Why You Should Fear Goodwill (Unless It’s Justified)

Brandon Chicotsky
Jul 31
14 min read

Updated: Aug 1

Goodwill can be a risky part of business deals. It’s the extra amount paid for intangible assets like brand reputation or customer loyalty when acquiring a company. If miscalculated, it can lead to overpayment, financial losses, and even regulatory scrutiny. High-profile cases like Kraft Heinz, Microsoft, and Sprint show how overvalued goodwill can cause billions in write-downs, damaging stock prices and investor confidence.

Here’s what you need to know:

What is goodwill? It’s the premium paid beyond tangible assets in a deal.
Why is it risky? Overvaluing goodwill can lead to financial strain, failed mergers, and regulatory issues.
How to value it correctly? Use methods like the income-based or market-based approach, and always rely on certified valuations.
Warning signs: High goodwill compared to market value, unrealistic projections, or delayed write-downs.
How to reduce risks: Conduct thorough due diligence, use multiple valuation methods, and structure deals with tools like earnouts or seller financing.

Goodwill can be a valuable part of a deal, but only if it’s based on realistic assumptions and proper valuation methods. Missteps can lead to long-term financial and operational issues.

Why Overvaluing Goodwill Is Dangerous

Overestimating goodwill can create risks that stretch far beyond just paying too much - it can jeopardize financial health, operational success, and even regulatory compliance. Let’s explore these risks in more detail.

Financial Risks of Inflated Goodwill

Paying a premium for goodwill is essentially a gamble on future performance, a gamble that might not pay off. Overvaluing a target company often leads to overpayment, which can shrink return on investment (ROI) and put a strain on financial resources [3]. This is particularly risky for businesses in the lower mid-market, where cash flow is tighter and margins for error are slim.

Research from the Harvard Business Review highlights this danger, revealing that 70% to 90% of mergers and acquisitions (M&A) fail annually, with overvaluation being a key factor [3]. Unrealistic projections, inadequate due diligence, and shifting market conditions are common culprits, often resulting in overpayment and goodwill impairment. The immediate fallout? Limited financing options, as lenders grow wary of deals where goodwill dominates the purchase price. Banks are quick to spot inflated valuations, which can lead to stricter borrowing terms.

Goodwill impairment doesn’t just hurt the balance sheet - it can shake investor confidence, drag down stock prices, and damage relationships with lenders [5]. For private companies, this can mean a lack of funding and ongoing financial struggles, creating a ripple effect that impacts business stability for years. These financial pressures often pave the way for operational and regulatory challenges.

Operational Problems After the Deal

The operational fallout from overvalued goodwill can be even more damaging than the financial hit. When goodwill is overestimated, it sets unrealistic expectations for post-acquisition performance [6]. Paying a premium based on inflated projections can leave stakeholders disillusioned if the business fails to deliver.

Integration issues are a common consequence. Cultural mismatches between merging organizations can lead to employee dissatisfaction, low morale, and high turnover [6]. These problems are amplified when there’s pressure to justify a high purchase price. Poor integration planning can disrupt operations, reduce productivity, and undermine the overall value of the deal.

History offers a cautionary tale. Take the 2000 merger of AOL and Time Warner. Cultural clashes and conflicting strategies led to a massive loss of market value, culminating in a $54 billion goodwill impairment by 2002 [7]. When integration is poorly executed, it can derail strategic growth, cause talent losses, and limit the new entity’s ability to thrive [6].

Regulatory Issues and Current Trends

The regulatory environment surrounding goodwill has grown increasingly strict. Authorities, such as the SEC, are paying closer attention to how companies value and report goodwill impairments. Overvalued goodwill can lead to inaccuracies in financial statements, drawing scrutiny from regulators [8].

Recent years have seen goodwill impairments reach staggering levels. In 2022, 400 U.S. public companies reported $136.2 billion in pretax goodwill impairments. By 2023, this figure had dropped to $82.9 billion across 353 companies, but the numbers remain concerning [4][5].

