Valuation of Goodwill

When a business is able to earn profits at a rate higher than that at

which a similar business earns, the former business is said to possess
goodwill. Goodwill is, therefore, an invisible asset by the possession of
which a business can enjoy super earning. Since it is invisible the
goodwill is called an in tangible asset. But since its existence can be
felt through superior earning power it is a real asset.
There are several causes for which a business may have a goodwill and
some of them are:
(1)Possession of a large number of profitable contracts ; (2)Suitable
nature of the business ; (3)Exclusive franchise ; (4)Protected valuable
patents and trademarks ; (5)Suitable location of the business ;(6)Ideal
window dressing ; (7)Government patronage ;(8)Reputability,
respectability and reliability of the proprietor or partners or
trustees ; (9)Special ability and skill of the persons in management,
etc.
In case of transfer of business, separation of the partners from the
business due to retirement, death, etc, assessment of the value of the
business for any reason, goodwill may have to be valued.

Methods of Valuation of Goodwill

There are various methods for valuation of goodwill of a business of

which the following are of common use:

(1) Few years’ Purchase of Average Profits Method: Under this

method goodwill is valued on the basis of an agreed number of years’
purchase of the average maintainable profit. The word maintainable
indicates several adjustments in respect of the factors which might
have influenced abnormally the profits of the years over which the
average is taken. If in any year there is an exceptional opportunity or
an exceptional expense or absence of expense, the profit for the year
has to be so adjusted as to get it free from such exceptional
influences.
Sometimes instead of the simple average of the adjusted profits as
discussed above, weighted average is taken into consideration. Weights
are given to each years’ profit on the consideration how each years’
profit is likely to influence the future profit trend.

(2) Super Profits Method: Under this method average super profit is
ascertained. Goodwill is calculated at a few years’ purchase of the
super profit of the concern. The number of years to be taken for
consideration depends upon the nature of the business, the steady or
fluctuating nature of the profit and also the nature of goodwill.
First, ascertain the average capital employed during the year. For this
purpose take the total of the closing real assets of the concern as
revalued (excluding the non-trading assets and goodwill already
appearing in the balance sheet unless such goodwill represented the
payment to the vendor).
In order to find out the average capital employed it is necessary to
deduct from the above the current liabilities and 50% of the profits
for the year after tax. The profit should also be excluding non-trading
income, if any. The average capital employed in this way excludes the
long term loans, debentures and preference shares.
The idea of capital employed is not suitable for the purpose of
valuation of goodwill of an individual company where valuation is to be
done to the advantage of the equity shareholders. In this case, from
the above total assets we deduct the current liabilities, long term
loans, preference capital, etc, also 50% of the profit for the year
after excluding non-trading income and after charging interest on long
term loans and debentures, preference dividend, etc.
The average capital employed is the mean of the opening and closing
capitals. As we have taken the closing net assets which includes the
profits for the year it is necessary to deduct 50%of the profit in
order to get the capital at the middle of the year. If, however, the
closing net assets are after the payment of dividend or after setting
aside a portion of the profit to proposed dividend account, necessary
adjustments must be done so that the average capital ascertained
includes only 50%of the profit after tax.
Now we calculate the normal average annual trading profit after tax,
but before charging interest on debentures and long term loans and
also preference dividend. From this average profit reasonable
managerial remuneration should also be deducted. The profit as
obtained after the above adjustments is to be compared with the
reasonable return on the average capital employed, calculated at the
rate of return earned by similar businesses. If the former exceeds the
latter the balance represents the super profit.
A few years’ purchase of the super profit is taken as the value of
goodwill.

(3) Annuity Method: Under this method the basis is super profit. Let
us take an example:-
Suppose the super profit of a concern has been calculated at Rs.50000
and it has been considered reasonable that 5 years’ purchase of the
super profit approximates the value of goodwill. The contention behind
this is that, the purchaser of the business can expect to enjoy super
profit of Rs.50000 per year for the next 5 years. If this is the
contention it is not reasonable that he should pay Rs. (50000*5) or
Rs.250000. He should pay an amount which will give him an annuity of
Rs.50000 over the next 5 years at the current rate of interest. This is
what is known as the annuity method of valuation of goodwill. Once the
super profit is ascertained, the present value and hence the value of
goodwill can be ascertained by the following formula:-
V=a/i[1-(1+i)^-n)] ,or,
V=a/i[1-1/(1+i)^n]
Where,
V=the present value of the annuity or the value of goodwill in
this case
a=the annuity or the annual super profit in this case
n=the number of years the annuity would be enjoyed
i=the rate of interest per rupee per year

(4) Capitalisation Method:-

(a) Capitalistion of Average Profit: Under this method the average

annual profit is to be ascertained after providing for reasonable
management remuneration. This profit should be capitalized at the rate
of reasonable return to find out the total value of business. Now the
value of goodwill will be the total value of business minus its net assets.
If, however, the net assets is greater ther will be no goodwill, rather
there is badwill.
(b) Capitilisation of Super Profit: Under this method the average
super profit is capitalised at a certain rate of interest and this
capitalised amount becomes the value of goodwill.