Methods for Valuation of Goodwill

Goodwill is the value of a firm’s reputation and its good brand name in the market. A firm earns goodwill through its hard work. Goodwill helps a firm in winning the trust and faith of the customers by fulfilling their demands in both qualitative and quantitative aspects. It can be said that the goodwill of a firm is a result of the past efforts made by it which helps a firm to earn higher profits in present and in the future as well. In other words, positive goodwill helps a firm to earn supernormal profits as compared to the other firms that earn only normal profits. Goodwill is considered an intangible asset of the firm. It means it cannot be seen or touched like other assets of the firm. It plays a very crucial role for any firm to survive and compete in the market. The following are the Methods for Valuation of Goodwill

Methods for Valuation of Goodwill

The below-mentioned methods are used for the valuation of the goodwill of a firm.

Methods for Valuation of Goodwill 1: Average Profit Method

Under this method, goodwill is calculated on the average basis of the normal average profits of the last few years. To find out the value of goodwill only the normal profits of the business for specified years are taken into consideration in this method. It means all the abnormal gains or losses and all non-business incomes or expenses are ignored while calculating the profits of a particular year.

The profits so calculated for different years is then added and their average is computed. This average profit is then multiplied by the number of years’ purchases to ascertain the value of goodwill.

The formula for calculating goodwill under this method is Goodwill = Average Profit * Number of years Purchase

Number of years’ of purchase implies the number of years for which the firm expects to earn the same amount of profits.

Steps to Calculate the Goodwill by Average Profit Method

Step 1: Ascertain the total normal profits of the business for the past given years.

Step 2: Add all abnormal losses such as loss by fire, theft, etc., to the normal profits (as mentioned above ). This is because these are not incurred in the normal course of a business.

Step 3: Subtract all abnormal gains such as winnings from lottery, speculation, etc., from the normal profits. This is because these are not earned in the normal course of a business.

Step 4: Add all normal business income that was not previously added to the normal profits and subtract all normal business expenses that are not subtracted previously.

Step 5: Subtract all non-business income, i.e. income earned from outside the business of the firm.

Step 6: Add all the profits for different years after considering all the above steps to find out the total profits of the past given years.

Step 7: Calculate the average profits by dividing the total profits (calculated above) by number of years.

Step 8: Multiply the above calculated average profits by the number of years’ purchases to get the value of goodwill.

Methods for Valuation of Goodwill 2: Weighted Average Profit Method

The weighted Average Profit Method is similar to the Average Profit Method for calculating the goodwill of a firm. Under this method, the only difference is that the weights such as 1, 2, 3, 4…etc. are assigned to the profit of each year.

Generally, the highest weight is assigned to the recent year’s profit and lower weights are assigned to the past year’s profits. The product of the weights and the profit are calculated and then are added to find out the sum total of the products. This total of product is then divided by the total of the weights to compute the weighted average profit. To find out the value of goodwill under this method, the weighted average profit so calculated is multiplied by the number of years’ purchase.

The formula for calculating goodwill by this method is Goodwill = Weighted Average Profit * Number of years’ Purchase

Steps of Calculate Goodwill by weighted Average Profit Method

Step 1: Assign the weights to each year’s profit in ascending order starting from the past year’s profit. It means the lowest weight will be assigned to the most past profits and the highest weight to the most recent profits. For example, if 2012 is the current year preceded by 2011, 2010, 2009, and 2008, then the weights are assigned from 2012 to 2008 as 5, 4, 3, 2, 1.

Step 2: Multiply the weights with the corresponding year’s profit.

Step 3: Calculate the total of the products.

Step 4: Divide the total of the products by the total of the weights in order to calculate the weighted average profit.

Step 5: Multiply the weighted average profit by the number of years purchase to get the value of goodwill.

The superiority of the Weighted Average Profit Method over Average Profit Method

The weighted Average Profit Method enjoys an edge over the Average Profit Method in producing better and reliable results. This is particularly in those scenario, where profits are continuously showing an increasing or decreasing trend over a period of years. This is because the Weighted Average Profit Method assigns more weightage to the recent years’ profits. Therefore, in order to compute a reliable valuation of goodwill one should go for Weighted Average Profit Method.

Methods for Valuation of Goodwill 3: Super Profit Method

A firm earn its profits from the capital employed in the business. Capital employed means the shareholders’ fund. i.e. sum total of share capital and reserves and surplus (i.e. undistributed profits). It can also be defined as the difference between total assets (other than fictitious assets) and external liabilities of a firm.

Under this method, goodwill is calculated on the basis of excess profit earned by a firm over the normal profit earned by its counterparts in the same industry. This excess of profit over the normal profit is termed as super profit. Therefore, to compute the value of goodwill under this method, super profits are multiplied by the number of years’ purchases.

The formula for calculating goodwill by this method is Godwill = Super Profit * Number of years’ purchase

Steps to Calculate Goodwill by Super Profit Method

Step 1: Calculate the Average Profit of the firm

Step 2: Calculate Capital Employed of the firm.
Capital Employed = Total Assets (other than fictitious assets) – External/Outside Liabilities
Or Capital Employed = Share Capital + Free Reserves – Fictitious Assets

Step 3: Calculate Normal Profits on Capital Employed on the basis of Normal Rate of Return

Step 4: Calculate Super Profit by deducting the Normal Profit from the Average Profit. Super Profit = Average Profit – Normal Profit

Step 5: Multiply the Super Profits by the Number of Years’ Purchase to get the value of goodwill.

Methods for Valuation of Goodwill 4: Capitalisation Method

Under this method, goodwill of a firm can be calculated by either of the following two ways.

Capitalization of Average Profit

Under this method, first of all the capitalised value of the business is calculated. This value is calculated by capitalizing the average profit on the basis of the normal rate of return of a business. To calculate the value goodwill of the firm the actual capital employed of a firm is deducted from the value of the business so calculated.

Therefore,the formula for calculating goodwill by this method is Godwill = Capitalized Value of Average Profit – Actual Capital Employed

Steps to Calculate Goodwill by Capitalisation of Average Profit Method

Step 1: Calculate the average profit of the firm.
Step 2: Calculate Capitalised value of Average Profit on the basis of normal rate of return by the following formula.
Step 3: Ascertain Actual Capital Employed of the firm.
Capital Employed = Total Assets (other than fictitious assets) – External Liabilities
Step 4: Deduct Actual Capital Employed from the Capitalised value of Average Profit to compute the value of goodwill.
Goodwill = Capitalised Average Profit – Actual Capital Employed

Capitalization of Super Profit

Under this method, goodwill is calculated by capitalising the super profits of the firm. It means under this average profit is calculated but instead of capitalisation of average profit, capitalising of super profit is done.

The formula for calculating goodwill by this method is Goodwill = Super Profit * ( 100 divided by Normal Rate of Return)

Steps to Calculate Goodwill by Capitalisation of Super Profit

Step 1: Calculate Capital Employed of the firm as:
Capital Employed = Total Assets – External Liabilities
Step 2: Calculate Normal Profit of the firm as:
Step 3: Calculate Average Profit.
Step 4: Calculate Super Profit of the firm by deducting Normal Profit from Average Profit, as:
Super Profit = Average Profit – Normal Profit

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