Public companies, in particular, face mounting pressure to disclose goodwill impairment risks accurately [8]. The SEC frequently uses hindsight to question why early warnings about potential impairments weren’t disclosed in prior periods [8]. However, private companies aren’t exempt from oversight, especially those involved in significant transactions.

For instance, Walgreens reported a $12.4 billion pretax goodwill impairment in Q1 2024, stemming partly from its VillageMD acquisition [9][4]. The SEC often compares a company’s market capitalization to its book value when evaluating goodwill impairments, requiring businesses to justify any discrepancies [8]. With goodwill often representing a large portion of assets, companies must ensure their valuations are backed by solid evidence.

The trend toward stricter regulatory oversight means businesses can no longer afford to treat goodwill valuation as a mere formality. Misjudging goodwill can lead to years of compliance headaches and additional costs.

"Goodwill impairment is often a red flag, signaling that a business acquisition has failed to meet management's expectations. It may reveal underlying challenges, from market volatility to operational inefficiencies, that can erode a company's financial health." - SD Mayer & Associates LLP [5]

In today’s regulatory climate, precise goodwill valuation is more than a negotiation point - it’s a critical factor in safeguarding the financial and operational integrity of a deal. Missteps in this area can have long-lasting consequences, both on and off the balance sheet.

How to Value Goodwill Correctly

Valuing goodwill requires a detailed, methodical approach that combines proven techniques, professional expertise, and a thorough analysis of financial data. Because goodwill represents intangible assets, getting the valuation wrong can have serious consequences, especially during business transactions. Below, we’ll break down the key methods used to quantify goodwill and why professional valuations are so important.

Main Valuation Methods

There are several established methods for valuing goodwill, each with its own strengths and best use cases.

The excess earnings method is a classic approach, developed over 90 years ago by the U.S. Department of the Treasury. This method estimates the value of intangible assets by focusing on earnings that exceed a fair return on tangible assets. Here’s an example: Imagine a machine shop generating $2,500,000 in revenue with $500,000 in seller’s discretionary earnings. If a 4× multiple is applied, the business value would be $2,000,000. Subtracting $1,350,000 in tangible assets leaves $650,000 attributed to goodwill. This process involves several steps, including estimating tangible assets, calculating fair returns, and applying a capitalization rate [11][13].

Income-based methods, such as discounted cash flow (DCF) and capitalized earnings, focus on analyzing past, present, and projected cash flows to determine a business's earning potential. These methods rely on robust market data to calculate discount and capitalization rates. For instance, if a business has seller’s discretionary earnings of $250,000 and is valued using a 3.0× multiple, the total valuation would be $750,000 [10][13][14].

The market-based approach uses transaction data from comparable businesses to estimate value. Adjustments are made to account for differences between companies. This method is often easier to explain to stakeholders because it’s based on real-world data [14].

Lastly, the asset-based approach calculates goodwill by determining the fair market value of a company’s tangible assets, subtracting liabilities, and then assessing the premium the business commands over its physical worth. This approach works well for asset-heavy industries but may overlook intangible elements like brand reputation or growth potential [13][14].

IRS Revenue Ruling 68-609 offers guidance on using the excess earnings method for valuing intangible assets. However, it advises against using this method when stronger evidence or better alternatives are available [11].

Each method has its place, but choosing the right one depends on factors like the type of business, industry norms, and the purpose of the valuation.

Why You Need Certified Business Valuations

When it comes to goodwill, professional, certified valuations are essential for avoiding costly mistakes. Certified third-party valuations provide a reliable benchmark for negotiations and ensure that goodwill is accurately assessed [13].

The complexity of goodwill valuation means that expert guidance is not just helpful but often necessary. For instance, the excess earnings method should only be used when no better alternative exists, and even then, it requires oversight by trained valuation professionals [12]. Certified valuations are also critical to meeting lender requirements, complying with regulations, and providing legal protection in the event of disputes. Banks and investors, in particular, depend on these evaluations to gauge risk and structure financing - especially when goodwill represents a significant portion of the purchase price.

For example, God Bless Retirement offers certified valuations that establish rigorous benchmarks for negotiations. Their evaluations help clients avoid overvaluing goodwill while ensuring legitimate intangible assets are properly recognized.

