First, what really is goodwill?

If I say that I have built up lots of goodwill with my friends, that suggests that I have built a decent reputation with them.

Maybe this could be in the form of favors.

I may have done a lot of favors for free. This builds goodwill.
I may have covered their backs when they were in trouble. This builds goodwill.
I may have bought them dinner. This builds goodwill.
Etc.

Goodwill is the reputation I have built over time. It is the positive image that my friends have of me, hopefully.

This is valuable.

Especially in the case of companies.

But, it is hard to quantify because it is intangible in nature. And, its non-identifiable.

What asset specifically does the value come from? Well, that’s not clear.

But, this extra value is captured in goodwill.

But, it we don’t know where this extra value exactly comes from, how do firms quantify it on their balance sheets?

Well, goodwill arises in the case of acquisitions.

So, if the firm acquires a company for more than it’s worth (on its books), then goodwill is recorded.

So, the way to think about it is the excess value that the buyer paid to acquire the company. That by definition is the value of goodwill.

It is the value that is attributed to all the good things you have done, but there is no clear asset from which its value is derived from.

Say UnlearnEdu has $200 of assets and $100 of liabilities. In this case, its book value of equity is $100.

If DropoutEdu pays $150 to acquire $100 of net assets, by definition it overpaid by $50.

This happens because the value of the target is not always tied to the value of its assets. This could be a starting point. But, it usually is the lower limit on a firm’s valuation.

So, the $50 gets captured as goodwill. The excess price that is not attributable to any asset, but the firm’s reputation and business strength that deserves the premium.

Bottom-line? Goodwill arises from acquisitions. It is the extra value that the market places on the firm’s net identifiable assets.