Valuation of Goodwill

 

Meaning of Goodwill

A firm’s reputation is generally assessed by goodwill. Despite its popular usage in business activities, its value is not yet properly understood in accounting language. However, it is considered as an invaluable asset- intangible in nature. But it is not a fictitious asset. In simple words, a business firm which earns reputation over a period of time gets the credit of goodwill.

Meaning of Valuation of Goodwill

Valuation of goodwill is the process of determining the value of the intangible assets of a business that are not reflected on the balance sheet. Goodwill typically arises when a business is acquired for more than the fair value of its net identifiable assets (assets minus liabilities). It represents the excess payment over the tangible assets and includes factors like brand reputation, customer relationships, employee skills, and other intangible benefits.

Need for Valuation of Goodwill

The need for valuation of goodwill depends on the form of organization. in case of sole proprietorship, it is valued at the time of disposal of the business. Goodwill cannot be sold as a separate item. In case of  a partnership firm, the need for valuation of goodwill arises on some important events such as, admission of nerve partner, retirement or death of a partner, change in profit sharing ration, dissolution or sale to a company.

In case of joint stock companies, the need for valuation of goodwill arises in the following circumstances:

i. When amalgamation of companies occur.

ii. When one company takes over another or when the business of one company is sold to another company.

iii. When a company wants to write off or reduce its debit balance in the profit and loss account.

iv. When a company wants to exercise controlling interest in another company.

v. For valuation of shares in the absence of stock exchange class takes place.

vi. When the Government takes over the company’s business.

Factors affecting the Value of Goodwill

i. The foremost factor that affects the goodwill is “Profit”. The profit position over past years and profit expected to earn in future are important factors.

ii. Capital employed to earn profit

iii. The yield expected by the investors

iv. The longevity of the concerns

v. Customer association with the business concern-personal approach

vi. Market share for its products

vii. Quality of services rendered

viii. The position of a particular concern with respect to its competitors in the field

ix. Nature of after sales services

x. Relationship between management and staff

xi. Location of the business enterprise

xii. Steps taken to popularize its brand

xiii. Technical innovations

xiv. Tax planning

xv. Relationship with statutory bodies and government agencies

Methods of Valuation of Goodwill

The following are the methods of valuation of goodwill:

1. Average profits method

2. Super profits method

3. Capitalization method

4. Annuity method

Each of the methods provides a different approach to valuing goodwill, focusing on various aspects of a business’s profitability and capital. Here’s a breakdown of each method:

1. Average profits method

The Average Profits Method for calculating goodwill involves using an average of the business’s annual profits and multiplying it by a goodwill multiplier to estimate the value of goodwill. This method is useful for businesses with stable and predictable profit levels. Here’s a step-by-step guide on how to apply this method:

Steps to Calculate Goodwill Using the Average Profits Method

i. Determine Average Annual Profit:

• Calculate Total Profits: Add up the annual profits of the business over a specific period (e.g., the last three to five years).
• Calculate Average Profit: Divide the total profits by the number of years to find the average annual profit.

Formula:

Average Annual Profit = Total Profits over the Period / Number of Years

 

ii. Determine the Goodwill Multiplier:

• The goodwill multiplier is a factor used to convert the average annual profit into the goodwill value. This multiplier is often based on industry norms, business risk, and expected return on investment.
• The multiplier reflects how many times the average annual profit is worth in terms of goodwill value.

 

iii. Calculate Goodwill:

• Multiply the average annual profit by the goodwill multiplier to estimate the goodwill value.

Formula:

Goodwill=Average Annual Profit × Goodwill Multiplier

Example Calculation

Suppose a business has the following annual profits over the past five years:

• Year 1: ₹8,00,000
• Year 2: ₹9,00,000
• Year 3: ₹8,50,000
• Year 4: ₹9,50,000
• Year 5: ₹10,00,000

Step 1: Calculate Average Annual Profit

Total Profits:

Total Profits=₹8,00,000 + ₹9,00,000 + ₹8,50,000 + ₹9,50,000+₹10,00,000=₹44,00,000

Annual Profit:

Average Annual Profit=Total Profits/Number of Years=₹44,00,000/ 5=₹8,80,000

Step 2: Determine the Goodwill Multiplier

Assume the goodwill multiplier is 4. This multiplier is typically determined based on industry standards, the nature of the business, or historical sales data of similar businesses.