Accurate valuations do more than just inform pricing; they also reduce risks and protect all parties involved in a deal.

Valuation Method Comparison

Choosing the right valuation method can make or break a business deal. Below is a comparison of the key approaches:

Valuation Method	Strengths	Weaknesses	Best Use Cases
Income Approach	Reflects future earnings and allows for risk adjustments	Requires reliable forecasts and involves complex calculations	Service-based businesses and companies with steady cash flows
Market Approach	Based on real transaction data and easy to explain	Limited by the availability of comparable data	Industries with frequent transactions and standardized markets
Asset Approach	Straightforward and based on tangible value	May overlook intangible assets like brand value or growth potential	Asset-heavy businesses like manufacturing firms

The choice of method depends on factors such as the company’s industry, stage of growth, and the availability of data. Often, valuators combine multiple methods to achieve a well-rounded estimate of a company’s value [14][15]. While methods like discounted cash flow and market-based valuations are generally preferred for their reliability, the excess earnings method can serve as a useful cross-check to validate results [11].

Warning Signs of Unjustified Goodwill

Identifying overvalued goodwill early is essential, especially when you consider that 70–90% of mergers and acquisitions fail to achieve their goals. Alarmingly, about one-third of goodwill value often reflects overpayment [6][20]. With S&P 500 companies reporting a massive $3.57 trillion in goodwill on their balance sheets [20], recognizing the warning signs of inflated goodwill is crucial to avoid deeper financial troubles.

Red Flags to Watch For

Several indicators can hint at goodwill being overvalued:

High goodwill compared to market value: When goodwill dominates a company’s balance sheet but lacks market justification, it’s a red flag [1][18].
Overconfidence from management: Unrealistic optimism about future performance can signal trouble, particularly when projections for growth or cost savings lack solid evidence [1].
Reluctance to write down goodwill: Companies that delay necessary goodwill impairments may be masking financial weaknesses, misleading investors and stakeholders [18].

The Impact of Goodwill Write-Downs

When goodwill’s recorded value surpasses its actual worth, companies face goodwill impairment. The fallout can be severe. In 2022, 400 U.S. public companies reported $136.2 billion in pretax goodwill impairments. By 2023, this figure dropped to $82.9 billion, reported by 353 companies, but the financial strain remained significant [17][4].

Goodwill write-downs can lead to:

Profit erosion
Reduced equity
Breached financial covenants
Lower credit ratings

A striking example is UPS’s Freight business. A flawed valuation led to a delayed goodwill write-down, ultimately resulting in a $45 million fine from the SEC and substantial profit losses [18].

"Goodwill balances provide investors with valuable insight into whether companies are successfully operating the businesses they own. Therefore, it is essential for companies to prepare reliable fair value estimates and impair goodwill when required. UPS fell short of these obligations." - Melissa Hodgman, SEC Associate Director [18]

Case Examples of Failed Deals

The consequences of unjustified goodwill are evident in several high-profile acquisitions that went awry, leaving companies with significant losses.

Procter & Gamble and Gillette (2005): Procter & Gamble’s $50 billion acquisition of Gillette included $35 billion in goodwill. While earnings per share rose by 69% post-acquisition, economic earnings per share dropped by 3%. The company’s return on invested capital fell from 16% in 2005 to 11% the following year and has since remained near 10%. Over the same period, Procter & Gamble’s 30% return lagged far behind the S&P 500’s 70% return [16].
Sprint and Nextel Communications (2005): Sprint’s $37.8 billion acquisition of Nextel turned into a disaster. By 2008, Sprint had to write off $30 billion in goodwill impairments, and its stock was downgraded to junk status. Cultural clashes and operational incompatibility were cited as major reasons for the failure [21][22].
Just Eat Takeaway and Grubhub (2022): Just Eat Takeaway acquired Grubhub for $7.3 billion, only to sell it to Wonder for $650 million in 2024. The $6.5 billion loss was a stark reminder of the risks tied to overvalued goodwill when anticipated growth doesn’t materialize [6].

