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entitlec
TABT2
OP CCONTENTS
Method
-
-
- -
-
-
-
-
-
-
-
-
-
-
-
Theory of Value and. the different
Of val
... -
- - .
Valuae in Exchange
Comnerc ial Val es
Purposeso
-
-
-
-
1
kinds
2
-
---
-- -
-
Taxation
-.
-
2
2
.-.-
-
Valuation - .......
- - - Bond isse.-s
Capitalization
-
-
-
-
Sale or Transfer -.
- New System of Aecounts - .
.
Valuation of Public Utitities a
St
.--3
--
3
--
4
-- 4
-aa4
--
Jethodsof Valuation
...
.a
-.
TangIble Values
-
-
Intangible
alues .a..
-
a
Goodwil
i ..
aa..
Definit ion
Economic Justification
The Law of Goodwill - a
Distinction
-4
4D
. 4
-a
a
aa
- -
q
-7
7
a-a
. -
a
and Going Concern
Anquisition of Goodwl
..
By Mortgage
By Death of th Owner
a
a
By sale or Transfe
Capitalingng
-
a
a
Go odwll
Upon Earni g Powe r
Watered Stock
-
-
-
18
13
14
14
-
14
,o.
a
15
a
Valuation
-44
~,
.S
betweenl Goodwill,
Going Val'e
~M.ethodso
4
on a number of
Y-;r>ears
Pchasea
a
-
-
16
aluation
-,,
.
the ndustry
16
Company
18
Consideration ½7017e4 in the
ofGoodThose
11
. w.ll
bearing on
Those bearing on te
Th nmber
of years .P"urchase
Proper rate o Interest
on
invGaSt
. an
a
aaa
7
- 22
a
25
,
,
Table of Contents - continued
...
~,"
_-
_
Page
Valuation on a new basis
...
..-27
.
-
Goodwill in the Balance Sheet
--
29
Itsannual reduction - -
29
OF GOODiILL CAPITALIZATION
TIM DEVELOPO~MNT
OI _
:ee
i_
Ob ject
-...
- -
-
-
-
-
]
-
._
-
-
,
-
_
:
-
-
-
-
-
T
-
-
-
31
Present means employed in creating Goodwill - 31
Goodwill as a studr in Mass
Psychology
..
Watch-wordof present Business-
Service
Advertising
-
32
- - 33
-
-- 32
-.
Goodwill as a tangible Asset
- 34
Banker's Viewpoint
Social
--
Goodwill
Success of Recent Cono !idation
The Law of
iminishing
-
Returns
Success
Analysis of Income Statemes
Conclusions --- -
-
-
35
35
36
38
---.
-
Determining
-
-..
Factors used in Determining
Success
31
.
--
-.- -.--.
40
41
43
PREFACE
This thesis is only an attempt to
give a very brief outline of the general Theory
of Goodwill Capitalization.
The subject is one
which involves all the ramifications of modern
business, and a thorough study would involve the
analysis of many specific businesses, methods
of financing, and the motives which governed the
entrepreneurs. If this little monograph will help
a little toward a further study
of the
subject,
then there will be some justification for its
being written.
THE TRY
O
GOODWILL CAPITALIZATION
PURPOSE
The purpose of this thesis is to study from
an Economic Point of View the theory of Goodwill and.
its relation to recent financial consolidations.
METHOD
This paper attempts first to give a brief
outline of the theory of Value. The general purposes
of Valuation are then discussed and the presence of
Goodwill is shown in the Valuation
of any competit-
ive business. The means employed in valuating this
Goodwill and the manner in which Goodwill has been
dealt with in recent consolidations are shown.
aORY
OF
e
THEORY O
VAUZE AND T
DIFFERENT KINDSOP
VALUE
Adam Smith said,"The word Value has two
different meanings, and sometimes expresses the
utility of some particular object and sometimes
the power of purchasing other
goods
which
Definition
value
the pos-
session of that object conveys". Modern Economists
have derived two kinds of value, which are Value
in Use and Value in Exchange. The former is the
value which an individual
attributesto any con-
crete substance as a means towards his personal
want gratification.
The latter
kind of value -
value in exchange - is the ability
one kind of
Value in
economic good has to replace another, or the a-
Exchange
mount which one good can obtain of another. The
price of a good is really its value in exchange.
Its worth is estimated by the market price,or
the amount of money agreed upon in any commer-
cial transaction.
There
are
changevalues,all
many different kinds of ex-
of whicb are determined
by
price. Someof these are as follows:Market Value:-
The price
which may be agreed
upon by a willing buyer and a willing
seller.
Taxable Value:- The value placed upon property
by Assessors.
Commercial
Value:-
The selling price or exchange
Commercial
Values ..
Page 3
value of a commodity at a given time and place.
Earning Value : The value based on earning capacity of the property, either from past earnings
or estimated earnings for the future. *
The real basis of Value is the esti-
mated earning power of the property or the physical entity. It is that quality in which interest is shown in any case of sale or purchase.
PURPOSE OF VALUATION
Prom the point of view of this paper,
the primary cause of Valuation
is in the case of
reorganization, involving exchange in ownership.
There are, however, many other causes for the
valuation of property, One of yearly occurrence
is that of Taxation. In this case, there is the
Taxation
possibility of a fluctuation in the assessed
value of the property.
Another cause, occuring frequently,
the necessity of a bond
issue. The recurrence
is
of
such issues is determined by the conditions of
business or the expansion of the concern. New
developments constantly occuring in a new country are also the underlying
causes of many bond
issues.
In the case of new concerns, a valu-
Engineering Valuation of Public Utilities and
Factories oster.
Bond
Issues
Page
6 4I
properties is essential
ation of the physical
before
a reasonable capitalization
can be deCa*P tal-
lzat I o
termine d.
Where a sale or transfer of a concern
is contemplated, there must be a valuation
of the
physical properties as well as an estimate of any
intangible assets, such as patents, goodwill, etc.
Sale or
Transer
Another cause of Valuation which is
sometimes met with is in the case of a company
desiring to install a new system of Accounting.
New system
In order that the new system be exact it is essential that a correct valuation
of
Accounts
of all property
be made.