Step 3: Calculate Goodwill

Goodwill=Average Annual Profit × Goodwill Multiplier

Goodwill = ₹8,80,000×4=₹35,20,000

Summary

• Average Annual Profit: ₹8,80,000
• Goodwill Multiplier: 4
• Goodwill Value: ₹35,20,000

Advantages:

• Simple and easy to calculate.
• Useful for businesses with stable and consistent profit levels.

Disadvantages:

• May not account for fluctuations in profit or changes in market conditions.
• Assumes future profits will remain consistent with past averages.

 

2. Super Profits Method

This method focuses on the excess profits that a business earns above a normal return on its capital employed. It highlights the profits attributable to goodwill and intangible assets beyond what would be expected from the capital alone.

Steps to Calculate Goodwill Using Super Profits Method

i. Calculate Normal Profits: Determine a normal rate of return on the capital employed based on industry standards or historical averages.

Normal Profits=Capital Employed×Normal Rate of Return

ii. Determine Super Profits: Calculate the excess profits by subtracting the normal profits from the actual profits of the business.

Super Profits=Actual Profits−Normal Profits

iii. Capitalize Super Profits: Capitalize the super profits to estimate goodwill, using a capitalization rate or multiplier.

Formula:

Goodwill=Super Profits × Capitalization Factor

Alternatively, if using a capitalization rate:

Goodwill=Capitalization Rate / Super Profits​

Example Calculation

Assumptions:

• Capital Employed: ₹50,00,000
• Normal Rate of Return: 10%
• Actual Annual Profits: ₹9,00,000
• Capitalization Rate: 20%

Step 1: Determine Normal Profits

Normal Profits=Capital Employed×Normal Rate of Return

Super Profits=₹9,00,000−₹5,00,000=₹4,00,000

Step 3: Capitalize Super Profits

If using a capitalization rate (i.e., rate of return on super profits):

Goodwill= Super Profits​ / Capitalization Rate

Goodwill = =₹4,00,000 / 20% ​=₹20,00,000

Summary

• Normal Profits: ₹5,00,000
• Actual Profits: ₹9,00,000
• Super Profits: ₹4,00,000
• Goodwill Capitalization Rate: 20%
• Goodwill Value: ₹20,00,000

 Advantages:

• Reflects the value of intangible assets and goodwill based on excess earnings.
• Useful for businesses with significant intangible assets.

Disadvantages:

• Requires an accurate assessment of normal profits and capitalization rates.
• Can be more complex to calculate.

 

3. Capitalization Method

This method involves capitalizing the average or super profits to determine goodwill. It’s a broad term that can include both the Average Profits Method and the Super Profits Method, but it specifically refers to the practice of converting profits into a present value.

Steps to Calculate Goodwill Using Capitalization Method

I. Capitalization Method Based on Average Profits

i. Determine Average Annual Profit:

• Calculate the average annual profit over a specified period (e.g., the last three to five years).

Formula:

Average Annual Profit= Total Profits​/ Number of Years

ii. Determine Capitalization Rate:

• The capitalization rate is typically based on the required rate of return or the risk associated with the investment. It reflects the expected return on investment.

iii. Calculate Goodwill:

• Capitalize the average annual profit using the capitalization rate to estimate the value of goodwill.

Formula:

Goodwill = Average Annual Profit / Capitalization Rate

Example Calculation for Average Profits Method

Assumptions:

• Average Annual Profit: ₹8,80,000
• Capitalization Rate: 15%

Calculation:

Goodwill = ₹8,80,000​ / 15% = ₹8,80,000 / 0.15 = ₹58,66,667

 

II. Capitalization Method Based on Super Profits

i. Determine Normal Profits:

• Calculate the normal profit based on a normal return on the capital employed.

Formula:

Normal Profits = Capital Employed × Normal Rate of Return

ii. Calculate Actual Profits:

• Obtain the actual annual profits of the business.

iii. Calculate Super Profits:

• Determine the super profits by subtracting normal profits from actual profits.

