Chapter 12 Appendix 12A Valuing Goodwill Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto

The Excess Earnings Approach A widely used method to estimate goodwill in a business is the excess-earnings approach Steps: 1. Calculate company’s expected annual average “normalized” earnings 2. Calculate annual average earnings if company earned same return as the industry average 3. Calculate company’s excess earnings 4. Estimate the value of goodwill based on excess earnings

Company’s Average “Normalized” Earnings Given the following for Tractorling Corp.: Identifiable net assets (FV): $ 350,000 Earnings history (2006–2010): 2006: $ 60,000 2007: $ 55,000 2008: $110,000 2009: $ 70,000 20010: $ 80,000 Total earnings for the five years = $375,000

Company’s Average “Normalized” Earnings Average earnings: $375,000 = $75,000 5 years We now need to normalize the earnings for Tractorling Corp.

Company’s Average “Normalized” Earnings Normalized earnings is representative of future earnings Accounting policies applied should be consistent with that of the purchaser Future earnings should be based on fair value of the net assets rather than the carrying amount of the net assets Non-recurring amounts are adjusted out (e.g., extraordinary gains/losses, unusual items)

Company’s Average “Normalized” Earnings Average previous earnings $75,000 Add: Adjust for Inventory $2,000 Adjust for Amortization 3,000 5,000 80,000 Less: Gain on Discontinued Operations (average) 5,000 Patent amortization 1,000 6,000 Expected Future Earnings $74,000

Average Earnings Using Industry Average Expected earnings without goodwill Industry average rate of return: 15% Fair value of net identifiable assets $350,000 Industry average rate of return 15% Normal earnings (if no goodwill) $ 52,500

Excess Earnings Expected future earnings $74,000 Normal earnings 52,500 Excess earnings $21,500 Excess earnings must now be discounted to their present value

Discount Rate Higher discount rate normally used: discounting future cash inflows that may be riskier higher discount rate will lower goodwill Factors to consider when determining discount rate: Stability of past earnings Speculative nature of business General economic conditions

Discount Period Discount period based on: Professional judgement Estimation of how long the excess earnings are expected to last

Value of Goodwill- Excess-Earnings Approach Rate of return required by purchaser = 15% Discount period = perpetuity Expected earnings = $74,000 Normal return = $52,500 Excess earnings = $21,500 Goodwill = $ 21,500 ÷ 0.15 = $143,333

Total-Earnings Approach Total-earnings approach is an alternative approach to estimating goodwill The value of the company as a whole is determined based on total expected earnings Fair value of identifiable net assets deducted from the value of the company Difference is goodwill

Total-Earnings Approach Goodwill = Fair value of Company – Fair value of identifiable net assets FV of Co. = $74,000 ÷ 0.15 = $ 493,333 FV of identifiable net assets 350,000 Goodwill $ 143,333

Other Valuation Methods Number of Years Method Excess earnings multiplied by the number of years excess earnings expected to last Advantage: simple Disadvantage: does not consider time value of money

Other Valuation Methods Discounted Free Cash Flow Method Project the free cash flow over a 10–20 year period Free cash flow: that amount of cash from operations in excess of what is needed to maintain existing capacity Discount this amount Result is the value of the business

COPYRIGHT Copyright © 2010 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.