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When looking to buy an existing business how do you value the goodwill if the assets are transferred at market value?

There are a number of ways of valuing goodwill apart from the assets and liabilities which make up the net assets. There are a number of definitions of goodwill. One of the most enduring is the right to earn super profits i.e. profits above the usual return on the money invested in the business.

So, for example if the net assets (assets less liabilities) were 100,000 and the usual return for investing in that industry was 8 per cent (being the bank base rate plus an allowance for added risk) you would normally expect a return of 8,000. So if the business consistently made 10,000 net profit, the super profit is 2,000. If the industry average price earnings ratio was 10, then goodwill would be 20,000 (2,000 times 10).

In calculating goodwill you would start with the profit and loss accounts of the business for say the last three years. Some adjustments might be necessary to the profits to arrive at the profits for the goodwill calculation (sometimes called the average maintainable earnings). The most usual adjustment is for payments to the owner/ manager over and above a reasonable salary for the work they do.

Once you have the average maintainable earnings you can do the goodwill calculation. You also need to find out the sort of price/earnings ratio common in the industry you are investing in. As a rough rule of thumb the price/earnings ratio of most private businesses is approximately half the figure of publicly quoted companies in the same industry or business sector.

You should seek the advice of a chartered accountant who is used to valuing businesses. But valuations, although often presented as precise calculations need to be viewed with caution. In the end a business is only worth what a willing buyer is prepared to pay and a willing seller is prepared to accept.

Once a goodwill valuation has been arrived at and the net assets specified you should view the total of the net assets and goodwill and to work out whether, all things considered, the business represents good value, in terms of its future earnings potential. You also need to consider how much finance you can raise. Often the goodwill is the price the seller will accept for the business less the net assets which are usually capable of more precise valuation.

See also: Goodwill hunting