Formula:

Super Profits = Actual Profits −Normal Profits

iv. Determine Capitalization Rate:

• Use the capitalization rate to capitalize the super profits.

v. Calculate Goodwill:

• Capitalize the super profits using the capitalization rate to estimate the goodwill value

Formula:

Goodwill = Super Profits / Capitalization Rate

Example Calculation for Super Profits Method

Assumptions:

• Capital Employed: ₹50,00,000
• Normal Rate of Return: 10%
• Actual Annual Profits: ₹9,00,000
• Capitalization Rate: 20%

Step 1: Calculate Normal Profits

Normal Profits = Capital Employed × Normal Rate of Return

Normal Profits =₹50,00,000 × 10% = ₹5,00,000

Step 2: Calculate Super Profits

Super Profits = Actual Profits − Normal Profits

Super Profits =₹9,00,000 − ₹5,00,000=₹4,00,000

Step 3: Calculate Goodwill

Goodwill= Super Profits / Capitalization Rate

Goodwill = ₹4,00,000​ / 20% = ₹4,00,000 / 0.20 =₹20,00,000

Advantages:

• Provides a systematic approach to valuing goodwill.
• Can be tailored to different types of profit calculations.

Disadvantages:

• Requires an accurate determination of the capitalization rate.
• May not account for all factors affecting goodwill.

 

4. Annuity Method

The Annuity Method for calculating goodwill involves valuing goodwill based on the present value of expected future profits treated as an annuity. This method considers the time value of money by discounting future profits to their present value. It’s especially useful when you have a stable forecast of future profits over a specific period.

Steps to Calculate Goodwill Using Annuity Method

i. Estimate Future Profits

Determine the annual profits that are expected to be generated by the business due to goodwill. These profits are projected over a specific period (e.g., 5 years).

ii. Determine the Annuity Period

Specify the time period over which the future profits will be received (e.g., 5 years, 10 years).

iii. Choose the Discount Rate

Select an appropriate discount rate that reflects the risk associated with the future profits. This rate is usually the required rate of return or the cost of capital.

iv. Calculate the Present Value of Annuity

• Use the annuity formula to calculate the present value of the future profits. The present value of an annuity formula is:

Present Value of Annuity = Annual Profit × Present Value of Annuity Factor

Where the Present Value of Annuity Factor can be found using annuity tables or financial calculators and is based on the discount rate and the number of periods.

v. Calculate Goodwill

• The present value of the annuity calculated represents the value of goodwill.

Example Calculation

Assumptions:

• Annual Profit Due to Goodwill: ₹2,00,000
• Annuity Period: 5 years
• Discount Rate: 10%

Step 1: Estimate Future Profits

Annual profit from goodwill is ₹2,00,000.

Step 2: Determine Annuity Period

The period is 5 years.

Step 3: Choose Discount Rate

Discount rate is 10%.

Step 4: Calculate Present Value of Annuity

Using the annuity formula, you need the Present Value of Annuity Factor for 5 years at 10% interest. This factor can be obtained from an annuity table or calculated as follows:

Present Value of Annuity Factor= 1 – (1+Discount Rate^{)-Number of Periods} / Discount Rate

Present Value of Annuity Factor= 1−(1+0.10^)−5​ / 0.10

Present Value of Annuity Factor≈3.791

Step 5: Calculate Goodwill

Goodwill=Annual Profit×Present Value of Annuity Factor

Goodwill=₹2,00,000×3.791=₹7,58,200

Summary

• Annual Profit: ₹2,00,000
• Annuity Period: 5 years
• Discount Rate: 10%
• Present Value of Annuity Factor: Approximately 3.791
• Goodwill Value: ₹7,58,200

Advantages:

• Takes into account the time value of money and future profit expectations.
• Provides a more nuanced valuation based on future performance.

Disadvantages:

• Requires accurate forecasting of future profits and selection of an appropriate discount rate.
• Can be complex and requires actuarial calculations.

 

Summary of Valuation of Goodwill

Each method of goodwill valuation has its own advantages and is suitable for different scenarios:

• Average Profits Method: Simple and based on historical performance.
• Super Profits Method: Focuses on profits above a normal return and captures intangible asset value.
• Capitalization Method: Broad approach that can use either average or super profits.
• Annuity Method: Accounts for the time value of money and future profit projections.

The choice of method depends on the nature of the business, the stability of its profits, and the specific needs of the valuation.