In the case of
ublic Utilities, a
valuation is sometimes required for general in-
Valuat ion
of Public
Utilitie S
formation.
METHOD OF VALUATIO
In all determinations
ue of properties,
affixing the val-
the investigation
is subdivided
into two main branches. These consist of:-
1.- Physical Value - This includes original cost; reproduction value; overhead charges;
scrap or salvage value.
2.- Intangible Value - Under this comes
development expenses; franchise value; going con-
cern value and goodwill value.
Inasmuch as Goodwill is excluded from
any valuation of public utilities, there has
been evolved in their case what is termed "Going
concern value" - this in effect is the same as
Goodwill under an assumed name. But the law
states that Goodwill is only applicable to competitive industries. The assumption that competition does not exist in the case of Public Utilities is not altogether true. Cases are on record where such competition has existed, as in
the case of different tramway companies operating on parallel streets, or electric light
companies supplying the same district with light
and power.
The evil of competition in Public Ut-
ilities was, however, soon recognized both by
the public and
petition
the management
concerned. Com-
was ruinous and cut-throat. An inter-
esting ease was that of the numerous tube companies in London, which at first suffered heavily through this competition. Non-payment of
dividends and the financial failure of some of
the companies led the directorates toward a consolidation and understanding.
In an effort to determine the "going
concern value" of Public Utilities, the following has been made the basis of estimates:-
Page
6
1. Number of consumers.
2. Population served.
3. The business organization
4. The degree of Efficiency
developed.
in Management.
5. The competency in Supervision.
*
In the final analysis the estimation
of Going value is determined by property income,
and is applied as the capitalization
of the net
return in the same manner as "Goodwill" for an
industrial enterprise,
In the case of Railroad valuation,
there seems to be a unanimity of opinion that an
appraisal of the physical property is no criterion of real value. The company should in addition be credited with past development expenses,
goodwill, and value as a going concern. The following from the Railroad Age Gazette is illustrative of the opinion among railroad men:"Goodwill, an established organization, and a loyal esprit de corps, are expensive
to acquire in money equivalent, skill, patience,
and talent; and while they do not appear in the
balance sheet of any railway, are nevertheless
things of real value. A manufacturing plant with
-
*
air Value - Hartman.
-
Page
an experienced administrative organization,
trained and disciplined operating staff and and
established trade, has a commercial and economic value in excess of a new and similar concern
and in corresponding condition".
GOODWILL
I'
,1
~I
The classical definition by Lord Eldon
was given in the case of Crutwell v Lye and is
as follows:-"Goodwill
is nothing more than the
probability that the old customers will resort
to the old place-involving
an element of per-
sonal choice and is inappropriate where there
can be no choice, and therefore should be given
no value". The emphasis in this definition must
be laid uon the "Choice" and the word"customers'
and the reason for this will appear, later.
er definitions
Oth-
have appeared from time to time,
all of them applicable and to the point. Well
known accountants such as Lisle, Dicksee, ar
Guthrie have given definitions. Lisle's, as follows:- "Goodwill is the monetary value placed
upon the connection
and reputation
tile or manufacturing
concern, and
of a mercandiscounts the
value of the turnover of business in consequence
of the probabilities
tinuing?.
Lisle placed
of the old customers conthe
basis of value upon
the place, name, and the chance that no one con-
Def inition
i,
li
_
Page
8
nected with the old firm would step in to com-
pete, Other elements are personal, trade-marks,
etc.
Goodwill
is a thing
to be acquired and
not created arbitrarily by book entry. That is,
it should be excluded absolutely from the balance sheet unless acquired at a price. Even then
the one justification
for the permanent exist-
ence of Goodwill is the existence
of some "trans-
ferable right which will secure to the purchaser
profits in addition to the normal returns on the
amount of capital invested".
In recent years, however, the practice
of considering the value of Goodwill as the difference between the true value of the assets and
the value placed upon them in the records, has
gained considerable vogue. This was due primarily to the great number of corporate organizations taking place during the last twenty years.
Due to this fallacy, the existence
of Goodwill
has been looked upon askance and quite commonly
interpreted as "watered stock".
Goodwill is always disposed of at a
price. It has, therefore, a meaning under the
Economic
Justification
of Goodwill
definition of exchange value. Goodwill is a measure of the individual's or corporations'
abstract
qualities, as measured by others. Concerns of long
Page 9
standing and unsullied business reputation have
two possible sources of ultimate profit; the first
is the constant excess profits received in the
every day course of business; the second is the
constant possibility
ial
of realizing on the potent-
value of Goodwill.
There is no question,
that, where the profits of a business are be.
yond normal economic returns on investments of
similar character, there is an inherent value
within the enterprise, a value which is not measurable by the direct tangible assets. In the ma3ority of cases this excess of returns has been
created at considerable expense and by careful
management of the enterprise. It seems reasonable, therefore, that when a new organization
takes over such an existing company, some money
value attaches to this immediate return on capital. The purchase of such a Goodwill may save,
the company, as Guthrie defines it, "the period
of perilous probation". It saves the new company
the expense of large budgets for advertising,
the
trouble of creating an efficient and loyal management, and finally it saves the company the
ever present fear of experimentation
with, per-
haps, a new product or a new location. The eoonomic factors for the existence of this Goodwill
Page 10
have been determined and the management are assured
that there is a
TH
ustification
for its existence.
LAW 0ON GOODWILL
In business cles,
will" has long been recognized.
the value of
"Good-
"It can hardly be
said, however, that at this time is there any definiterecognition
of intangible assets as such in
our legal system".*
In this way, therefore, the
law has been very far behind business practice.
Yet, the law has been asked repeatedly to determine the
ustice of certain clauses in contracts
made by business men, when the goodwill of the firm
had to be disposed of and protected. It was held
at one time that any agreement where the vendr
was forced to refrain from trade due to the disposal of his goodwill, was in effect a measure in
restraint of trade. However, the rights of the
vendee have generally been recognized, where he
had paid a definite sum for the goodwill,
he was entitled
in that
to a measure of abstenance on the
part of the vendor. This has led to clauses where
the vendor was forced to refrain from business for
*
"The Law on BusinessProblems"-
MacMillan, 1922.