Other notable examples include General Electric, which recorded $23 billion in goodwill impairments in 2018, and British American Tobacco, with impairments totaling $31.5 billion in 2023 [2].

These cases echo findings from KPMG research: only 17% of acquisitions create value, 30% yield no impact, and 53% actively destroy value [16].

How to Reduce Goodwill Risks

Reducing goodwill risks requires a structured approach. With careful planning and expert guidance, both buyers and sellers can minimize potential challenges and protect the value of their transactions.

Best Practices for Buyers and Sellers

Thorough due diligence is a must. Examine cash flow, assets, liabilities, and legal contracts in detail. Confirm intellectual property ownership and review agreements to identify any hidden liabilities that could impact the deal's value.

"Take complex operational systems and then blend it into another ecosystem with similar complexity of parts, and there are literally many issues that can go wrong. You have to look at all of them."
Alexandra Reed Lajoux, Member of the Board of M&A Standards

Use multiple valuation methods to verify assumptions and reduce blind spots. Relying on just one approach, like Discounted Cash Flow (DCF) or comparables analysis, can leave gaps. A combination of methods provides a clearer picture of the target's actual worth.

Be cautious when estimating synergies. Overestimating potential synergies is a common misstep in M&A deals. Set realistic expectations and avoid letting overly optimistic projections inflate the purchase price.

For sellers, retaining key employees is essential. In service-based businesses especially, key personnel often represent a significant portion of goodwill value. Implement retention strategies early and consult experienced sell-side advisors to maintain value during the transition.

Transparent communication is another critical element. Define stakeholder groups, establish timelines for sharing information, and create opportunities for feedback. Clear messaging about the strategic goals and potential impacts fosters trust and reduces the risk of value erosion.

Finally, keep monitoring and reassessing post-acquisition. Market conditions can shift, and regular evaluations can help identify goodwill impairment issues early, ensuring the long-term health of the deal.

Using God Bless Retirement's Certified Valuations

God Bless Retirement offers certified valuations tailored for deals under $25 million EBITDA, ensuring goodwill is assessed with precision. These valuations eliminate much of the guesswork that can lead to overvaluation by combining standardized techniques with deep industry expertise.

Certified professionals bring specialized training in valuation methodologies and understand the regulatory, legal, and tax implications involved. This expertise is critical in distinguishing between justified goodwill and overestimated components.

The process starts with a free preliminary valuation, offering a confidential assessment with no upfront cost. For clients who proceed with a full listing service, the comprehensive valuation becomes part of the broader sale process, building trust with potential buyers and providing a solid foundation for pricing negotiations.

Regular updates to valuation reports during financial events help clients adapt to changing market conditions. This flexibility ensures that valuations remain relevant throughout the transaction, reducing the need for repeated appraisals. Additionally, these valuations are transferable across different stages of the deal, from initial pricing discussions to final negotiations.

In cases where traditional financing struggles to support goodwill-heavy deals, tailored financing options can provide a practical solution.

Financing Options for Goodwill-Heavy Deals

When goodwill represents a large portion of the purchase price, traditional financing can present challenges. Understanding alternative options can help structure deals that work for both parties while managing risk effectively.

Financing Option	Eligibility Requirements	Benefits	Drawbacks
SBA Loans	Business must meet SBA size standards, have good credit, and provide adequate collateral	Lower down payments (10–15%), longer repayment terms, competitive rates	Extensive documentation, slower approval process, limited goodwill financing
Seller Financing	Seller willingness to carry a note, buyer creditworthiness	Flexible terms, easier qualification, can bridge valuation gaps	Seller assumes risk, potential disputes, limited buyer leverage
Equity Rollovers	Seller retains an ownership stake, buyer demonstrates management capability	Aligns interests, reduces cash needs, preserves seller expertise	Shared control, potential conflicts, complex exit strategies

SBA loans often limit the amount of goodwill financing, acting as a safeguard against overvaluation. Seller financing, which may include earnout provisions, ties payments to future performance. This structure ensures that if the projected benefits of goodwill don’t materialize, the seller shares the loss. Equity rollovers, where the seller retains partial ownership, align both parties’ interests and encourage the success of the business post-transaction.

