A purchaser may attempt to forecast the future income of a target company in order to arrive at a logical purchase price. Goodwill is often, at least in part, a payment for above-normal expected future earnings. A forecast of future income may start by projecting recent years’ incomes into the future. When this is done, it is important to factor out “one-time” occurrences that will not likely recur in the near future. Examples would include the cumulative effect of changes in accounting principles, extraordinary items, discontinued operations, or any other unusual event.
Expected future income is compared to “normal” income. Normal income is the product of the appropriate industry rate of return on assets times the fair value of the gross assets (no deduction for liabilities) of the acquired company. Gross assets include specifically identifiable intangible assets such as patents and copyrights but do not include existing goodwill. The following calculation of earnings in excess of normal:
Expected average future income = $40,000
Less normal return on assets:
Fair value of total identifiable assets = $345,000
Industry normal rate of return = 10%
Normal return on assets = (34,500)
Expected annual earnings in excess of normal = $ 5,500
There are several methods that use the expected annual earnings in excess of normal to estimate goodwill. A common approach is to pay for a given number of year’s excess earnings. For instance: Acquisitions Inc. might offer to pay for four years of excess earnings, which would total $22,000. Alternatively, the excess earnings could be viewed as an annuity. The most optimistic purchaser might expect the excess earnings to continue forever. If so, the buyer might capitalize the excess earnings as a perpetuity at the normal industry rate of return according to the following formula:
Annual Excess Earning
Industry Normal Rate Of Return
$5,500/0.10 = $ 55,000
Another estimation method views the factors that produce excess earnings to be of limited duration, such as 10 years, for example. This purchaser would calculate goodwill as follows:
Goodwill = Discounted present value of a $5,500-per-year annuity for 10 years at 10%
= $5,500 x 10-year, 10% present value of annuity factor
= $5,500 x 6.145
Other analysts view the normal industry earning rate to be appropriate only for identifiable assets and not goodwill. Thus, they might capitalize excess earnings at a higher rate of return to reflect the higher risk inherent in goodwill.
All calculations of goodwill are only estimates used to assist in the determination of the price to be paid for a company. For example, Acquisitions might add the $33,798 estimate of goodwill to the $319,000 fair value of Royal Bali’s other net assets to arrive at a tentative maximum price of $352,798. However, estimates of goodwill may differ from actual negotiated goodwill. If the final agreed-upon price for Royal Bali’s assets was $350,000, the actual negotiated goodwill would be $31,000, which is the price paid less the fair value of the net assets acquired.