Before we begin with the methods of valuation of goodwill, let us first understand the idea of Goodwill. We can call the goodwill of a firm an intangible asset that represents the benefit arising out of reputation and other advantages. A well-to-do business firm earns a good name and connections in the market, and this advantage is not available to newly set-up businesses. Goodwill is the monetary value of this benefit that a buyer is willing to pay when buying the Business.
Did you know? A firm can only acquire Goodwill, and it cannot be self-created. An Organization recognises goodwill only when selling its Business, and it does not matter if the firm has built it over the years.
Valuation of Goodwill
We know that goodwill is an intangible asset that allows a firm to earn greater profits over expected returns. The firm can only recognise it in the books when the business buyer has paid the consideration in monetary terms. Though goodwill is invisible, it significantly contributes to business value. Examples of goodwill are the value of a firm’s brand name, the strong customer base, greater employee associations, patents, etc. It is well-known that every well-established company has advantages like brand value and the trust of customers. The buyer is willing to pay an extra amount for these factors when selling the business. We call it goodwill. A customer buys a business hoping to earn super profits in the future. So, he is eager to pay its financial worth in the form of goodwill
Here comes the valuation of goodwill into the picture. It refers to calculating the goodwill to evaluate the firm’s intrinsic value upon acquisition. The valuation of goodwill arises in the instances like business combinations or amalgamations, and it has many approaches.
When is Goodwill Calculated?
The valuation of Goodwill occurs in the following scenarios:
- Partnerships- The firm needs goodwill valuation at the time of admission, retirement, or death of a Partner. The need for goodwill valuation also arises at the time of dissolution or amalgamation of the firm. A firm also needs to value goodwill at the time of change in the profit-sharing ratio of the old partners.
- Company- Goodwill valuation takes place during Acquisitions and Mergers.
- Sole Proprietorship- Goodwill valuation occurs while calculating purchase considerations related to the sale or acquisition of the Business.
Methods of Valuation of Goodwill
The methods of valuation of goodwill should be consistent with the market practices of the Business. The following are the most commonly used methods of goodwill valuation:
1. Few Years’ Purchase of Average Profits Method
2. Super Profits Method
3. Capitalisation Method
1. Few Years’ Purchase of Average Profits Method of Valuation of Goodwill
It is the simplest methods of valuation of goodwill. In this method, the firm Values the goodwill based on an agreed number of years’ purchase of the average maintainable Profit. We consider the following factors under this method:
- Subtracting the year's abnormal gains from that year's net profit.
- Adding the abnormal loss of the year to the net profit of that year.
- Deducting income not earned from operations from the Net Profit of that year. For example, income from investments.
The Average Profits Method includes two methods:
A) Simple Average Profit Method- In this method, the firm values the Goodwill based on the Numbers of past years’ profits. It then computes the average of such gains, and it does this by dividing the total of such Profits by the Number of years. For calculating the value of Goodwill, the firm multiplies the average of the profits with the agreed number of years of purchase.
Average Profit = Total Profits/ Number of Years
Value of Goodwill = Average Profit x Number of Years of purchase
B) Weighted Average Profit Method- Under this method, the firm assigns a weight to each Profit, assigning more weightage to the profits of the more recent year. Hence, the firm calculates the anticipated future profits and goodwill with accuracy. The following are the steps for calculating goodwill under this method:
- Allot weights to the Profit of the latest year.
- Compute the Product of profits by multiplying the weight with the gain of that particular year.
- Calculate the weighted average Profit by dividing the total products of profits by the Total Weights.
- Weighted Average Profit= Total of products of profits/ Total Weights
- Calculate the value of the goodwill by multiplying the Weighted Average Profit and the Number of years of purchase
Goodwill = Number of years of purchase x Weighted Average Profit
2. Super Profits Method of Valuation of Goodwill
In this method, the firm calculates goodwill based on the Super profit. Super Profit means the excess of actual profit earned over the normal yield. The actual profit is the profit that an organisation makes with or without taking the adjustment. If there is no anticipated super profit, there is no goodwill for the firm. The Number of years of purchase a firm takes into consideration depends on many factors. These are the nature of the firm’s business, the Nature of the firm’s Profit, and the nature of the firm’s goodwill. The steps to compute Goodwill under this method:
1. Compute the Actual Average Profit by dividing the total profit by the Number of Years.
Actual Average Profit= Total Profits/ Number of Years
2. Compute the Normal Profit by multiplying the Capital invested within the firm with the Normal rate of return.
Capital Employed =Total Assets - Current Liabilities
The Normal Profit=Capital Employed x Normal Rate of Return/ 100
3. Calculate the Super Profit by subtracting the Normal Profit from the Actual Average Profit.
4. Compute the firm's goodwill by multiplying the Super Profit and the Number of Years of Purchase.
The Super Profit Method includes two methods:
A) Annuity Method- Here, the basis is the average Super Profit. The value of goodwill is the current value of an annuity of the average Super Profit discounted at a given Rate of Interest.
Goodwill = Super profit x Discounting factor
B) The Purchase Method by Number of Years- In this method, the firm evaluates the super profits in a definite number of purchase years for calculating the value of goodwill.
Super profit = Actual profit - Normal profit
3. Capitalisation Method of Valuation of Goodwill
Under the Capitalization Method, the organisation, determines the capitalised value of its profits. It helps to find the amount of capital the firm needs to make the desired profit. There are two ways of calculating the value of goodwill under this method:
A) Capitalization of Average Profit Method: Here, the firm estimates the capitalised value of the average profit based on the standard rate of return. The following steps are involved in calculating the value of goodwill under the Capitalization Method:
1. Compute the Average Profit by dividing the total profits by the Number of Years.
2. Compute the Capitalized Value of the Average profit
The capitalised value of the Average Profit= Average Profit x 100/ Normal Rate of Return
3. Find the Goodwill of the Firm by deducting the Capital invested from the Capitalized Value of the Average Profit.
Goodwill= Capitalised Value of the Average Profit - Capital Invested
Capital invested is the difference between Assets and Liabilities as on the date of valuation of Goodwill.
B) Capitalization of Super Profit Method: Under this method, the firm determines the capitalised value of the Super Profit based on the Normal Rate of return. It enables the firm to assess the amount of Capital it requires to earn the Super Profit. The steps for calculating the value of goodwill;
1. Calculate the Super Profit by finding the excess of the Actual Average Profit over the Normal Profit.
2. Find out the Goodwill of the firm. In this method, the value of Goodwill and the capitalised value of the Super Profit are equal.
Hence, the formula for calculating the goodwill= Super Profit x 100/ Normal Rate of Return.
Also Read: What are the major accounting conventions?
Goodwill's valuation impacts the short-term and long-term success of an Organization’s business. Though many have defined Goodwill, no one has given a clear definition. A firm values its Goodwill by obtaining assumptions from the Valuer. The main elements of the Valuation of Goodwill are profitability, Normal Rate of Return, and Capital Employed. In this blog, we discussed the meaning of Goodwill, its valuation, and the methods of valuation. These methods are the Average Profits Method, the Super Profits method, and the Capitalization method.
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