Goodwill Valuation Methods

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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 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 five years.

ABC & Company proprietor Mr.A 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 four years of purchasing average profit for the last six years.

#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 is 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

#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 the company’s net tangible assets.

  • 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 millionNet 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 using the weighted average method.

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 business’s success. Generally, three to five years of purchase is usually takenA 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 on the business, and the seller wants to increase the business’s premium irrespective of super-profits or average profits.Sometimes a business may be making losses. Even then, goodwill may be paid if the business prospects are very high. It depends on the synergies an acquiring company gets due to the merger and not solely 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

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 –

  • Steps for Goodwill Impairment TestNegative GoodwillAmortization of Intangibles