Valuation of Goodwill

Meaning
Goodwill is the extra value attached to the business over and above the intrinsic value of its net assets. It is
an intangible asset and is existing due to the brand name of the company, good customer relations, good
employee relations, technical advancement etc. In other words, it is the reputation of the firm expressed in
monetary terms.

Definition
Prof. Dicksee has defined goodwill as " When a man pays for goodwill, he pays for something which places
him in the position of being able to earn more than he would be able to do by his own unaided efforts." The
capacity of a business to earn profits in future is basically what is meant by the term goodwill.

Factors affecting valuation of Goodwill

 Location factors: Favourable location influences the earning capacity of the business and enhances
its goodwill.
 Time factor: A long established business enjoys better goodwill than a newly started business.
 Nature of business: The nature of products, the risks involved, the competition etc., determine the
value of goodwill.
 Efficiency of management: Efficient management contributes to higher profits and growth of
business and consequently increases the value of goodwill.
 Stability of business: A stable business enjoys higher goodwill than an unstable business
 Future Prospects: The better the future of the business more is the goodwill and vice-versa
 Other factors: Past profits, general economic condition, political stability, money market conditions,
trade cycles, government policies, etc., are other factors which influence the value of goodwill.

Purchased Goodwill
Purchased goodwill is that goodwill which is acquired by a firm for a consideration, whether paid in cash or
kind. The difference between the price paid to a company as a continuing concern (going concern) and net
worth can be individually identified and evaluated. Such difference is the goodwill you get.

Inherent or Non-Purchased Goodwill

Inherent goodwill is not purchased for a consideration but is earned by the efforts of the management. It is
the firm's worth that is greater than the fair value of its separable net assets. It is internally generated and
develops over time due to a company's strong reputation.
Calculation of Non-Purchased Goodwill by Arbitrary method
In this method either the purchaser or seller or both parties may estimate the value to be placed on the
goodwill
This method normally applies in situations where the profits cannot be used as a guide to future profit.

Calculation of Goodwill (Purchased Goodwill)

Methods of Valuation of Goodwill:
1. Average Profit Method
Step I: Calculation of Adjusted Average Profits
a) Simple average (Average Annual Profits)
Total Profits/Number of years
b) Weighted Average (Weighted Average Annual Profits)
Total Products/Total weights
Step 2: Calculation of goodwill using the formula
Value of Goodwill = Adjusted average annual profits X number of years of purchase

2. Capitalization Method- Simple Average Profit Method

Steps-
a. Calculation of average profits
Average profits= Total Profit/Number of years
b. Calculation of Total value of business
Total value of business = Average profits/NRR (Normal rate of return)
c. Calculation of Goodwill
Goodwill= (Total value of Business-Net worth) X No. of years of purchase

3. Capitalization Method- Adjusted Average Profit Method

Steps-
a. Figure out the given values in the problem
b. Calculation of adjusted average profits
Average profits= Total Profit/Number of years
c. Calculation of Total value of business
Total value of business= Adjusted Average profits/NRR
d. Calculation of Goodwill
Goodwill= (Total value of Business-Net worth) X No. of years of purchase

4. Super Profit Method

Steps-
a. Calculation of adjusted average Profits
Average profits= Total Profit/Number of years
b. Calculation of average capital employed
Average Capital Employed= Net Worth -1/2 of Current year's profit
c. Calculation of Normal profits
Normal Profits= Average Capital Employed X NRR
d. Calculation of super profits
Super Profits= Adjusted Average Profits - Normal Profits
e. Calculation of Goodwill
Goodwill= Super Profits X Number of years of purchase

5. Annuity Method
a. Calculation of adjusted average Profits
Average profits= Total Profit/Number of years
b. Calculation of average capital employed
Average Capital Employed= Net Worth -1/2 of Current year’s profit
c. Calculation of Normal profits
Normal Profits= Average capital employed X NRR
d. Calculation of super profit
 Super Profits= Adjusted Average Profits – Normal Profits
e. Calculation of Goodwill
Goodwill= Super Profits X No. of years of purchase
f. Annuity Value= Super Profits X Annuity