Goodwill Valuation

Goodwill Valuation Methods

Goodwill valuation is the systematic evaluation of the goodwill of the company to be shown in the balance of the company under the head intangible assets and top methods to value include Average Profits Method, Capitalization Method, weighted average profit method and the Super Profits Method.

Goodwill Valuation

Let us discuss these top 4 methods –

#1 – Purchase of average profit method

Under this goodwill valuation method, the average (mean or median) profit of the last few years is multiplied by a certain number of years in order to calculate the value of goodwill.

Goodwill Formula = Average profit x Years of purchase.

  • Average profit = Total profits of all or agreed years/Number of years.

Example #1

X & Co wants to sell the business to ABC & Co on 31st Dec 2016. Profits of the business are as follows for the last 5 years.

Year Net Profit(US$) Remarks
2011 100 million
2012 120 million Includes one-time profit of $5 million which is not expected in future
2013 90 million Includes the extraordinary loss of $10 million which is not expected in future
2014 150 million
2015 200 million
2016 220 million

ABC & Company proprietor Mr.A, who is currently employed at $1 million. The business of X & co, which is currently managed by salaried employee X at $0.5 million. Now ABC decided to replace the manager and decided to be managed by Mr.A.

Both companies agree to value goodwill based on 4 years purchase of average profit for the last 6 years.

Goodwill of X& Co
  Profit of 2011  100 million  100 million
  Profit of 2012 120 million
  Less: One-time profit of 5 million 5 million 115 million
  Profit of 2013 90 million
  Add: Extraordinary loss of       10 million 10 million
  Profit of 2014 150 million 150 million
  Profit of 2015 200 million 200 million
  Profit of 2016 220 million 220 million
  Total $885 million
  Average profit (885 million/6) $147.5 million
  Add: Manager salary 0.5 million
  Less: Mr.A Salary 1 million
  Expected average Net Profit $147 million
  Goodwill  (147X 4) $588 million

#2 – Purchase of weighted average profit method

This goodwill valuation method is simply an extension of the above method, where instead of a simple average, we use a weighted average. This method is used when the trend of profits are rising.

Example #2

Let us use the above example to understand this method. Weights attached are as follows 2011-1, 2012-1, 2013-2, 2014-2, 2015 & 2016-3

Goodwill of X& Co
  Profit of 2011  100 million  100 million
  Profit of 2012 120 million
  Less: One-time profit of 5 million 5 million 115 million
  Profit of 2013 90 million
  Add: Extraordinary loss of       10 million 10 million 100 million
  Profit of 2014 150 million 150 million
  Profit of 2015 200 million 200 million
  Profit of 2016 220 million 220 million
  Total $885 million
  Weighted Average profit [(100*1)+(115*1)+(100*2)+(150*2)+(200*3)+(220*3)]÷(1+1+2+2+3+3) 164.5 million
  Add: Manager salary 0.5 million
  Less: Mr.A Salary 1 million
  Expected average Net Profit $164 million
  Goodwill (164X 4) $656 million

#3 – Capitalisation Method

In this method, goodwill is calculated by ascertaining the difference between capitalizing the expected average net profit using the normal rate of return and net tangible assets of the company.

Example 3

Let us again continue the above example to calculate in this method. The normal rate of return is assumed at 10%, and an average profit of the X&Co as calculated above is $147 million and

Assuming assets of the company are $1850 million and liabilities are $600.

  • Capitalised value of profit = 147 million/10%  = $1,470 million
  • Net assets of the X&Co=  1850 million-600 million = $1,250 million US$
  • Value of goodwill = 1470- 1250 = $220 million        

#4 – Super profit Goodwill Valuation Method

Under this goodwill method, super profit is calculated to determine the value of goodwill. Super profit is the excess profit earned by the company compared to its peers in the industry.

Goodwill = Super Profit x No of years of purchase

Lets us take an example to understand it further.

Example 4

The following are the details of XYZ &Co.

US $
  Capital Invested $60,000
  Profits
  2011 $10,000
  2012 $11,000
  2013 $15,000
  2014 $21,000
  2015 $18,000
  2016 $19,000
  The market rate of return on investment 10%
  The rate of risk return on capital invested in the business 2%
  Remuneration of alternative employment of the proprietor if not engaged in the business $2,000
  Average profit (10000+11000+15000+21000+18000+19000)÷6 $15,667
  Less: Propeitor employeement remunaration $2,000
$13,667
  Normal rate of capital employed 10% +2% =12% on $60,000 $7,200
  Super profit(13,667-7200) $6,467
  Goodwill ($ 6,467×4 years)(Assuming 4 years of purchase) $25,868

In this goodwill valuation example, average profit may be calculated by using the weighted average method as well.

Top Things to know about Goodwill Valuation

  • One or two years of profit is taken for goodwill valuation if the retiring chairman of the business is the main source of the success of the business. Generally, three to five years of purchase is usually taken.
  • A large number of years may be taken if the super profit is large or business is highly profitable.
  • Sometimes goodwill also increases if many parties are bidding to the business, and the seller wants to increase the premium of business irrespective of super-profits or average profits.
  • Sometimes a business may be making losses, even then goodwill may be paid if the prospects of the business are very high.
  • It is also dependant on the synergies an acquiring company gets due to the merger and not solely depends on profits.
  • Sometimes, goodwill valuation also depends on the technology or R&D a company possesses or a specific set of customers a company may have or specific sectors a company may be operating in.

Goodwill Valuation Video

Recommended Articles

This article has been a guide to Goodwill Valuation. Here we discuss the top 4 methods to value goodwill, including super profit, average profit, weighted average profit, and capitalization method. You can learn more about accounting basics from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *