The 4 important methods adopted for valuing goodwill are:
- by an arbitrary assessment.
- by a capitalization of expected net profits or earnings (or Capitalization Method).
- by a certain number of years purchase of past average profits or earnings.
- by super profits or earnings.
- Purchase of Super Profit
- Annuity Method
- Capitalization of super Profit Method.
Each of these methods will be discussed now.
(1) Arbitrary Assessment
The valuation of goodwill is arrived at by making a valuation by one of the parties, i.e. vendor or purchaser to which the other agrees. The parties may together estimate the value to be placed on the goodwill or an independent party may be called in to give his opinion as to the value, it being left to the parties to decide whether they will accept or reject such valuation. This method can be used only when information relating to earning capacity is available. If this information is not available because of non-availability of the profit immediately prior to sale or if the profits are abnormal or unreliable then such profits cannot be used as a guide to future profits. Similarly information relating to earning capacity may not be available if the business being acquired may be converted into one of a different nature from that existing prior to date of purchase such as where a retail shop dealing in garments is purchased with a view to converting it to a pharmacy. Consideration should also be given to the question of trading advantages (e.g., quotas) made available to the purchaser by a vendor and licenses to import goods up to authorized values. There are really no guides obtainable from the accounting data as to the valuation of such benefits passed on to the purchaser and their worth remains a matter of assessment to be agreed upon by the parties.
(2) Capitalization of Expected Future Net Profits (or Capitalization Method)
The following are the main steps to be taken in computing good will by this method:
a) Ascertain the average net profit which it is expected will be earned in future.
b) Capitalize this net profit at the rate which is considered a suitable return on capital invested in a business of the type under consideration.
c) Find the value of the net tangible assets used in the business, i.e., assets less outside liabilities : (here outside liabilities will also include preference capital) and
d) deduct the net tangible assets as per (a) from the capitalized profit obtained in (b) and the difference is goodwill.
Past adjusted profits generally provide the basis for ascertaining the average .net profit which it is expected will be earned in .the future. A reduction is, made for remuneration of proprietors (if that has not-already. been done) and in the case of a limited company, income tax payable on such profit. If, of course, it is known that certain expenses will not recur or that other or increased expenses are likely to be incurred, then due allowance should be made for these. The main difficulty in valuing goodwill by this method is arriving at what return on capital is deemed appropriate to the particular business concerned. Normal return on ‘capital invested in a business depends on the pure interest (i.e., the return which can be expected without incurring any risk, as, return on buying government securities), the business risk (i.e. a margin, to cover the ordinary risks attendant in business) and the financial risk.
The future maintainable profit needs elaboration. While making an estimate of future maintainable profit on the basis of past profits, the following points arc to be taken into consideration :
- All unusual working expenses should be excluded. Interest on debentures and depreciation on all fixed assets should be excluded. If fixed assets are revalued for goodwill purpose, depreciation should be based on the revalued figures of fixed assets.
- Non-trading assets such as non-trading investments should be excluded from the capital employed and income derived from such assets should also be excluded from profit.
- All necessary provisions for liabilities such as provision for taxation should be made. But appropriations of profits such as amount transferred to general reserves, sinking fund for redemption of a liability and dividend equalization reserve should not be taken note of as such transfers merely transfer profit from one account to another account and the availability of maintainable profit is not affected.
- Preference dividend should be deducted.
- While calculating average profits, profits for the past four or five years during which conditions have remained normal should be considered.
- Effects of developments which have already taken place but whose results are likely to come in the future should also be considered.
- If the profits of the past four or five years have been increasing or decreasing in a significant manner, it will be better to give more importance to the profits of the last year and least importance to the profits of the first year. This is because conditions of the last year are likely to have more effect on future maintainable profits. This can be taken care of by taking weighted average profit by assigning weights as 1,2,3,4 and 5 to the profits of 1st year, 2nd year, 3rd year, 4th year and 5th year respectively. This practice is not to be followed if there is consistent decline of profits. In that case, profits for the future should be lower than the profits for the latest year.
