METHODS OF VALUATION OF GOODWILL :
One of the main factors contributing to the value of goodwill is the earning capacity of the business. Following are the usual methods of calculating the value of goodwill:
(i) Average Profit Method:
Under this method, goodwill is valued on the basis of a certain number of years’ purchase of the average profits of the past few years.
| Example: Suppose on 1st April, 2013 on the admission of a new partner, it is agreed that goodwill of the firm is valued at three years purchase of average profits for the last five years. Further, suppose the profits for last five years have been as follows:For the year ended 31st March 2013 10,740
For the year ended 31st March 2012 7,900 For the year ended 31st March 2011 5,430 For the year ended 31st March 2010 400 (loss) For the year ended 31st March 2009 8,500 Value of goodwill will be calculated as follows: Total profits for the last 5 years = Rs. (10,740 + 7,900 + 5,430 – 400 + 8,500) Average profits = Rs.3217, = Rs. 6,434 5 Three years’ purchase of the above mentioned average profit= Rs. 6,434 x 3 = Rs. 19,302
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(ii) Super Profit Method
In this case the future maintainable profits of the firm are compared with the normal profits for the firm. Normal earnings of a business can be judged only in the light of normal rate of earning and the capital employed in the business. Hence, this method of valuing goodwill would require the following information:
(i) A normal rate of return for representative firms in the industry.
(ii) The fair value of capital employed.
(iii) Estimated future maintainable profits.
There are three methods of calculating goodwill based on super profit:
(a) Purchase of super profit
As per this method, value of goodwill is obtained by multiplying super profit by a certain number of years.
| Goodwill = Super profit x No. of year purchase. |
(b) Annuity method
Goodwill according to the annuity method is the present value of a terminal annuity of super profit for a reasonable period during which the super profit is likely to occur. It is calculated as:
Super profit x Annuity rate.
(c) Capitalization of super profit
In this method, the value of goodwill is arrived at by capitalizing the super profit at the normal rate of return. It is calculated as:
Super profit x 100
Normal rate of return
(iii) Capitalization Method
The capitalization of profit method values goodwill at the excess of capital that should have been employed for earning the average profit over the capital which has been actually employed. In this method, the value of whole business is found by using the formula:
Average annual profit x 100
Normal rate of return
From this figure, the net assets (excluding goodwill) of the firm are deducted and the resultant figure will be
the goodwill.