Traditionally, it has been held that the value of a company equaled its net worth, that is, those elements that constitute the company’s own funds. However, this item (which is defined as the difference between assets and liabilities) doesn't take into account an intangible asset that is inherent to a company and which can generate future profits: goodwill.
A company´s worth is not only determined by what is established in its accounting books, through its balance sheet; there are a number of intangible elements that can generate both benefits and future contingencies. These are known as goodwill and are defined as the ability to generate profits thanks to the value of the company´s brand, its client portfolio, positioning, know how, or the value of its patents. It is calculated as the difference between the price paid for a company, compared to its net worth.
Apart from goodwill, there are other assets and liabilities that can make a company´s market value very different from its book value. For example, those items accounted for at amortized cost. If we analyze a bank´s balance sheet, items such as loan investment, deposits and issues are valued this way. Similarly, other assets (property or stock) are valued at their historical cost.
In some cases, intangible assets can create more value than tangible assets. Such is the case of certain soft drink companies, which would not be so successful if it were not for the value provided by brand name recognition.
How is a company’s goodwill valued?
In spite of being inherent to a company, the accounting value of goodwill can only be determined by a business combination. It is calculated as the difference between the sale price and the fair price of the assets and liabilities of the company. By way of example, if the net worth of a company is 50 million euros and it is bought for 70 million euros, the amount of the goodwill is 20 million euros.
At the time of acquisition, all the assets, liabilities and intangibles of a company should be evaluated at fair value. Once this exercise has been completed, the price paid should be compared to this net worth adjusted to its fair value. The difference between the two would be justified by the company´s capacity to generate future positive cash flows (goodwill) or negative cash flows (badwill).
As a counterpart to goodwill, badwill has been established. This concept arises when the price paid is lower than the adjusted net worth (after assigning a fair value to the assets and liabilities). Normally, it is produced when the company acquired s, after the acquisition, facing a restructuring, staff reduction, etc., with costs that are greater than the synergies, and which are discounted when the price is established.
The international accounting norms adopted by the European Union (specifically, IFRS3, of the International Financial Reporting Standards) establish that goodwill is not amortized. However, each year a stress test is performed to ascertain the correct value of a company´s goodwill.
This test consists of making annual projections of the acquired company, in which its current value is calculated, and some theoretical dividends are estimated. If the resulting amount justifies the reported cash flow, goodwill remains unchanged. If it does not, goodwill is adjusted downward.