Methods of Valuing Goodwill of a Company

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Goodwill is the value of a company’s reputation. It is the difference between the company’s expected profits and the normal profits of its competitors. Goodwill is important because it can give a company an advantage in the marketplace. A company with goodwill can charge higher prices, attract more customers, and have more negotiating power.

Goodwill is the intangible and immeasurable value of a company. It is made up of the firm’s brand name, its loyal customer base, and its reputation for excellent quality products which contribute to the firm’s higher profits than normal.

“Goodwill is the current value of expected future income in excess of the normal return on investment in net tangible assets.”

Kohler

“Goodwill is nothing more than the profitability that the old customers will resort to the old place.”

Lord Eldon

Different Methods of Valuing Goodwill of a Company

As an intangible asset, goodwill is difficult to value. When a business is sold, its value depends on the agreement between seller and buyer. There are various method of Valuing Goodwill of a Company. These include:

  • Super Profit Method
  • Average Profit Method
  • Weighted Average Profit Method
  • Capitalization Method
  • Annuity Method
  • Purchase Method

Super Profit Method

The difference between estimated future maintainable profits and normal profits is known as super profit. A company may possess some advantages that allow it to earn some extra profits, which is referred to as super profits. It is calculated by multiplying the super profits by the number of years since the business was purchased. It would be earned if the business invested its capital in other businesses with similar risks. To calculate the value of goodwill under this method, the following steps are followed:

Step 1: Calculate Capital Employed by the formula, Capital employed = Fixed Assets + Working Capital

Step 2: Calculation of Current Year profits after tax, Current years’ Profit after Tax = [Current year’s Profits – Abnormal Gain + Abnormal Loss – Normal Loss + Normal Gain] – Tax

Step 3: Calculation of Average Capital Employed, Average Capital Employed = Capital Employed – ½ of Current Year’s Profit after tax

Step 4: Calculate Normal Profits by the formula, Normal Profits = Average Capital Employed ✕ Normal Rate/100

Step 5: Calculate the Average Profit after tax as per the Average Profit Method

Step 6: Super Profit = Average Profit after Tax – Normal Profit

Step 7: Goodwill = Super Profit × Number of years of Purchase

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Calculation of Capital Employed

The capital employed helps in calculating the normal profits of the business. The following points are considered while calculating the capital employed:

(i) Both current and fixed assets should be included in the capital employed. These assets should be valued at the current market prices. Following assets should not be included:

Fictitious assets like discount on issue of share/debentures, preliminary expenses, etc.

Outside investments should not be included in the assets.

Goodwill appearing in the balance sheet should also not be included.

(ii) From the total assets the outside liabilities should be deducted. The outside liabilities will include: debentures, creditors, provision for tax, outstanding expenses, bills payable, loans, etc. So, Net Capital Employed = Fixed Assets + Current Assets – Outside Liabilities

Example

From the following information calculate the value of goodwill on the basis of 3 years purchase of super profits of the business calculated on the average profit of the last four years (simple average and weighted average):

(i) Capital employed – Rs. 50,000

(ii) Trading profit (after tax):

2010 Rs. 12,200;

2011 Rs. 15,000;

2012 Rs. 2,000 (loss); and

2013 Rs. 21,000

(iii) Rate of interest expected from capital having regard to the risk involved is 10%.

(iv) Remuneration from alternative employment of the proprietor (if not engaged in business) Rs. 3,600 p.a.

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Average Profit Method

In this method, Goodwill is calculated by multiplying the Average profit by the number of years since purchase.

Goodwill = Average Profits × Number of Years’ of Purchase

Example

X Ltd. agreed to purchase the business of a sole trader. For that purpose, goodwill is to be valued at 3 years’ purchase of average profits of the last 5 years.

Weighted Average Profit Method

This method is a modified version of the simple average profit method, which multiplies the weighted average profits by the number of years since the purchase was made. This method is generally employed when profits have shown a continuous upward trend over time.

Weighted Average Profits = Total of Products of Profits/Total of weights

Goodwill = Weighted average profits × No of years’ of purchase

Example

Y Ltd. proposed to purchase business carried on by Mr. A. Goodwill for this purpose is agreed to be valued at 3 year’s purchase of the weighted average profits of the past four years.

The profit for these years and respective weights to be assigned are:

YearProfitWeight
201020,2001
201124,8002
201220,0003
201330,0004

On a scrutiny of the accounts, the following matters are revealed:

(a) On 1st September, 2012 a major repair was made in respect of a plant incurring Rs. 6,000 which was charged to revenue, the said sum is agreed to be capitalized for goodwill calculation subject to adjustment of depreciation of 10% p.a. on reducing the balance method.

(b) The closing stock for the year 2011 was over valued by Rs. 2,400; and

(c) To cover management costs an annual charge of Rs. 4,000 should be made for the purpose of goodwill valuation.

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Capitalisation Method

Using this method, goodwill can be calculated by capitalizing either average normal profits or super profits.

Capitalisation of Average Profit Method

Step 1: Calculate average profit after tax as per average profit method

Step 2: Calculate capitalized value of average profits as under, Capitalized value of average profit = Average Profit after Tax × 100/Normal Rate

Step 3: Calculate Average Capital Employed as calculated in Super Profit Method

Step 4: Goodwill = Capitalized Value of Average Profit – Average Capital Employed

Example

From the following calculate the value of goodwill according to capitalisation of Average Profits Method:

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Capitalisation of Super Profit Method

Using this method, the goodwill is determined by capitalizing the super profits using a normal rate of return. This method determines the amount of capital required for generating the profit.

Goodwill = Average Annual Super Profits × 100 / Normal Rate of Return

Example

Balance Sheet of X Ltd. on 31st March, 2013 was as under:

Annuity Method

By taking the average super profit as the value of an annuity for a specific period of time, goodwill can be calculated. This discounted present value of the annuity (PV) is calculated by discounting at the rate of interest (normal rate of return). Annuity tables can be used to find out the value of annuity for Rupee 1. If the annuity value is not given, the following formula can be used to calculate it:

Purchase Method

A company’s goodwill is the excess of the purchase consideration over its net assets, which is the price it received for selling its assets.

Goodwill = Purchase consideration – Net Assets of the firm

Net Assets = Assets – Outside Liabilities

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