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.
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Source: Goodwill Valuation (wallstreetmojo.com)
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.
| 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
| 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 | 110 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 | (164 X 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.
- Goodwill = Capitalised average net profit –Net tangible assets
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 assetsNet AssetsThe net asset on the balance sheet is the amount by which your total assets exceed your total liabilities and is calculated by simply adding what you own (assets) and subtract it from whatever you owe (liabilities). It is commonly known as net worth (NW).read more 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.
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
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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 –
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