Schaub & Isaacs, -
Page 11
a reasonable time and at a reasonable distance
from his former place of business.
The law has however, treated goodwill
as property for some time. This is evidenced by
the stamp duty on conveyances and such agreements,
customary in England.
Taxation has also made it necessary
that intangible assets be recognized. As to whether it is real or personal property depends en-
tirely upon individual cases. The goodwill of a
partnership is generally deemed personal property. The real distinction is whether the goodwill is attached to the individuals or whether
it is local and ascribable to the unusual attributes of the property.
In the latter case, it
is real property.
The question has achieved a great deal
of importance to society in very recent years,
with the advent of the recent large consolidations, and is occupying the attention of many
students of economics and finance. The present
tendency to lump all intangible assets into Goodwill is looked at askance, while the present methods of valuation
are deemed inadequate.
.~~~l
DISTINCTION
i
TVEEN GOODWILL, GOING VALUE AD
GOING
CONCERN VALUE
An allowance for "Goodwill" is not applicable to Public Utilities when such a property
is a monopoly. All court decisions of recent years
have been against this, because of the fact that
the element of personal choice has been elimin-
ated, and also because any excess patronage which
has caused excess revenue has been due solely to
economic necessity,
and not to any particular
goodwill work by the Public Utility. Due to this
attitude of the law, there has been created the
term
Going Value".
John W. Alvord has defined
it thus, "Going value may be defined as the value of a created income, or is the cost of re-
producing a given income". William H. Bryan
states that Going Value is like Goodwill, but
is even more tangible. Going Value has no ex-
istence without earnings and is inherently derived from consideration of the efforts to create revenues.
Public Utilities are strictly governed by Public Utility Commissions and all
such
companies must adhere to the policies outlined
by them. This policy has determined that the
capitalization
of such companies must be in close
agreement to actual assets and cash. The earnings
can in their case be generally attributed entirely
Page 13
:
.to te
amount o capital
investea,
wnenever such
-
earnings commenceto exceed a normal return,
their
rates are reduced far the benefit of consumers.
however, on Page 5, an estimate
As stated,
is us-
ually made to determine the "Going Concern Value"
when such necessity arises. Going Value has been
estimated by the United States Circuit Court as
10% of the Tangible Assets.
METHODS
? ACQUIRING GOODWILL
There are three main ways in which Good-
will may be acquired. Of these, the first two do
not carry a great deal of weight in this discussion, while the third is the one
here great in-
terest lies at the.present time.
1st. Acquisition by the death of the formar owner
This is rmrely a case of
inheritance and
does not involve the valuation of Goodwill during the
exchange of ownership. A peculiar question has arisen where the Goodwill has been bequeathed, without the property
or plant which produced the goods
necessary for the maintenance of it. In this case
the tendency of the courts is to decide against
the abstract ownership of Goodwill, without the
substance.
2nd. Acquisition by mortgage.
In the case of default, of a mortgage, the
Goodwill inherent in the property will pass to the
Page 14
Mortgagee, Even here, however, the same question
as above will arise, to decide whether or not
the goodwill is separable from
the property.
3rd. By Sale or Transfer.
Under this heading comes all recent re-
organizations where the valuation of goodwill has
been made a subject of close study. In such cases,
there is involved the actual sale and transfer of
goodwill, where such has existed.
METHODS OF CAPITALIZING
GOODWILL
In the capitalization of an enterprise,
there are three principal means employed. From
Capitalizing
the legal point f view, the capitalization is
Earnin
aceording to
supposed to be equal to the net worth of the enterprise. This is generally the same as Investment
Value. Another method to me asre
the value of the
enterprise, is the cost of Reproduction.
Such a
theory applies to tangible property, but it runs
into difficulties when an appraisal is made of
the intangible values. The third method is the cap-
italization of earning power. From the business
point of view this nmethod is entirely satisfactory,
provided that an accurate estimate has been made
of the earning power and its probable stability
in the future. This latter method is usually accepted in the United States, England
and France.
Germany, on the other hand, adheres strictly to
the point offview of Law, where there must be
strict correspondence between investment and
Power
T
Page 15
capitalization.
Due to the generally accepted principle of capitalizing according to earning power,
there exists in the majority of corporations a
great deal of capital investment which has no
tangible assets behind them. When an organizat-
Watered
Stock
ion is earning 50, on its investment and the
normal return in the industry is, perhaps, 15%,
the directors
have only one way to reduce these
excess earnings. The capitalization
is increased
three times, and the apparent returns are 16.16f.
The difference between the new capitalization and
the tangible assets are now- classified as Goodwill,
Franchises,
or Patents. In all the recent reorgan-
izations this excess has been represented by Com-
mon stock. Where this common stock has been retained by the original owners no harm is done,
but where the stock
has been sold on the exchanges
to investors, considerable loss has often resulted,
because of a failure to realize the expected profits.
The investment becones a total loss and popular opinion is quite sceptical
and distrustful towards
what is now called Watered Stock. In many cases,
however, the
i
flotation of the stock has been en-
tirely successful, provided that it was not thrown
A.
on the market too rapidly after the readjustmnnt.
Goodwill must always be acquired for a
Page 16
price. This fact is well recognized,
but the de-
termination of the proper price has been the point
of greatest difficulty. It is the general practice
to base the value
of goodwill upon so many years'
purchase of the average net profits of the bus-
iness, *
it has already been stated that Goodwill
is not due solely to the application of capital
to Industry, but also to the results of the eff-
Valuat ion
on a nudmber
of years'
icient management.
There is, therefore, a fallacy
purchase.
in this theory. It is quite possible to conceive
of
the
existence
of Goodwill within a company when
the old managementis in charge, and the rapid disappearance of it when the new managementhas taken
it over. Goodwill is
largely
a personal
thing. Of
course, the consistent good quality of goods and
their general reliability in service is Goodwill
which cannot be removed. But the policies of
corp-
orations have a great deal to do with the development and continuance of it. The enlightened at-
titude of the present industrial age is shown by
the careful means employed to give service and
that stable
satisfaction. It is by this means
Goodwill is created.
CONSIDERATIONS
IVOLVED
IN THE VALUATIO
O
GOODWILL
A careful estimation of Goodwill involves
-
-
* "Goodwill and Its Treatment
in Accounts"- Dicksee.
