The financial accounting term goodwill refers to the present value of earnings that are in excess of normal profitability for a particular industry. Goodwill is commonly recorded when a business is acquired and the price paid is in excess of the book value of the company.
Goodwill = Cost - (Tangible Assets + Identifiable Intangible Assets - Liabilities)
Investors are often willing to pay a premium to acquire a company if they're able to demonstrate they can produce profits in excess of what the industry would suggest are "normal," and those excess profits can be reasonably expected to continue into the future. Above average earnings may be a result of a monopoly, customer loyalty or manufacturing efficiency.
Competitive market forces typically limit the ability of any company to generate these excess earnings for more than three to five years. Therefore, the amount of goodwill paid will be less than five times the calculated excess earnings each year. That being said, assigning a goodwill premium to a company is typically a very subjective exercise.
Goodwill is an intangible asset, and as such appears on the company's balance sheet. Amortization is the process of allocating the cost of goodwill to the accounting periods over which it can be expected to provide economic benefit.
Company A wishes to acquire Company B. The total of all tangible and identifiable intangible assets is $10,000,000. Company B's balance sheet indicates liabilities of $6,000,000. Using industry benchmarks, Company A's management team has determined Company B generates excess profits of $100,000 annually. Company A's management team is willing to pay goodwill in the amount of four times the excess profits.
The proposed cost to acquire Company B would be:
= $10,000,000 - $6,000,000 + $100,000 x 4
=$4,000,000 + $400,000, or $4,400,000