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.

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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 31^st 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 lossExtraordinary Loss Extraordinary Items refer to those events which are considered to be unusual by the company as they are infrequent in nature. The gains or losses arising out of these items are disclosed separately in the financial statement of the company.read more 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	*[(1001)+(1151)+(1002)+(1502)+(2003)+(2203)]÷(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 Assets The 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.

	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 investmentRate Of Return On Investment Rate of Return on Investment is the rate at which a company generates a return on investment during a period when compared to the cost of the investment made by the company. It is calculated by dividing the return on investment during the period by the cost of the investment.read more	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
Normal rate of capital employedCapital Employed Capital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital."read more Capital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital."read more Capital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital."read more 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.

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Goodwill Valuation