Page 17
the answering of many fundamental questions, which
may be divided
into those concerning the specific
business as a whole, std those concerning
the.
Those
bearin
company whose goodwill is to be calculated.
In
the fornrr category are the following:1. Is the industry one of a staple nature
or does it manufacture non economic goods? A
business which supplies the community with necessities is one whose future existence is assured,
while the market of a business, manufacturing
non essentials is very problematical. A case in
point is that of the bccle
industry in 1910
where the goodwill was capitalized upon the expectation of a continued demand in the industry.
2. What are the possibilities of competition?
The amount of capital necessary to start in the
business and the ease with which such a business
may be started,are important.
true where the possibilities
This is particularly
of profits in the
Industry are large. Dewing in his "Corporate
ro-
motions and Reorganizations" gives an instance
in the Cordage consolidations. In this case, no
sooner had the company bought up potential competition in one quarter than it was forced to
repeat this phase in another quarter. The result
was an enormous capital investment in practically
en
the ndustr
in General--
Page 18
non producing plants, and the company failed.
3. What are the normal returns of the Industry?
The normal returns in the Industry must be arrived
at very accurately. It is well knownthatthe returns on investments in the Railway businesses are
very different from those in the Insurance or Banking
business. This is caused by society's apprec-
iation of the risks in some
businesses
and
their
absence in others. Therefore, even if the net
profits
in a business
are large,they shouldbe
comparedwith the expected returns in the se
bu sine s s.
4. What is the present status of the industry?
The present status of the industry should be determined, i.e. whether or not it is a new or
mature
a
industry recognized by society. Obviously,
isgradually declining it wuld
if theindustry
be unsound to determine the goodwill upon the
profits of past years.
The questions which involve the actual company
whose goodwill is to be determined are as follows:1. The element of transfer. When it is a
question of selling the personal
clientele
of
Those
b eari
on
....
company
professional men, the question of the degree of
transfer is very important. This may sometimes
be quite impossible unless the vendor takes definite steps to
ments
see that it is accomplished.
to accomplish
Agree-
this are often included in the
Page 19
articles.
2. In any business, the goodwill may have been
the result of the management's efforts. This should
be carefully determined and if necessary,
the old
management should be retained until their methods
have been thoroughly mastered.
3. The attitude of the vendor must be looked
into. Dicksee speas
of a case where one of three
partners had been expelled by the others. In this
case there was reasonable probability that the
profits would be less due to the hostility
of the
expelled partner.
4. The question of a probable monopoly in the
field should be considered. This may be due to
location, patents, secret processes, etc. Location plays an important part in the situation
of sunreerresorts, and their large profits are
thus explained. In the case of patents, the im-
portant thing to knowis the date of expiration.
The value of the patents should be made also by
expert patent attorneys. Secret processes are very
unstable. At any time, new methods may be discovered which will nullify the value of the present process. It is in any case a very doubtful
asset.
5. In the determination
of profits, any un-
usual conditions which have occurred to increase
Page 20
the normal returns should be discounted at their
proper value. The period of the war is a very good
example, when such businesses as the Steel companies earned enormous dividends due to extraordinary conditions. Any estimation of Goodwill based
on past earnings should take into account such
variable factors. Unusual conditions may also be
taken as those which involve undue risks. One
proprietor may consider ordinary business what
another considers great risk.. The criterion
this case is a reasonable
in
judgement as to what
constitutes a normal risk in the business under
considerati on.
6. Profits should not be stated until adequate Reserves have been made for Repairs, De-
preciation and other contingencies which may arise
in the business. Neglecting
result in overstating
such reserves would
the profits, and a con-
sequent overstating of Goodwill. Interest paid
on borrowed money is one of the items which is
frequently overlooked. This is in effect a pen-
alty on the enterprise for insufficient capital.
Depreciation on all property
as well as current
and defffred assets must have been made. Sometimes there are unpaid municipal assessments which
have been neglected.
Page 21
7.
In placing a value on property and inTentory, a
rigid cost theory should be adhered to in both
cases, unless the present value of the property
is less than the cost value. In that case, the
former should be used. In the case of reorganizations where a reappraisal has to be made, many
factors have to be considered. The value of certain leases must be determined; mineral rights or
timber lands must be valued by expert engineers.
'Where the
company is of such a nature that ad-
vertising forms a large part of its yearly expenditure, cognizance must be taken of its value in
creating a market for the goods, and thus creating goodwill. Inventory values must be based on
cost, and such cost should be that obtained in a
fairly normal year. The great increases in inventories during the past two years should be entirely
neglected. for the purposes of reappraisal.
the ordinary fluctuations
However,
of prices should not be
discarded, inasmuch as these are the conditions
underwhich the business must continue.
8.
going concern has generally assets which
are in some way extraneous to the
business.
As a
reserve for a rainy day, many businesses invest
some capital in government
bonds, or other non
fluctuating securities. The retxn
on these is in
Page
22
general less than that obtained from capital
invested in 'the active enterprise
of the business.
In such a case it seems best to exclude such an
investment from any calculation involving Goodwill.
Its inclusion would decrease the valuation,
and it
does not appear just that a company should be pen-
alized for good practice and conservatism, Companies will also build for the future so that the
present buildings are much in excess of immediate
requirements. The cost of such buildings
should not
be a charge against profits for the determination
of Goodwill. Such non productive capital clearly
represents potential profits for the business.
Having determined the tangible assets
and the net profits on them, two questions still
remain in the actual determination
of the amount
of Goodwill. First, there must be determined the
number of years purchase which is to be used for
the particular business under consideration, and
secondly, the rate of interest which is to be used.
In this discussion two very important
Number of
assumptions are made. First, that the agreement
Years
Purchase
is being made between a willing buyer and a willing
seller.In such a case, the vendor will de all in
his power to help the vendee take his place with
all the advantages accruing.
Secondly, it is as-
sumed that the vendee will have the priviledge
of
Page 23
ol ttade name. This is especially imusing th-e
portant.
Diczsee estimates its value to be eqal
to half of the twhole.Dicksee fzther
I
i
I
the value of a Goodwill according
classifies
to the nature
of a business, as follows:_
1. Wholesalers
an d retailers.
