Methods of Valuation of Goodwill. The most commonly used methods of valuation of goodwill are as follows:
(i) Few Years’ Purchase of Average Profits Method;
(ii) Super Profits Method;
(iii) Annuity Method; and
(iv) Capitalization Method
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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.
Under this method, average super profit is ascertained. Goodwill is calculated at a few years’ purchase of the super profit of the organization. How many years’ purchase shall be taken into consideration depends upon the nature of the business, the steady or fluctuating nature of the profit, and also the nature of goodwill. Under this method, a few years’ purchases of super profit are taken as the value of goodwill.
Goodwill = Super profit X few years
Super profit is the difference between actual profit and normal profit.
The actual profit is the profit earned by the organization taken with or without any adjustment. Sometimes, several years’ average profit is also considered.
Normal profit is calculated by multiplying the average capital employed within the organization by the normal rate of return.
Normal Return = Average Capital Employed X Normal Rate of Return
The normal rate of return is the likely rate of return of the organizations doing similar business. Average capital employed is the average of the opening capital employed and closing capital employed. Whereas capital employed, while calculating the value of goodwill, is the difference between total net assets less current liabilities.
Capital Employed = Total Net Assets – Current Liabilities
Both the opening capital employed and the closing capital employed may not be found in a single instance. In that case, the average capital employed may be found out by deducting 50% of the current year’s profit after tax from the closing capital employed or adding 50% of the current year’s profit with the opening capital employed. Average capital employed includes long-term liabilities, bonds, and preference share capital (excluding non-trading assets and goodwill).
To find out the closing capital employed, the total of the closing real assets of the organization as revalued is to be taken. For this purpose, the non-trading assets and goodwill already appearing in the Statement of Financial Position are not to be taken. Goodwill may be taken within the total assets if the goodwill has been purchased or something has been paid for goodwill.
To calculate the normal average (simple or weighted) annual trading profit after tax but before charging interest on debentures and long term loans and also preference dividend. (If however, the capital employed does not include debentures, long-term loans, and preference capital, the above items are also to be charged). From this normal average, reasonable managerial remuneration should be deducted. The profit as obtained after the above adjustments is to be compared with the reasonable return on average capital employed, calculate at the rate of return earned by similar businesses. If the former exceeds the latter the balance represents the super profit.
Under this method, the basis is the super profit. The value of goodwill is the present value of an annuity of the annual super profit payable over an expected number of years at the current rate of interest.
Once the super profit is ascertained, the present value and hence the value of goodwill can be ascertained by the following formula:
Here,
V = the present value of the annuity or the value of goodwill in this case.
a = the annuity of the annual super profit in this case.
n = the number of years the annuity would be enjoyed.
I = the rate of interest per taka per year.
Under this method, there are two sub-methods- (i) Capitalization of Average Profit Method, and (ii) Capitalization of Super Profit Method.
Under this method, the average annual profit is to be ascertained after providing reasonable management remuneration. This profit should be capitalized at the rate of reasonable return to find out the total value of the business. Now the value of goodwill will be the total value of the business minus its net assets. If, however, the net assets are greater, there will be no goodwill, rather there is bad will.
Under this method, the average super profit IS capitalized at a certain ate of interest and this capitalized amount becomes the value of goodwill.
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