Blue sky, what is it? And how do I know if my company has any?
First, let’s define blue sky. Blue sky, or goodwill, is the excess purchase price over the market value of the tangible assets recorded on the balance sheet. For example, if a company has $500,000 of current assets and $500,000 of net fixed assets on the balance sheet ($1,000,000 of total assets) and the buyer pays $2,000,000 for all the assets of the company, blue sky (or goodwill) is $1,000,000.
Goodwill is created by excess cash flow above the required rate of return on the tangible assets of the company. A quick example is when the owners have invested $500,000 in current assets and $500,000 in net fixed assets for a total of $1,000,000 in tangible assets. If the company only generates $100,000 of cash flow that implies a 10% return on the tangible assets. Under these facts, it is unlikely any goodwill exists because the cash flow is relatively low. Alternatively, if cash flow was $500,000 instead of $100,000 then the implied rate of return is 50% and it is highly likely goodwill exists.
Next, how do you know if you company has any goodwill? An easy calculation would be to take last year’s EBITDA (earnings before interest, taxes, depreciation and amortization) and divide that into your total assets less current liabilities ([total assets-current liabilities]/EBITDA). The result is your implied EBITDA multiple for tangible assets only. The lower the implied multiple for tangible assets is the more likely you have goodwill, and vice versa. As a rule of thumb, anything under a 2.0x implied EBITDA multiple, and you probably are generating goodwill.