2, Manufacturers.
,
4
r -Fn
aS,
-
_
This assumption
is based upon the fact that whole-
sale trade relies
upon old connections and is thus
stable. There is a slight prejudice
re-
wing to the personal prejurdice of people
tailers
nown as Shop-Keepers.
to be
aainst
Goodwill of manufacttirze a-
urers is still le8s valuable due to the
mount o
capital involved and the fact tat
com-
petition is quite free. Of course where the element of monopoly enters in, tre
in its value.
an increase
The
goodwill
fessions is still less valuable
ficulty
of maintaining
the owir,
the
it
is
diately
of the
pro-
owing to the dif-
former
reputation
of
and because of the personal nature of
the connection. Genrral speaking, the value of
Goodwill of a share in a bus inss
ally
greater
than
connection of t
the 'hole,
due t
old mmagemenft
is proportionthe continued
or owner.
Dicasee states tha following as the
number of years purchase:
Pagfe 24
1. Wholesale or Retail
- I
t 4 years purchase
2. Manufacturing concern - 1 to 3 years
3. Professions
1 to 2 years.
However, where the element of monopoly enters,
factors as high as 10 are frequently used. That
is the commonfigure used in connection with News-
papers. In all the recent consolidations even this
figure was exceeded, the highest
al WallPper
eing the Nation-
Compan4yof 16. The element of mn-
opoly was, however, recognized in these cases,
and furthermore payment was made in stock of less
tn
the par value.
The former customof estimating the
number of years as five is no longer adequate
today. In view of the greater stability and perm-anence of the present businesses, it seems reasonable that this limit m
be extended to eight
or even ten years. Recently the courts upheld six
years.
te
(Von Au v Magenheimer,
126 ApI,.Div.257), in
ecase of a chain of candy stores. The permanence
of business has been greatly enhanced by the increase
of trained experts for the anagement
of large
corporations, and this tends to the establishment
of permanent goodwill.
In the determination
of the rate of
Interest on Investment, one must deal primarily
with the risks attendant on the business. The
Page 25
market quotations for interest rates on loans
are of very little value
We can, nevertheless,
in this determination.
imrnediatly refer to the
roper rate
of Interest
otnI8ts
rather widespread method of securing capital
by the flotation
of 7% Cumulative preferred
stock, as has occurred in all therecentfinanr:ial onsolidationas; but it mai be noted in
passing that the greater
numberof these stocks
contain unusual provisions whichin reality
them security
gave
almost on a par with debenture
bonds. There is no question that had not these
provisions existed, the rate of interest would
have been higher. It would not be fair to arbitrarily set 7% rate, as being the
proper
re-
turn on the capital invested in the business whose
goodwill is to be valuated. Quite often, the most
economical means possible
to raise the money con.
sists of the combineduse of bonds, preferred stocks
and commonstocks. Where a definite provision for
a certain ratiox betweenearnings and interest
charges
and dividends, is made, this mthod is
quite generally employed. Inasmuch as the rate
of interest increases with an increase in risXk,
it is readily seen that such a procedure will reduce
the average rate of interest applicable
the capital invested.
against
nt
Page 26
Local factors of considerable interest
are also involved in the estimation
er rate of
has the
o
the prop-
interest. The trend of vertical trusts
normal effect of decreasing the rate.
This is due to the absence of risks taken care
of by the control of raw material and other supplimentary activities. This type of organization
is furthermore immune from the present govern-
as
ment activities,
trade.
Of course,
it acts not in restraint of
ny
business which may be ad-
versly affected by gvernment legislation has
a very much
ower goodwil on that acconut.
The nature of the business aiLso affects the rate.
If it is such a
cial difficulties
worth their
and t1h rate
ind that in the event of finan-
thetangible assets are only
scrap value, there
is an addedris-,
of interest increases.
Page 27
VALUTATION OJ A IW
BASIS
The preceding discuseion has been based
entirely upon the assumption that Goodwill was to
be capitalized on excess earnings, over and above those due to capital and good management.
The net resulting profits over a period of years
were capitalized at what appeared to be a just
rate of interest. It has, however, been pointed
out that in the conception of Goodwill the element of the consumer is vital
(Page 6). It
is
upon the consumer that all the work in Industry
rests,
and
absence
ould
he show his disfavor
of his custom,
by the
the goo&will of a bus-
inessquicklydiminishes
Therefore,
of thought has arisen in
hich the basis of the
estimationis the number of customers.
titde
which the
a new line
The at-
public set up in 1920 was a
virtual buyers strike, and greatly diminished
the trade of a business. Had the goodwill been
measured at that tins
on the basis of the growth
ot the immediate past years, it
cases have shown
times it
would in most
a phenomenal value. Yet at that
was actually decreasing at a most ab-
normal rate.
We seet,therefore,
method,
while
that the present
good in periods of ordinary activ-
Page 28
ity, has really a lag of at least a year. It is,
not susceptible to the rapid
changes which oc-
cur in business cycles. It has been pointed out
that in the case of retail establishments,
the
number of its clientele is a very good expression of the volume of its business, and that,
the refore,
Goodwill could be measured in this
way. Any such method, based e ither
number of cstomers
sold,
upon the
or the number of articles
with the specific
profits on each, will
give the value of goodwill at that
rticular
time. However, vien a business changes hands, it
generally
years,
does
so for a considerable
number of
and thereasonable
value to arrive at,
is not the one of the moment, but that which is
determined from the particular
business
swingof the
cycle at that time.
It would be simple
to determine the
value of Goodwill on the above assumption, were
it
not for the fact that
businesses
themselves
are continually
growing.With
and an increase
of successful
years behind it,
an increase in size,
there
is continual decrease of risks, greater
stability and a stroner probablility that te
business will continue. All these factors should
be takeninto consideration
Goodwi11.
in the measurement
of
Page 29
STATUS 0F GOODWILL I
THE BALANCE SET.
The status of Goodwill in the Balance sheet differs according to the opinion of
management.It is not really a question of accounts. In many oases the Goodwill is carried
from year to year at the same valuation.
