Getting on the goodwill band wagon
You can spend truckloads of cash on it. You can sell it for a pile of cash.
But it is just mist and ghosts until you sell your business. It is the sum of the soft side of business – reputation, buzz, word of mouth and the good decisions you have taken. It is your goodwill.
Goodwill (simplistically put, the difference between what all the tangible assets of a company are worth and what the buyer pays) can be massive. When Barclays bought a 57% stake in Absa, almost half of the £2.7-billion it paid, or 44%, was for goodwill.
R12-billion is a lot of good vibrations
Barclays’s share of the value of the brand and other intangibles were worth £1-billion (more than R12-billion) to Absa’s shareholders. That is a huge amount of money - real money that physically changed hands, not smoke-and-mirrors money that appeared and disappeared on a computer screen.
However, goodwill becomes real only when a company is acquired and the premium is realised. So when a company is up on the sales block, how does the intangibility of reputation transform into millions of rands in market value? It happens through a set of models, techniques and metrics and, sometimes, a healthy dose of wishful thinking.
“The way value is computed is based on the income or cash-flow stream and the risk associated with that,” said Elizabeth Sherratt, KPMG’s director for transactions and restructuring. “Although there are pretty solid parameters and principles for valuation, the true value negotiated between parties may sometimes be different from the calculated value because it is dependent on considerations such as relative positions of strength, emotive issues, differing views of trading projections, growth potential, different assessments of risk, strategic importance and other factors, many of which can only be determined through a process of negotiation.”
Scientific method meets gut feel
There are many generally accepted and well-established valuation techniques for measuring goodwill. Whether these calculations are borne out by the business’s performance over the longer term is often the cause of red faces and, sometimes, gallons of red ink.
Sherratt said that subsumed into goodwill were matters such as the quality and quantity of the workforce, the established distribution channels for manufacturing or services businesses and even aspects such as retailers having better locations for their stores in malls than competitors. Goodwill is a larger factor in acquisitions in service industries in which big price premiums can be paid, because net asset values are typically low.
Goodwill stems from the investment companies make every day in things that do not necessarily translate into immediate bottom-line sales. Sure, you could force your staff to work their fingers to the bone and generate amazing revenues at low cost, but investors would also see a significant risk to long-term revenues if there was a morale collapse, workforce militancy, endemic absenteeism and revolving doors for skilled staff.
A value of high importance
Goodwill’s contribution to a company’s value is much more than the popularly known brand value that is celebrated in a slew of various “top brand” awards. It also encompasses aspects such as the employer brand - whether good people want to work for you. It plays out in staff’s motivation and morale, the company’s attractiveness to new talent and the diligence shown in how service or products are delivered.
That is why, in the Top Companies Reputation Index study, workplace environment was one of the major contributors to companies’ overall index scores - whether a company is perceived as good to work for, has good employees and skills programmes and treats its staff well.
Building goodwill is also why companies invest large amounts of money in corporate social investment. Senior management may believe they have a moral imperative to give something back, but they also need to create a positive reputation among the company’s stakeholders that they act in their best interest as well as that of society at large.
The value of niceness
A good reputation of the goodwill kind can be critical for companies that are highly successful, say, to the point of being a market dominator or even holding the de facto monopoly or duopoly (so common in South Africa).
A company regarded as being a good corporate citizen is likely to be scrutinised less aggressively by regulators, be less subject to complaints, or have less punitive sanctions levelled against it than one perceived as a profit-at-all-costs evil empire.
Other factors related to goodwill are a clear strategy that stakeholders understand and good corporate governance that gives stakeholders confidence that a business and its activities are transparent and managed well. “If there are good corporate governance principles in place, it should affect how the business is run day to day and this should ultimately also translate into positive in goodwill,” said Sherratt.
This factor is measured in the Top Companies Reputation Index study in the governance dimensions through four attributes in the questionnaire.
Also subsumed into goodwill are distribution channels and geographic presence, relating directly to customers’ experience of getting hold of goods or services and the customer service they get, as well as technical expertise and training, which relate directly to the ability to execute and influence goodwill.
In theory, spending on marketing will enhance your goodwill by enhancing your brand value, especially in terms of consumer-focused businesses. A potential acquirer who is determining a fair price to pay for a business will certainly consider whether brand value is a key driver of value. “If we were doing an evaluation and trying to establish brand strength, we would use an index such as the brand studies as one of the pieces of useful information in establishing the extent to which brand drives value,” said Sherratt.
“Goodwill premiums should be underpinned by strong financials and fundamentals, but reputation in the market is also a major influencer of the price premium: where there is lots of market interest and there are strong growth prospects, there’s likely to be value. Where there’s buzz there’s a high probability of success.”
When the wheels come off
There are many examples of the ultimate value of an acquired business being quite different to the price paid for it. If the value is not realised there will be some kind of impairment - a write-down of some or all the acquired goodwill on the balance sheet.
“Absa is a great example where 44% of the purchase price related to goodwill,” said Sherratt. “Six years later none of that goodwill has been impaired. The premium paid even survived the financial crisis of 2008-2009. Vodafone’s acquisition of Vodacom was also done at a significant premium to net asset value. Most of the premium was attributed to goodwill, according to Vodafone financial statements.”
On the other hand, goodwill is sometimes not reflected because of illiquid shares that do not trade. For example, until recently Mercantile Bank traded at a price-to-book ratio below one: the market value of the company reflected in share price was low compared to the net asset value recorded in its accounts, which means that, until fairly recently, no goodwill was reflecting.
The result for Mercantile Bank was a cheeky offer from Bidvest last year, which was rejected because the existing owners believed the company was worth a lot more. Over time, they were proved right as the share price finally shook of its malaise and started climbing.
Very damaging in real terms was the enormous goodwill that Telkom ascribed to MultiLinks Nigeria when it set its acquisition price in 2007. It resulted in a fiasco that cost investors R2.1-billion when Telkom had to write down MultiLinks’s value in 2010. Telkom spent R2.8-billion on this ill-fated venture and within three years had to write down assets of R3.2-billion and R2.1-billion in goodwill. It is a huge amount of money to disappear at the stroke of a pen because a goodwill premium did not materialise.
“According to our 2011 survey of acquisitions in South Africa (in a cost of capital and impairment testing study), one-third of companies have found some kind of impairment,” said Sherratt.
Humans are complicated creatures who do things for opaque reasons, which explains why we choose brand X over brand Y in the supermarket, or why we will tolerate bad service from one company but not another. It also plays out in the boardroom, where business leaders argue over whether a company is worth a few hundred thousand rand, or a few million.
We may have complex models for measuring these intangibles requiring a lot of judgment and even a dose of intuition, but reputation is very real, nonetheless. A company is often worth more than the money it makes and the assets it owns. The question is: How much more? That is the leap of faith we must make when we invest in goodwill.