Goodwill is an intangible asset for a company that comes in many forms such as: reputation, brand, domain names, commercial secrets, etc. It can be difficult to calculate, but there are two methods for doing so.
Halsbury's Laws of England (4th edition, Vol. 35) states that:
“The goodwill of a business is the whole advantage of the reputation and connection with customers together with the circumstances, whether of habit or otherwise, which tend to make that connection permanent. It represents in connection with any business or business product the value of the attraction to the customers which the name and reputation possesses.”
International Financial Reporting Standards (IFRS) IAS 38, "Intangible Assets," does not allow recognizing internally generated goodwill (Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance). The only accepted form of goodwill is the one that acquired externally, though business combinations or acquisitions.
For example, Facebook (FB) bought the domain name fb.com for $8.5 million from American Farm Bureau Federation. Apparently, this domain name did not have any other benefit than name. Thus, the whole amount paid can be considered as goodwill and Facebook would recognize it on its balance sheet. However, before the acquisition, the American Farm Bureau Federation could not recognize it on its balance sheet.
How To Calculate Goodwill
According to IFRS 3, "Business Combinations," goodwill is calculated as the difference between the amount of consideration transferred from acquirer to acquiree and net identifiable assets acquired. The general formula to calculate goodwill under IFRS is:
As you see, the amount of non-controlling interests (NCI) appears in the formula, thus the methods of non-controlling interest measurement will affect in determining the goodwill. Under IFRS 3, there are two methods for measuring non-controlling interests (NCI):
- Fair value
- Non-controlling interest’s proportionate share of the acquiree’s net identifiable assets
Example: “A Inc.” acquires “B Inc.”, agreeing to pay $150 million to obtain a 90% interest in B. The fair value of the non-controlling interest is $16 million. Considering that the fair value of net identifiable assets to be acquired is $140 million and that no equity interests existed, the amount of the goodwill will be: $26 million ($150 + $16 - $140). This is also called "full goodwill method."
Under the second method of measuring the NCI, the goodwill value that is recognized is $24 million (150 + [140 x 0.1] - 140). Thus, there is a difference of $2 million between the amount of the goodwill calculated under the two methods.
The Bottom Line
Despite being intangible, goodwill is quantifiable and is a very important part of a company's valuation.
Disclosure: At the time of writing, the author did not have holdings in any of the companies mentioned in this article.