In
others, it is stated as being nominally Mrth
one dollar. In those eases, it
is
generaly
worth millions of dollars. Some businesses
are,
of course, inherently based on Goodwill. There
is the easeof the Wrigley Chewing GumCompany,
the Coea-Cola Company, etc.
One the other
wherethe business
of a company is really
on partial
monopoly or prestige,
Goodwill is generally left
and,
based
the item of
out. Such companies
are the Eastman odakcCompany, the General El-
ectric Company,the
estinghouse Electric
One of the reasons given for
preciation of Goodwill is, that
the valuation
of years'
inasmuch
Co.
the
de-
as
of it is based upon a given number
purchase of the coneern's
average
net profits less a fair return on capitalization,
its cost is consumedconcurrently with the close
of the period for which it has been purchased.
Such a view is quite extreme, andas has been
previously ntioned,
is not pplied except where
the profits are exceptional. Dicksee says that,
Reduction
n
in the
Balanee
"Goodwill does not depreciate",
liable to fluctuations,
of
but it is however
some extreme. Goodwill
is never written down. not because it is suosed
to
have been reduced in value, but merely be-
cause it is considered
practice. The exact
stated in the
present
the
amount
more conservative
at Whioh Goodwill is
balance sheet is krnown not to re-
its currentvalue,but only shows what it
may have cost originally. The question is really
one of extreme conservatism in financial circles,
and the habit inbred in ood, business men to
remove all questionable
items from their balance
sheets. Indirectly it is also insurance for the
future, inasmuch as it may be realized upon the
times of stress.
Page 31
CHAPER
TE
TWO
DEVEL0LENT~ OF GO-ODiL'LCAPITALZATION
IN RCEET
YEALRS
OBJECT:,m_
_i
Two primary
questions
will be
cnsidered
here, one is the present tendency of business men
to
create Goodwi ll and the nmans employed in doing
so, and the second will be a short discussion on
the justification of Goodwill capitalization
as
shown by the success of recent consolidations.
Previous considerations
bave21
idespec-
ial emphasis upon the tangible factors which af-
feet the amountof Goodwill. These have to do
with the possibility
Pre sent
of greater earnings. In
mea;
of creatin__
the past great attention has been laid upon the
quality of product, trade ma.rs, and some attention to service.
Today, however, far seeing business
n
are recognizing the fact that the development of
Goodwill is a mtter
of mss
sult has been a tremendous
psychology. The reimpetus in this dir-
Goodwill as
a stud;yin
ection. Formerly this Goodwill development was
looked upon as a matter which would take care
of itself in the course of
time.
=ut these sound
ideas of the old world have not
suited the ag-
gressive American
The spirit of
the
equal
business man.
century, which is one of rapid change and
rapid
results,
s seized him in its grasp.
This impatience for success has in inumerable
mass
-l,,.,.
Page 32
cases led to the most phenomenal
results.
rapid growth of Americmn business
wonders o
The
is oneof the
the economic world.
The means employed to accomplish such
results is well worth while a thorough study.
As a basis for it all was a sound principle of
tusiness.policy.
The rendering of
ecenomi
service was made the basis of business. The
disastrous attempt to unload goods upon he
consumer, vwhichhe really has no use for, was
Watch-word
of pre
en t
bus ines s Service
stopped. This action in itself vwuld have had
only negative results, had not executives realized that the consumer's vision of his necessities is very
imited.
From this simple
idea arose a process of education,
a process
where the consumer was shown economic needs
whieh
he had never realized before. Although
such actions my
appear as purely
selfish from
a disinterested point of view, yet a general
distribution of the
good things which civil-
ixation possesses is not destructive wrk. Bean
hind it lay the advancement of civilization,
aim wkich is surely
The primary
worthy
of any enterprise.
method employed
the product before the ultimate
vertising.
to bring
Advertis ing
consumer was Ad-
During the past two decades there has
Page 33
f ad-
in the concept
been a complete revolution
vertising as a business policy. Before that time,
censervatism dictated little
or no advertising
whatever. It was looked upon as a flagrant
flaunting
of ones qualities
day, however, advertising
on the public.
To-
is looked upon as a
employed to render an actual
legitimate rearns
service to the public.
in this way
Expenditure
is now regarded in many quarters just
as legiti-
as the buying of the machinery
mate an inestment
which manufacturers
the product.
There is ample
justification for this thought, Advertising
is the
of'the goods; without it the mrel*t
prime mer
for the goods would be greatly restricted, with
an attendant
lessboth to the consumer ad to the
mantuacturer.
Due to this new concept of the mrits
of
Advertising the handling of it in the bocks of
corporations is being changed. It has
ized that
besides
en real-
providing for the immediate
of the product, it also creates Goodwill,
movement
Goodwill as
a Tani ble
sarketing the future
whereby the expenses of
product is mterially reduced. Elujah W. Sells
of Haskins
& Sells, Certified Publio Accounts
of
ew Yorkz says that
effe ct
has a direct/in
"such advertising
creating
the Goodwill of a business
which
or measurable increasing
may be considered
as an
Asset,
i
Ir1
investntnt,
while that which is
one to maintain
a normal distribution or call attention to special
temporary prices should be considered an expense".
The much more conservative view of the bankers is
also undergoing
a change. Their policy has been
to consider all Advertising as a direct and im-
mediateexpense. Recently Printer's Int sent a
circular to all the ldrger bankers of the country,
asking them their
iews as to the distribution
of Advertising. Of that number 42%
replied that
Bankers'
Advertising was now being considered an investment; 33% were directly opposed to such a line
of thought, while the remaining 25% were noncomittal on the subject.
Advertsing
is not the only
e ans now,
employed to create this permanent Goodwill. Manufacturers see to
that their product gives
U
service to the ulti mate consumer.
of service accommodation is
This element
a considerable fact-
or in the expenses which many concerns must meet.
But it is contended that the measure of satisfact-
ion given to the consumer is greatly beyond what
is expended.
sumer must p
is qite
The popular concept that the conin the long run for this service
erroneous.
Such ideas do not place proper
value upon the repeat sales which take place with
not expense incurred.
wing to this fact, there is
wV
i int
p
Page 35
virtually
no extra burden on the consunr.
