Most business people expect that an established business is worth more than its asset base. This extra value is known as business goodwill.
In other words, you can determine your business value as the sum of its assets plus business goodwill.
The accepted way to estimate the value of business goodwill is to capitalize the so-called excess business earnings. You can use the well-known Capitalized Excess Earnings business valuation method, sometimes called the US Treasury method to do the job.
Business value = Assets + Business Goodwill
Once you determine the fair market value of business assets, you can calculate the value of business goodwill as follows:
- Start with business earnings, usually net cash flow.
- Subtract a fair return on business net tangible assets. The difference is the excess business earnings.
- Capitalize the excess earnings to calculate the value of business goodwill.
Business goodwill value: positive or negative?
The value of business goodwill you get from above is positive for most established businesses. Occasionally, a business goodwill result can be negative. What can this mean?
- Business earnings are below the fair return on business assets.
- Some business assets are not fully used to generate income.
- The business is seen as high risk which calls for a high rate of return on business assets.
Handling negative business goodwill
If you get negative business goodwill value, consider these points:
- Make sure you account for all business earnings correctly. See how net cash flow is calculated.
- Identify which assets are either overvalued or not fully used to produce these earnings. Adjust the asset values.
- Revisit your fair rate of return figure. See how to build it up to properly capture your business risk.