Audit and Technical Partner Leavitt Walmsley Associates Ltd
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Goodwill: Guide to simplified valuations

25th Feb 2013
Audit and Technical Partner Leavitt Walmsley Associates Ltd
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Accounting for goodwill has always been one of the more controversial issues faced by accountants for many years, explains Steve Collings.

AccountingWEB recently covered the issue concerning goodwill and intangible assets in an earlier article which addressed the accounting requirements for goodwill, as well as intangible assets.

Many accountants will associate goodwill as being the value inherent in the business due to a built upon reputation or the value attributed to a well-known brand or company name. Lord MacNaghten in the case of Commissioners of Inland Revenue v Muller & Co Margarine (1901) AC215 defined goodwill as follows:

“What is goodwill? It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation and connection of the business.  It is the attractive force which brings in custom. It is the one thing which distinguishes an old established business from a new business at its first start. Goodwill is composed as a variety of elements. It differs in its composition in different trades and in different businesses in the same trade. One element pay preponderate here, and other there.”

Lord MacNaghten merely defined goodwill in his summing up, which is one thing. The challenge for accountants is how such goodwill is valued. 

Valuation techniques

There are various techniques associated with the valuation of goodwill which can be split into the three most common:

1. Simple multiple approach

2. Turnover approach

3. Whole company approach

Simple multiple approach

The simple multiple approach is more appropriate for small, straight-forward businesses (typically owner-managed businesses). In a nutshell the way this works is to apply a multiple to sustainable profits before management/owners’ remuneration. 

The range of multiples used in the calculation of goodwill usually varies between one and five. Typically where a business is showing strong growth and is experiencing high levels of profitability, the multiples used will be at the higher end of the scale. On the flip side, if a business is in decline, the multiples used will typically be at the lower end.

Illustration

Company A Limited is a husband and wife run company.  The following information is relevant:

  • The company operates in the publication of e-books through a website
  • The company has witnessed steady growth over the last few years and have started to see an increased number of subscribers to their products
  • Turnover for the last financial year amounted to £1m and profit before taxation is £70,000 after directors’ salaries of £30,000
  • Net assets are very low with computer equipment being the only real assets owned by the company as the business is operated from a converted garage at the marital home. Net assets amount to £15,000

The couple have asked you to value the goodwill in their business and provide them with a business valuation.

£70,000 pre-tax profit plus £30,000 remuneration results in profit of £100,000. If you opt for a multiple at the lowest end of the scale (one), this will give rise to goodwill of £100,000. Add to this the net assets of the business of £15,000 and this will give a business valuation of £115,000.

Turnover approach

This method is commonly used in a professional practice (such as when an accountancy or solicitors’ practice is being sold). Multiples are then applied to these fees which are usually between 0.5 and 1.5 - though of course such ranges are often subjective and will depend on various factors such as the quality of the clients, financial health of the business and historical trends. As with the simple multiple approach, a business that is experiencing a higher level of growth will often have a higher multiple applied to it - this can sometimes be as high as 2.5 for a business that is experiencing a high degree of profitability and growth and as low as 0.25 for a business in decline.

When such businesses are being sold it is not uncommon to apply a multiple for a company in the same industry/profession that is quoted and to then discount this multiple back to take account of the smaller size of such a business as can be illustrated as follows:

Illustration

A firm of accountants consists of four partners and is an independent practice and not listed on any stock market. The practice has been in existence for several years, is well-established with a good client base. Two of the partners are relatively young and over the last six years have been driving the practice forward and have been successful in gaining a number of lucrative clients. The firm currently rents its offices from an unconnected third party commercial lettings agency. Financial facts are as follows:

  • Turnover is £2.5m
  • Margins are standard
  • The corporate financiers have estimated that quoted firms are currently trading at 1.4 x turnover

The partners have asked for a valuation of the goodwill attributable to the firm.

The valuation is calculated as £2.5m turnover multiplied by 1.0 = £2.5m goodwill. You have to discount back the 1.4 multiple as this applies to a firm that is listed on a stock market. The four-partner firm above is not listed and relies on the partners as well as a lack of assets, hence the multiple selected is 1.0.

Whole company approach

This is generally a very common approach to valuing goodwill. It works by valuing the entire business and then deducting tangible/intangible assets to find the residual amount which is the goodwill. 

In a nutshell, the whole company approach works by basing the valuation on a multiple that is applied to sustainable profit. Where this results in a valuation that is less than the adjusted net asset value, the assumption is that there is little (or even no) goodwill inherent in the business. The calculation uses a P/E ratio which is basically the relationship between after-tax profits of a business and its capitalised value. P/E ratios are often adjusted to take into account any ‘one-off’ items such as one-off bonus payments to directors or other exceptional items.  

Illustration

A company makes post-tax profits of £200,000 and is sold for £1.5m. The P/E ratio is calculated as (£1.5m/£200,000) 7.5.

An important point also to emphasise is that assets contained within a company’s balance sheet will need to be valued at fair value, where applicable and not at the lower of cost and net realisable value which is the method often used when the balance sheet itself is constructed.

Illustration

A company is in the plant and machinery hire business and has been established for several years and has an extremely strong customer base that places a significant amount of repeat business. 

