What is Goodwill?
Goodwill is an asset that is created when one company acquires another. It represents the difference between the price the acquiror pays and the “fair market value” of the acquired company’s assets. For example, if JerryCo bought Ford Motor for $15 billion, and the accountants determined that Ford’s assets (plant and equipment) were worth $13 billion, $2 billion of the purchase price would be allocated to goodwill on the balance sheet. In theory the goodwill is the value of the acquired company over and above the hard assets, and it is usually thought to represent the value of the acquired company’s “franchise,” that is, the loyalty of its customers, the expertise of its employees; namely, the intangible factors that make people do business with the company.
What is the effect of Goodwill on Book Value?
Well, book value usually tries to measure the liquidation value of a company — what you could sell it for in a hurry. The accountants look only at the fair market value of the hard assets, thus goodwill is usually deducted from total assets when book value is calculated.
For most companies in most industries, book value is next to meaningless, because assets like plant and equipment are on the books at their old historical costs, rather than current values. But since it’s an easy number to calculate, and easy to understand, lots of investors (both professional and amateur) use it in deciding when to buy and sell stocks.
Article Credits:
Last-Revised: 18 Jul 1993
Contributed-By: John Keefe