However, over a ten-year period, it increased considerably – in December 2006, its value was estimated at $1,403 million.
Apple Inc. has seen the value of its goodwill literally explode over the past decade. In September 2007, it was estimated to be worth just $38 million, it then jumped to $207 million a year later, $1,135 million in September 2012, then $5,116 million in September 2015, and $5,414 in September 2016. The increase over the past twenty-four months has been considerably slower than during the previous years. The most impressive jump was from September 2013 to September 2014 when it jumped from $1,577 million to $4,616 million.
The goodwill value of Alphabet Inc., the parent company of the American multinational technology giant Google, stood at $19,395 in September 2016, compared to $1,892 in December 2006, and $7,300 in December 2010.
Video – What is the definition of goodwill?
In this Money Week video, Tim Bennett explains what goodwill is. He says that it is something investors, directors and other stakeholders cannot afford to ignore. If you want a clear, easy-to-understand explanation of the term, watch Mr. Bennett’s presentation.