Sometimes, a bidder on a work contract may bid lower than what would maximize his/her profit from the contract and the reason for that is to create goodwill (to increase expected future business from the buyer). How would you value the goodwill that is obtained in this way?
Valuing goodwill obtained through underbidding can be subjective and depends on various factors. Here's a general approach to arrive at a valuation:
1. Evaluate Expected Future Business: Assess the potential increase in future business resulting from winning the contract at a lower bid. Consider factors such as the buyer's likelihood of providing repeat business, the average duration and frequency of contracts, and the potential for referrals to other potential clients.
2. Calculate Lifetime Customer Value (LCV): Estimate the total value a customer/buyer would bring over their lifetime as a client. This includes not only the profit from the initial contract but also the potential profit from future contracts. LCV can be calculated by multiplying the average annual revenue per customer by the average duration of the customer relationship.
3. Estimate Customer Retention Rate: Determine the probability that the buyer will continue to award future contracts to the bidder. Consider factors such as the buyer's satisfaction with past performance, alternative options available to the buyer, and the bidder's ability to maintain a competitive advantage.
4. Discount Future Cash Flows: Apply a discount rate to account for the time value of money and uncertainty. This rate should reflect the risk associated with future business and the bidder's cost of capital.
5. Calculate Net Present Value (NPV): Estimate the present value of the expected future cash flows by discounting them to their current value. This will provide an estimate of the net monetary value of the goodwill obtained.
It's important to note that valuing goodwill is inherently subjective, and different analysts may use alternative approaches or factors specific to the industry or market. Moreover, the accuracy of the estimate relies heavily on the quality of the data and assumptions used.