These are the activities
ify t
which
just-
valuationof Goodwillwhich is now foundin
fihere this item has been
all large corporations.
acquired after a reasonable investigation
merits, it represents the capitalization
cial
Goodwill.
of soc-
Social
Goodwill
There are, however, many who
loox at this askance a
judgement
of its
question the business
in the creation
of this enormous amount
of Goodwill.A discussionof this
subject
leads
us to the second question regarding the success
of recent consolidations.
S1 CCS
OF
1.,:z1z
T
6.
SCO iJ6P0Z'DATI
In this connection it may be of interest
to tabulate here someo thne valua"ons placed
upon Goodwill by sor
list
is fairly representative
mor conaervativel
Name
of thesecorporations.
_ _ __ _
__
Sears -Roebuck
Goodrich
Woolworth
Stude baker
May De pt.
Underwood
Loos e- Nila s
illys-Overland
Max rei 1
hdled
Assets_
____
of the larger
and
corporations.
_
____
16l,000 ,000
100,000,000
65,000,000
60,000,
00
34,000,000
16,000,000
15,000,000
110,000,000
67,000,000
Deere
82,000,000
Case
Hart, Sch affne r
12,000,000
17,000,000
m. riting Pap
217,00,000
Allis Chalmers
Hendee Ifg.,Co.
imperial Tob. Co.
Int. hoe Co.
The
4,000,000
7,000,000
25,000000
t
34,000,000
l __
____Go odwi _____
30,,o00,000
__
fer cen ta ges.
57,00,000
49
57
20,000,000
33.3
50,000,000
15,000,000
77
2,000,000
44
50
53
13
37
22
16
18,000,000
59
67
20,000,000
47
8,000,000
8,000,000
14,000,000
25,000,000
18,000,000
10,000,000
5,000,000
27,000,000
13,000,000
71
108
38
-
axe
36
This list leaves out such Corporations
as Gexral
will
Electric whiich shows the item of Good-
at a nominal
sum
of
l1. The conservative
manner in which this company is handled is
.tnow, but the mre
well
fact that this item is shown
in this way is no criterion of stability. The
Goodyear carried out the same practice before its
recent reorganization,
but in its last Balance
sheets does not give it at all.
In all promotions
there
is a great
spirit of optimism while the promoters themseles
quote the advantages of consolidations,
emphas-
izing the great economies possible through large
The law of
diminishig
Returns
scale production. While these factors
are
undoubt-
edly present, ti'adverse factors should not be
overlooked. There are many industries where these
economies do not apply, and when they are applicable,
there is another
aw of economics known as the law
of diminishing returns which should not be overlooked. This law is at present little understood
in the way it applies to business.
There is no
question of its application being the
same as
that in pure economics where the organization is
so efficient that ay furttherelaboration brings
it into force.The law as applied to business rather
means the decreasing utility of the individual in
big business.
It requires genius to control
a large
Page 37
organization
so as not to run foul of this enemy.
Business men are aware of it, but it is not brought
forcibly to them except in times of stress. It
involves
the
difficult
human element
and is therefore very
to handle. There are numerous instances
of the application of this law in the recent deThe Hood Rubber Company of Watertown
pression.
employed about 10,000 men during the great period
of activity
in 1919 amd 1920. Whenit was appar-
ent that a period o
stress
was setting
management immediately desired to
in,
the
reduce prodact-
ion. They began this process by cutting the work-
ing force by 1,000
n
reduction in Production
*
Instead of the expected
there was the peculiar
phenomenonof a temporary increase,
same rate
of prodwition
continued.
and then the
The management
continued this process, but no results in
rodat-
ion were apparent until the working force was reduced
woring
to 6,000. That
is,
when the company was
under boom conditions, the wring
force
was only 66.6% efficient. The same conditions
took place at the
inchester Arms in New Haven,
where the company employed about 20,000. The force
had to be reduced to 14,000 before the necessary
reduction in production was obtained. In this case
it is seen the force was 70.0o efficient,
which
?ame 38
is closely related to the experience of the Hood
Rubber Company. A thorough study of these reductions
during 1920 and 1921 would be of great
an effort to arrive at te
interest
normal efficiency
in
of
the worker When the labor marltet is in his favor.
It is seen that this law of diminishing
returns is of vital importance
to the success of
largecompanies.
In small concerns this problem is
not of the same importance, as the worker i
gen-
erally under the direct supervision of foremen or
superintendents who are able to see that the worker
produces a normal amount for the wages received.
In an attempt to determine the suc cess
of the recent consolidations,
iting factors,
there are somelim-
which must be enforced in order that
the results of the brief study have some definite
value.
rimarily there is very little value in
basing any conclusions upon the past eight years,
Limiting
Pactors
in
De terminn
when the abnormal condition of the World War were
predominant. iBusiness conditions
were such, that
even concerns which had very bad and inefficient
management were practically insured of a reasonable
degree of success.
Second. There is a wide dis-
tinction between consolidation carried out as the
result of a successful internal growth, lilt the
Woolworth combination,and the amalgamation of
companies which were in competition with each other.
uess.
Page 39
The former have an assured field
for their suG-
cess, as they are merely continuing their normal
growth.On the otherhand, concerns which were of
the same financial strength, and competing in the
same mnaret, had no specific advantage,
consolidation
involved an element o
and their
speculation.
Iven here, the consolidation must not be such,
that it was merely the absorption of some smallor concerns by the large giant. In such a case
the acknowledged
discounts the
success of the larger concern
element of speculation.
Third. Combinations which serve a local market
should not be considered as giving the basis
of a good judgement for the suess
of the con-
soliation. Here is a safety factor which greatly decreases the
the
element
of speculation. inally,
time of consolidation
should be considered
carefully. A combination entering business Just
previously before a business depression will have
a difficult time in spite of any inherent advantages of consolidation.
On the other hand, a
consolidation with no advantages of combination,
will have considerable
success,
ride
on the
crest o
the
it if is able to
busirnss wave. We may
state,therefore, that ay analysis of success
ou/d
which
is inherentlyf
c
within thec/miy iat/vn.- c cban
which is inherentl7 y within the combinati on.