The company’s turnover is £15m and post-tax profit has remained stable at £800,000 per annum.  There are no exceptional items and the company’s balance sheet shows net assets of £600,000 including its building which was purchased for £100,000 several years ago and has an open market value at today’s prices of £1.2m. 

The company’s external accountants have arrived at an adjusted P/E ratio of six.

The directors of the company are considering selling the business and have asked for a valuation to be placed on the company’s goodwill.

Valuation:          

Post-tax profit £800,000 x 6 £4,800,000
Net assets £600,000
Gain on property £1,100,000 £1,700,000
Goodwill £3,100,000

In this scenario the property uplift gives rise to a material difference in the goodwill valuation. Other factors that may also give rise to a difference in the goodwill valuation could include assets that are let out to third parties (hence do not contribute to the profitability of the business) and any surplus cash that may need accounting for.

Conclusion

Goodwill is (probably) one of the most controversial and subjective areas of accountancy and has the potential to lend itself to a whole host of misdemeanours. This article has concentrated on simplified valuations of goodwill, but these often become more complex in real-life situations.

Steve Collings is the audit and technical partner at Leavitt Walmsley Associates and the author of ‘Interpretation and Application of International Standards on Auditing’. He is also the author of ‘The AccountingWEB Guide to IFRS’ and ‘IFRS For Dummies’ and was named Accounting Technician of the Year at the 2011 British Accountancy Awards.

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Replies (6)

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By cfield
26th Feb 2013 00:16

Ongoing contracts

Good article Steve, but it would be good to explore how goodwill is influenced by the value of ongoing contracts. Take a firm of estate agents for example. They may have have properties on their books that they've been instructed to sell as at the valuation date, but the fees are contingent on a) how much the property sells for, and b) whether it sells at all.

Firstly, you have to decide whether the contracts are part of the overall goodwill of the business or separate assets to be valued in their own right. That will be a subjective judgement based on the probability of sales materialising.

Secondly, how do the contracts not valued as separate assets affect goodwill? After all, if a new client enters the branch whilst the value of the business is being negotiated and instructs you to sell his house, that surely must affect the value somehow, but to what extent? Turnover and profit multiples are based on historic information and will not be affected by the new contract. Nonetheless, clearly the firm is worth at least a little bit more as any sales commission on that new contract will go to the buyer.

This is quite a relevant issue with most professional firms, including accountants. Let's imagine an Arab oil sheikh arrived in the midst of selling my practice and asked me to quote for his accounts, I would expect the buyer to increase his offer (assuming I could prove he wasn't my brother in a white sheet and a false beard). 

I wouldn't expect him to claim that goodwill was unchanged because the business had not actually been won yet. After all, how much would you pay for a lottery ticket if there was a 5-1 chance that you could win a million pounds?

It's beyond the scope of this article, but I also wonder whether ongoing contracts can qualify for Entrepreneurs Relief on the grounds they are part of the overall goodwill, or if you have to treat them as separate assets not qualifying for ER as they are usually less than a year old.

I'm inclined to say they do, as the only way they differ from all the other potential sources of future profit that make up goodwill is in their identifiability and the likelihood of profit materialising in the short term. I recently had a debate with HMRC on this point. Would be good to know what others think.

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Galaxian
By Galaxian
26th Feb 2013 08:08

ER

It is not necessary that the assets themselves have been owned for one year - it is the business that must be owned for that period.

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By newport daz
27th Feb 2013 12:16

Goodwill Valuation

Hi all this is my first post after discovering this excellent site, so if my question is in the wrong place or is hijacking the thread I apologise and please delete me. However, it does regard goodwill valuation.

 

I'm an ACCA student that works for a CTA and a common manouvre he uses to gain tax relief for clients is as follows:-

 

Sole trader has plant and mchinery, vehicles etc then incorporatesw putting said assets into company. Large amounts of goodwill are generated on the balance sheet as a consequence.

 

This is what I don't understand. At college we're taught that :-

 

Consideration paid              x

less net assests aquired    (x)

Goodwill arising                  x

 

My question is, if the ltd compnay aquires the assets but doesn't pay anything for them, how does the goodwill arise and how do you put a value on the goodwill that has arisen?

 

Again i'm sorry if this is the wrong place, delete me.

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By G A Lyon
27th Feb 2013 13:12

There is no third party as such

You don't have a consideration to start the calculation, you start with net asset value and add the calculated goodwill (on basis appropriate) to get to consideration. Usually on incorporating a sole trader this then is credited to the Directors Loan account.

 

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By jdm5454
28th Feb 2013 11:58

Not forgetting that the sole trader will then have a potential capital gain.

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By mtoms
25th Nov 2013 14:55

Owners remuneration

This was a useful article.  We have had our goodwill valuation disputed by HMRC partly on the basis that they want to deduct an assumed owners remuneration from profits before applying a multiple to profits. This is a professional Chartered Surveyor firm and they are using the following:-   Net Profit less: £80,000 x 3. This article suggests that the profit before owners remuneration should be used as a basis. Does anyone have a similar experience and recommend a reply to HMRC

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