What is the value of goodwill?
Valuing goodwill in business acquisitions is a challenging part; the value of goodwill is subject to many different perceptions. The seller may place great value on the accumulated customer base, while the buyers perception of value of the same customer base is quite different. This raises questions: "How much value is built up with the customer base?", "Can a price be put on the value of 1 customer at all?", "And what is that value based on?". Answers to these questions are found by working with many well-known metrics such as customer-lifetime value, conversion rates, email opening rates, average order value per customer and many more. Many metrics used to get a handle on what is essentially intangible: Goodwill.
Goodwill explained
It is relatively easy to determine the value of a company from its assets and liabilities for accounting purposes, but of course, a company is more than what is on the balance sheet. For example, like the example mentioned earlier, in its operative years a company has gathered many customers, built up good brand awareness, developed special internal knowledge or gained great online visibility. The exact value of these qualities is difficult to determine, mainly because these accumulated values cannot be directly quantified. These hard-to-quantify values are also called intangible capital gains. In this article, we take a closer look at these intangible capital gains values, goodwill, and answer the most important questions:
1. What is goodwill?
Goodwill is all the intangible capital gains a company has accumulated and the future earnings potential of these capital gains. It is especially important to consider the terms "accrued capital gains" and "earnings potential". The "accrued capital gains" are the past accumulated qualities that have allowed the company to grow and support the company in its current state (and success). The earnings potential is the ability to generate profits in the future with the qualities accumulated in the past.
Goodwill, by definition, therefore includes appreciation of the past (the qualities accumulated) as well as the future (how the qualities continue to pay off). To use a metaphor; The accumulated goodwill is like fertile soil for a good harvest. The more fertile the accumulated soil, the better the harvest in the future. If we think of a good brand awareness for example: this is not quick to build up and therefore a competitive advantage, it gives credibility and will reduce future marketing costs. All for the benefit of the company's future profit potential. Good brand awareness is the fertile ground from which future (additional) profit potential can be harvested. But how fertile is the soil, the accumulated added value, really? And can the competitor easily imitate, improve or even take over these qualities, thus creating additional risks?
These are all important questions for arriving at an informed value judgment of goodwill. But before we dig deeper into "how to calculate goodwill?" a few more examples of goodwill to get a better idea and delve into goodwill for e-commerce companies.x
Examples of goodwill:
- Name recognition
- (Specialist) knowledge in the company
- Loyal customer base
- Location / online visibility
- Patents
2. What is goodwill for e-commerce companies?
Online businesses can take advantage of the online playing field in addition to the regular ways of building goodwill. These sources of accrued capital gains are often overlooked, which is a shame.
Goodwill through online data tracking
E-commerce companies have the unique ability to track, track all business processes down to the last detail. From marketing campaigns with number of views, to customer review scores. Thus, the process is monitored from a to z and can be managed on this feedback. Online businesses have much more data collection points than physical businesses, or at least; collection and anticipation is much faster. This makes for a fast feedback loop and to business processes that can be perfected to perfection. There is value in the ability to track a lot online and process the feedback. Knowledge has been gained through much trial and error and this has resulted in a company that is optimized to a far degree. An example:
Using Facebook ads for 10 years without tracking the results and incorporating this feedback brings little in terms of added value. But if a Facebook pixel has been running for 10 years and the results have been continuously examined, the feedback incorporated into better targeting, then the 10 years of optimized ads and all the knowledge certainly adds value. This accumulated knowledge significantly increases the future profit potential. Namely, the next ad can be targeted to the most receptive audience, age, location, with the best performing ad visuals, texts and the most effective conversion optimization etc. In short: A strong Facebook pixel leads to more sales for less cost because the company knows how to reach the customer more and more efficiently and effectively. Because of this valuable knowledge, the future profit potential is higher, i.e. goodwill is built up. To calculate the goodwill, this profit is discounted to the present and the assets are subtracted. You can read more about the calculation under question 3: How to calculate goodwill.
Goodwill through online visibility
Building up online visibility is like building up and marking out a territory. When an e-commerce company is among the first listings in search engines, it means a big lead in clicks, and often customers. Therefore, in the online playing field, it is not enough to merely work on increasing brand awareness, but it is additionally important to gain online territory on keywords the company stands for. There are several ways for building online territory, important examples being search engine optimization (SEO) and link building. An example of how SEO and link building creates value:
Building online visibility through SEO and link building mainly requires one major investment; time. Time in writing unique and relevant content, in making the right contacts and optimizing the offering. In vein of the well-known English saying "things worth having are worth waiting for", building online visibility can also be seen. It goes slowly but when it is built it is worth a lot. Customers find your business easily while your costs remain low, this increases future profit potential, and this added value can be classified as goodwill.
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We now have a clearer picture of what goodwill is and where online businesses can build goodwill. The next step is to calculate goodwill.
3. How to calculate goodwill?
Recognizing goodwill in accumulated qualities is the first step, the second step is to express goodwill in a specific value. Goodwill is the difference between a company's accounting / intrinsic value and its market value. The accounting value is calculated by setting off the assets on the balance sheet against the liabilities. What remains is visible equity and can be shown as value for accounting purposes. The economic value is calculated by looking not only at the status quo, as with accounting value, but it also looks at the qualities of the business and how these qualities can generate additional returns in the future. The projection of the additional return in future years is discounted to the now so that it is expressed in a present economic value. This calculation is often done using the discounted cash flow method. The beauty of the economic value is that it takes into account both the historical performance, after all these can be seen in the current result, and it looks at the future earnings of these qualities.
Goodwill is the difference between economic value and accounting value. In most cases, the buyer and seller of a business will use the economic value as a starting point, then in negotiations they will compare their perceptions regarding the accrued capital gains. The goodwill actually paid and capitalizable is then the difference between the final acquisition fee paid (the market price) and the apparent equity.
Help with goodwill valuation
Would you like advice regarding goodwill or a valuation of your business? We would be happy to get in touch with you! You can reach us at 020 218 44 99. Are you considering an acquisition of a business, please see our 'For Sale' page for all online businesses for sale.