Financial Accounting

What are various methods of valuation of goodwill?

Goodwill

Goodwill is valued based on the valuer’s assumptions. The methods used to value goodwill vary according to the facts of each case and are frequently based on industry conventions.

There are five methods of valuation of goodwill which have been explained below:

  • Average maintainable profits method
  • Super profit method
  • Capitalisation method
  • Annuity method
  • Hidden method

Average Maintainable Profit Method

Under this method, average profit means average profits of actual profits of the past three to five years, depending upon the nature of the business. The average of actual profits must be adjusted in the light of future events that may affect the future profits, so this method is also known as “future maintainable profits”.

Under this method, we can calculate the value of goodwill by multiplying the average future maintainable profits by a certain number of years. The following formula is used for calculating the value of goodwill:

Steps:- In the first step, we have to calculate the average maintainable profits for the past few years are as follows-

Average maintainable profits= Total adjusted profits / No. Of year

Step:- Calculate the Value of goodwill by using the following formula:

Goodwill= Average maintainable profits x Number of years purchased.

To calculate the total adjusted profits, the following adjustments should be made to the profits.

  • Any abnormal losses such as strikes, floods, accidents etc., added back to the past profits.
  • Any uncommon profits should be deducted from past profits.
  • Interest, remuneration, commission etc. should be adjusted.
  • The past average profits should be calculated after deducting tax at current rates.

Example of Average Profit Method of Goodwill Calculation

1st April 2017 on the admission of a new partner, it is agreed that the goodwill of the firm is valued at three years purchase of average profits for the last five years. Further, suppose the profits for the last five years have been as follows:

For the year ended 31st March 201710,740
For the year ended 31st March 20167,900
For the year ended 31st March 20155,430
For the year ended 31st March 2014(400) – Loss
For the year ended 31st March 20038500

The goodwill will be computed as follows:

Total profits for the last five years = 10,740+7,900+5,430+(400)+8,500 =32,170

Average Profit = 32170/5 = 6434

Three years’ purchase of the above mentioned average profit= 6434 x 3 = 19,302

Thus, the value of Goodwill = ₹19,302

Super Profits Method

Super profit method of valuation of goodwill is one of the most popular methods of valuation of Goodwill. Under the super-profit method, the value of goodwill is based on super-profits. Super profits are the profits earned above the normal profits, i.e. excess of the actual profits over the normal profits.

For calculating the value of goodwill, the following formula should be followed:-

Super Profits = Actual Profits – Normal Profits

Normal Profits = Capital Invested X Normal rate of return/100

Goodwill = Super Profits x No. of years purchased

Capitalisation Method

under this method, the value of goodwill is calculated in two ways such as-

  • The Capitalisation of Average Profits Method
  • Capitalisation Super Profits Method

a. The Capitalisation of Average Profit Method

In this method, goodwill is the surplus capitalised value of the firm’s average profit over its actual capital employed. The formula for calculating the value of goodwill under the capitalisation of average profits method is as follows-

Goodwill = Capitalised Value of Average Profits – Capital Employed

Here:

Capitalised Value of Average Profits = Average Profits X (100 / Normal Rate of Return)

Capital Employed = Assets – Liabilities

b. The Capitalisation of Super Profits

For calculating the value of goodwill, the formula is as follows-

Goodwill = Super Profits X (100/ Normal Rate of Return)

Example: The adjusted forecast maintainable profit is ₹40,000, capital employed is ₹200,000, the normal rate of return is 15%, and the capitalisation rate is 20%.

Here the value of goodwill shall be = [40,000 – (200,000 x 15%)] / 20%

= [40000-30000]/0.20

= ₹50,000

Annuity Method

Under this method, goodwill is calculated by taking the average of the super profit as the value of an annuity over a certain number of years. The present value of the above annuity is discounted at the given rate of interest (the normal rate of return is the value of the goodwill. Following is the formula to calculate goodwill under the annuity method:

Goodwill = Super profits per annum x Relevant annuity value

Hidden Goodwill

A hidden goodwill method is used in such a case when no particular method of valuation of goodwill or information is provided in the question. The following steps are followed to calculate the value of hidden goodwill:-

Under the hidden goodwill method, the value of goodwill is calculated based on capital contributed by the partners and their respective shares in the firm.

First of all, find out the total capital of the firm by using the formula:-

  1. Total capital= New partner capital * Reverse of new partner’s share
  2. Deduct from the total capital, the combined capital of all the partners
  3. Balance is the value of goodwill

In other words, Hidden Goodwill = Sundry Debtors – Outsiders Liabilities.

I hope you understand how to calculate goodwill using various methods of valuation of goodwill.

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