Earnouts and contingent payments are also effective tools for managing goodwill risks. These mechanisms adjust payments based on the realization of projected benefits, such as customer retention or operational cost savings. By aligning the financing structure with specific goodwill sources, buyers and sellers can ensure valuations are tied to measurable outcomes rather than overly optimistic forecasts. Proper financing structures are essential for balancing risk and performance.

Conclusion: Managing Goodwill Risk and Opportunity

Goodwill can be a double-edged sword in business transactions, offering potential advantages but also posing serious risks. The key lies in distinguishing genuine goodwill from overvalued figures and taking proactive measures to protect your investment.

Approximately 65% of buyers report that valuation differences between acquiring and target companies frequently impact deal outcomes [24]. When goodwill is overvalued, the fallout can be costly. A striking example comes from 2020, when U.S. retailers like Macy's and Gap Inc. faced multi-million-dollar goodwill impairments as the COVID-19 pandemic hit store performance hard [19]. These examples highlight the importance of understanding and mitigating risks tied to goodwill.

To avoid such pitfalls, adopting a disciplined approach to goodwill evaluation is crucial. Relying on multiple valuation methods rather than a single technique can provide a clearer picture of true value. Regulatory standards, like those under GAAP and IFRS, mandate annual goodwill impairment testing, making today's decisions impactful for years to come [23].

Navigating these complexities often requires expert input. Certified valuation professionals can help identify and quantify intangible assets that might otherwise be overlooked. For smaller businesses - those with under $25 million in EBITDA - specialized brokerages like God Bless Retirement offer tailored expertise to assess goodwill accurately and structure deals that balance the interests of buyers and sellers.

The goal isn't to sidestep goodwill altogether but to ensure it reflects authentic value. When properly assessed and managed, goodwill can serve as a strategic asset that drives sustainable success. On the flip side, inflated or poorly managed goodwill can lead to financial challenges that undermine even the best-laid business plans.

FAQs

How can goodwill be accurately valued during a business acquisition?

When valuing goodwill in business acquisitions, several reliable methods can be applied. One popular option is the Capitalization of Earnings method. This technique determines the present value of anticipated future earnings and then subtracts the net value of the company’s tangible assets to estimate goodwill.

Another approach is the Asset-Based Method, which compares the purchase price of the business to the fair market value of its physical assets. This method provides a clear comparison between the tangible worth of the company and its overall valuation.

Additional methods include the Average Profit Method, which calculates goodwill by averaging profits over a set time period, and the Market-Based Approach, which relies on industry benchmarks and similar transactions to estimate goodwill. Each of these methods brings a distinct perspective, so it’s important to select the one that best suits the specifics of the deal and the financial characteristics of the business.

The Risks of Overvalued Goodwill

Overvalued goodwill can lead to serious financial and operational challenges, but there are clear indicators to keep an eye on. For instance, a noticeable decline in critical financial metrics - such as revenue, profit, or cash flow - might point to goodwill impairment. Another red flag is when goodwill represents an unusually large chunk of the total purchase price or surpasses the value of tangible assets. Both scenarios could suggest an overvaluation.

To address these risks, companies should perform regular impairment tests. These tests compare the book value of goodwill to its fair value, helping to identify potential issues early. It's also crucial to carefully break down the purchase price, evaluating identifiable assets and questioning whether the expected synergies are realistic. By taking these steps, businesses can ensure goodwill is reasonable and steer clear of costly financial missteps.

What impact can goodwill impairment have on a company’s finances and investor trust?

Goodwill impairment can have a noticeable impact on a company’s financial standing. It reduces net income and lowers the goodwill value listed on the balance sheet. More importantly, it often points to deeper operational or market struggles, which can be a cause for concern among stakeholders.

For investors, this kind of impairment can shake confidence. It might indicate that earlier valuations were too optimistic, creating doubts about the company's financial stability. This, in turn, can lead to falling stock prices and heightened market volatility. Essentially, goodwill impairment not only highlights past overestimations but also casts uncertainty on the company’s future prospects.

Why You Should Fear Goodwill (Unless It’s Justified)