Wednesday 29 June 2016

Business Goodwill - What's It Worth?

First, let's break down exactly what goodwill means. When business owners say “goodwill” they usually mean economic goodwill and not accounting goodwill, which is a plug number on a balance sheet.

Economic goodwill refers to the the fair market value of a business that is over and above the value of its tangible assets and its identifiable intangible assets. IMPORTANT:  NOT all businesses have goodwill. Only those businesses that can generate sufficient cash flow such that the present value of the cash flow exceeds the value of their net tangible assets and identifiable intangible assets have goodwill.

See the chart below for an illustration:

Divorce and the Division of Property - How to Equalize Assets

In Ontario, when a married couple divorces and assets need to be divided, there is generally an equalization payment that is made from a payor spouse to a payee spouse in order to equalize the increase in the spouses' net family property.

The increase in net family property is essentially the net property (assets less liabilities) each spouse owned at the date of separation, less the net property they owned at the date of marriage.

Example – if John and Mary each had $0 (or very close to $0) in property when they married and then at the date of separation John owned $1,500,000 in net property and Mary owned $500,000 in net property, then John would be required to make $500,000 equalization payment to Mary. After the $500,000 payment they would each have $1,000,000 in net property (equal).

It is important to note that if John owned a specific asset that Mary could not demand to be compensated with that asset on demand (example – if John owned an investment property in his name, Mary could not demand that John sign it over). What Mary would be entitled to receive is an equalization payment that equalizes the value of net family property as at the separation date.

Top 10 Finance and Business Valuation Terms for Newbies

There is a lot of jargon that is thrown around in the world of finance and business valuation.  This blog post attempts to lift the veil on some of the more commonly used finance & business valuation terms.  Although there are many, many more terms that could be included on this list, these listed below are but a sample....

1. EBITDA – it stands for Earnings Before Interest, Taxes, Depreciation and Amortization. To calculate the EBITDA of a business you would take the net income of the business and add back the interest expense, income taxes, depreciation & amortization. EBITDA is an “unlevered” measure of profit – it is a profit measure before interest expense is deducted. It is intended to be a proxy for pre-tax cash flow but it does have some deficiencies such as not accounting for capital expenditures, changes in net working capital or differing tax rates.

2. Enterprise Value – in business valuation, Enterprise Value (EV) refers to the total value of a company, its debt and its equity combined. The theory is that EV is a measure of a company's total worth without the 'noise' associated with its capital structure. Using a house as an analogy... if your home was appraised to be worth $1 million and you had a $600,000 mortgage on it then the 'EV' of your house would be $1 million and the equity value of the home would be $400,000 ($1 million less $600,000). To calculate the equity value of a business you would subtract business debt from its EV.

A commonly used business valuation ratio is the Enterprise Value / EBITDA ratio. Example - if a business is valued at $400,000 Enterprise Value and has an EBITDA of $100,000 then the EV/EBITDA ratio would be 4x.  This ratio could then be compared to industry peers.

Business Valuation - K.I.S.S.

There is a misconception that many people have that the more quantitative and complex a business valuation model, the better the business valuation final conclusion will be. The reality is usually quite different, especially when analysis-paralysis sets in.  Sometimes the K.I.S.S. principle is a good one to remember.

In reality, when an arm's length buyer and seller negotiate the purchase & sale of a business they usually do not go to great pains to calculate things like foregone tax shield, unlevered betas, equity risk premiums, size premiums, and so on. A buyer and seller in the heat of a negotiation will usually focus on things like:
  • How sustainable is the cash flow of the business?\
  • How risky is the business's source of earnings?
  • How can the buyer transition the business to himself?
  • Can they grow the business?

are the truly important issues to get right.