How do you calculate goodwill in an acquisition (purchase price allocation)?

Purchase price allocation assigns the price paid to the target's assets and liabilities at fair value, and whatever is left over becomes goodwill. I start with the equity purchase price, then subtract the fair value of identifiable net assets.

To get that fair value, I begin with the target's book equity and remove any goodwill already on its balance sheet, since that is replaced by the new calculation. Then I add write-ups: PP&E or inventory marked to fair value, and intangible assets that were not on the books, such as customer relationships, technology or brand names. In a stock deal those book write-ups do not change the tax basis, so they create a deferred tax liability equal to the write-up times the tax rate, which reduces net assets.

For example, suppose the buyer pays $1,000M for a target with $600M of book equity and no existing goodwill. Asset write-ups total $200M, so at a 25% tax rate the new deferred tax liability is $50M. Identifiable net assets at fair value are $600M plus $200M minus $50M, or $750M, so goodwill is $1,000M minus $750M, or $250M. In an asset deal there would be no new deferred tax liability, because the tax basis steps up too.