Goodwill: Guide to Valuation
Before buying securities, experienced investors look at the issuer’s financial report. And among its assets they find goodwill. This term refers to the value of a company’s goodwill expressed in monetary terms. Here is what goodwill is, what it consists of and how to calculate it.
What Is Goodwill
Goodwill is usually understood as business reputation and its components. For example, goodwill is affected by:
- Product quality.
- Qualification of employees.
- The size of the target audience.
- Volume of consumer demand.
- Brand valuation.
It’s possible to evaluate goodwill for any business, even if it’s a local grocery store or an online casino.
Goodwill is recognized in the financial statements under “other intangible assets” in the subsection “non-current assets”.
Goodwill is also valued:
- When buying a company — the cost of real capital is deducted from the purchase price.
- When shares are traded on the stock exchange — the cost of real capital is deducted from the market value of the company.
Companies are required to evaluate goodwill annually according to international financial reporting standards and reduce it if impairment events occur. Let’s say a scandal erupts around the company, charges are brought against it in court, or consumers learn that the quality of products has become worse.
What High Goodwill Indicates
In 2023, Amazon’s goodwill is valued at $22.749 billion. That’s 8.9% of the value of all assets.
It’s the ratio of goodwill to assets that matters to an investor. If the ratio starts to increase rapidly, it could indicate that the company is in a buying boom. The following factors can influence the high value of goodwill.
The company employs a highly skilled workforce. A more skilled workforce increases a company’s competitiveness and its resilience to industry challenges. Attracted professionals help the company to develop faster than competitors.
Popular brands and reliable partners cooperate with the company. A company with a positive business reputation rating increases the trust of potential business partners and suppliers. Such a company has a higher chance of getting a major project or starting cooperation with government agencies.
The company can sell goods at a higher markup. Goods of a well-known brand are more expensive than similar goods of less popular brands. A high markup increases the company’s profit, and the investor can count on dividends.
The consumer develops a loyal attitude towards the brand. If customers trust the brand, it’s easier for the company to conduct experiments and launch new products. Customers are more willing to try the goods of their favorite brands.
Investors prefer to invest in companies with a high assessment of business reputation.
For example, in securities that are steadily increasing in value. But too much goodwill (for example, when it equals or exceeds the value of assets) can indicate a stock bubble. This is a period of frenzied demand, when the value of securities
For example, in securities that are steadily appreciating in value. But too much goodwill (e.g., when it equals or exceeds the value of assets) may indicate a stock bubble. This is a period of frenzied demand when the value of securities rises rapidly and unreasonably. Once market participants realize that the price is overpriced, the bubble bursts — the price of the securities drops precipitously.
Whether Goodwill Can Be Relied Upon to Value Investments
According to a study by Arthur Andersen, in 1978 the book value of U.S. companies was about 96% of market value. Already in 1998, this figure dropped to 27%, and the downward trend continued. Now in the stock market, the valuation of goodwill of U.S. companies is almost more important than ever.
But companies can always write off goodwill, and top management can always use this concept for financial manipulation of reporting.
Summary
It’s best not to ignore goodwill when evaluating companies for investment. The share price of an issuer with a positive business reputation may increase.
The reputation indicator can be used to deceive, indicating potentially high volatility of securities and real competitive advantages. Besides analyzing financial statements, an investor should monitor economic news.
Quality advertising, a high level of innovation, and a well-known person in management may be behind high goodwill. These “provide” some portion of the stock price.
Therefore, it’s important for the investor to understand whether they are satisfied with this security, or whether the goodwill may be significantly impaired in the near future, for example, if the famous person leaves the company.