(3) Purchase of fast Average Profits :
This method of valuing goodwill is commonly met with in practice and probably is the one most generally understood. It is calculated on the following basis:
- The profit (gross or net) for an agreed number of years preceding valuation are averaged so as to arrive at the average annual profit earned .during that period. Avenge used may be simple or weighted.
- The goodwill is then estimated to be worth so many years’ purchase of such average profit. The number of years selected is presumed to bear relation to the number of years benefit to be derived from past association.
This method is generally adopted when a partner dies or retires and a clause to this effect is frequently found in partnership agreements.
The number of years over which the profits are averaged and the number of years’ purchase applied, may considerably vary in practice but generally fall between one and five years. This method suffers from two defects, i.e., the uncertainty as to me number of years’ purchase of profits and no account is taken of the capital to be employed in the business. The profit which should be taken for the purpose is normal.
This method is adopted for valuing the goodwill of the professional persons or firms such as Chartered or Cost Accountants, Doctors, Advocates, etc. It ignores the amount of capital employed for earning the profit.
(4) Super Profits :
It is the excess of the average profits over the normal profits based on normal rate of return for representative firm in industry. For computation of super profit, the following three factors are required :
(i) Normal rate of return. This is the rate of profit or return which an investor expects on his investment in a particular type of industry. It may be aggregate of pure rate of return (i.e., return on risk free securities) and risk rate of return.
(ii) Capital employed. It may be calculated on the basis of assets side items or liabilities side items.
Proceeding from assets side capital employed = Fixed Assets + Trade Investments + Current Assets – Debentures – Current Liabilities.
Proceeding from liabilities side :
Capital employed = paid up equity and preference share capital + Accumulated balance on capital reserves, general reserves and credit balance in profit and loss account ± Revaluation profits (or loss) – Fictitious assets — Non-trading assets.
A refinement in the figure of capital employed can be average capital employed. Average capital employed can be calculated as follows :
Average Capital Employed
= ½ (Capital employed at the beginning + Capital employed at the end of the year) or Average Capital Employed
= Capital employed at the end of the year – ½ of current year’s profit after tax.
= Capital employed at the beginning of the year + ½ of current year’s profit after tax
(iii) Normal Profit. It is calculated by multiplying the normal rate of return with capital employed or average capital employed as the case may be.
Super Profit method has three variations i.e.
(a) Purchase of Super Profit.
(b) Annuity Method.
(c) Capitalization of Super Profit.
(a) Purchase of Super Profits
In this method of valuing goodwill, attention is focused upon super profits which are those profits remaining after deducting from the estimated annual future profit:
(a) reasonable remuneration of proprietors and management, and
(b) an amount considered to be a reasonable return on the amount of capital invested in the tangible assets.
While averaging the past profits it is desirable to cover a span of years, in such a way as to include all possible seasonal changes and fluctuations. Allowance should be made for expenses charged against past profits which arc not likely to recur and also for expenses which are likely to recur in the future. The next step is to reduce this by amount which is considered to be reasonable in respect of the services of the proprietors. This reduction would only be made where there had been no such charge for management against the average profit selected. The matter of taxation may also require to be considered from the purchasers’ point of view.
There must also be deducted an amount which is calculated to be a reasonable return on the capital invested in tangible assets. The reasonable return differs from business to business.
This percentage is then applied to the capital invested and the resulting figure deducted from the already reduced average profit, the final result giving the average annual super profit. On this basis the goodwill is to be calculated, say five years’ purchase of super profits, then it will be arrived at by multiplying the average annual super profits referred to above by five. If the super profits are large, a large number of years’ purchase is allowed for calculating the value of goodwill. In case of professional people, goodwill is usually valued on the basis of one year’s purchase of gross fees earned because in case of a profession personal skill of the professional will play a very important role in earning the income.