Page 40
Having determined what reservations we
shall apply in choosing the combination,
it remains
to find how we are to determine their suceess of
fai lure .
Briefly, we may say:- What were the
earnings before consolidation, and what were they
five or ten years later? :- in othe r words what
were
ond itions before
nd after? In order to
arrive at these statements, it is necessary to
Determining
Success.
.-i -
have available the earnings of the subsidiaries
before
consolidations,
and later the financial
statements ol the consolidations
ater
five or
ten years.
The following table gives a number of such con-
solidations with the amount of their net returns
or Profits available for dividends after the
first year of operation and also for the year
1920.
Name
Profits in
the ye ar
Year of Pro fit
year.
1920
after
1st.
Incorp.
___
_
1906
1912
1911
1911
1910
1912
$2,050,000
3,500,000
5,414,000
2,506,000
1,100,000
Willys-Ove rland
1912
Maxwe11
5,230,000
Am. Writing Co.
Allis, Chalmers
Hendee Mfg. Co.
Int.
Shoe Mfg.-
1912
1911
1911
1911
1899
1913
1913
1911
anhattan Shirt
1912
Se ars-Roe buc k
Goodrich
Woolworth
StudebaKer
rnderwo od
Loose-Wile
Deere
Case
s
1880-
Hart,Schaffner
Percent age
Increase
ll, 746,000
6, 793,000
7,501,000
9,822,000
2,246,000
945,000
2,939,000
1,529,000
4,647,000
1,936,000
778,000
1, 770,000
4,360,000
2,397,000
493,000
1,410,000
2,013,000
i, 687,000
755,000
3,564,000
e55,000
760,000
1,508,000
6,270,000
574,000
574,000
* -
decrease.
473
94
38
292
104
22
44*
g3*
6.5
19*
19.5
20.5*
372
316
00
I
Page 4L
It is very difficult to obtain the earnings
of the subsidiaries
before theconsoli&atda.
cases no data is available, whereas
prospectuses
In some
in others only
can be used. Where the consolidation
was due to natural expansion,
ch data is avail-
able in reports rendered to the various fiscal
agencies.
The above table was takn
rom Mbody's,
and the .following data on earnings before consolidation are also taken there.
Name
Woolworth
Studebaker
1910
1911
$5,065,000
944, 000
Un derwoo
Case
1910
1911
603,000
1, 060,000
Hart,Schaffner 1910
Hendee Mfg.Co. 1912
937,000
1,514,000
Int.Shoe Co.
1,215,000
1910
These tables show that in a few cases
there was phenomenal expansion, While
in as mny
there was an actual decrease in the profits after
Analysis
a series of years. It must also be noticed that
Stategents
where the profits
were extraordinary,
the con-
solidation had generally been the result of natural
expansion, te wit:-.Sears-Roebuck, Hart-
Schaffner
& Marx, and Studebaker.
Some doubt may
be thrown on the accuracy of the returns
Allis Chalmers as their
financial
o the
strength
has
never been very great, nor have their dividends
justified the unusual expansion ,cwn by the difference
in profits
for the years 1912 and 1920.
of
Finally, considerable weight must be given to the
effect of the great expansion and increase in activity during the year of 1920. It was in every way
an extraordinary
business
such
year, and in the course of normal
unusual
profits would not have been
shown.
We have also five cmpanies
hich show
only normal expansion during this period, and
also
four
which show a decrease in earnings. Where
this deficit exists, it
can be accounted for.
In the case of Willys Overland and
were several causes.
Maxwell,
there
anagemnt contributed sme-
what, and the product had considerable resistance
in the arket,
which was not properly overcome.
Finally in the case o
the Overland, the law
of
diminishing returns came into force. The Case
people had a different problem on their hands;
theirs was one of
a diminishing
demand, caused
by war conditions. The market was dominated by
the InZf/f/
price
wars
Harvester Company, and coneiderable
were going
on. The Hendee Mfauufact-
uring Co. showed very considerable profits before
consolidations,
but these were at the height of the
Motor cycle period. Banking on a future
demand,
the amalgamation toox place. AlthoWh
these ex-
pectations have proved to be more reliable than
that fathered by the bicycle companies of past years,
Page 43
the Hendee Company have suffered by a slowing up
of demand, greater competition, and better product.
CONCLUSIONS. This brief analysis clearly shows that
the
success o
new consolidations is very problem-
atical. Even with the data taken dring
very advantageous te the
period
consolidations, the re-
sults are very disappointing. The war offered
these companies an exceptional opportunity to
make unusual showing,
and to later state that
doubt that the promotors saw
this opportunity,
and. made every effort to take advantage of it.
The results are either a strong indietment a-
gainstthe management or the so called inhe rent
advantage s of combin
s.
Anarticle substantiating these results
has just
Dewing,
come to the writer's notice. Mr. A. S.
published
in the Quarterly Journal of
Ecnomics "A Statistical Test of the
Success
of
Consolidation" - wherein he took 35 corporations
representing different industries and compared
tbeirPast,present,
and expected earnings.
conclusions aregiventfter
had elapsed
His
sufficient ti*
to
to permit the consolidation
perfect its organization, to reconstruct its
plants and to effect all the anticipated economies
Page 44
of combination and large scale production, and
after
considerable
sms of new money had be en
invested in bettermnts and newplants, the
earnings gradually diminished until they were
no more, perhaps a little
less, than during the
first year of consolidation. Andthe first year
of earnings, as has been shown already, were less
than the earnings of the separate plants before
consolidation".
However, the fact remains that economic capitalization
of Goodwill took place and
with no disastrous effects. Although the expected expansion did not take place, there
were no serious set backs due to the consol-
idations. Therefore, these businesses were paying dividends on their preferred
stocks as us-
ual and in addition paying a substantial div-
ident on the commonwhich represented,
in
general, no equity whatever. This represented
the economic usage of Goodwil, and as
such
was
valuable in the further expansion of Industry.
;z
I
11
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Esquerre, P.J.
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Simpson, K.,
"The Capitalization
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The Johns Hopkins Press - 1921
Preema,
H.C.
"Some Considerations Involved in the
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A1exander Hamilton Institute -
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Statemgnts1loy, H.
'Valuation of Public Utility Properties".
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