Goodwill Valuation Methods
Goodwill valuation is the systematic evaluation of the goodwill of the company to be shown in the balance of the company under the head intangible assets and top methods to value include Average Profits Method, Capitalization Method, weighted average profit method and the Super Profits Method.
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Source: Goodwill Valuation (wallstreetmojo.com)
Let us discuss these top 4 methods
#1 Purchase of average profit method
Under this goodwill valuation method, the average (mean or median) profit of the last few years is multiplied by a certain number of years in order to calculate the value of goodwill.
Goodwill Formula = Average profit x Years of purchase.
- Average profit = Total profits of all or agreed years/Number of years.
X & Co wants to sell the business to ABC & Co on 31st Dec 2016. Profits of the business are as follows for the last 5 years.YearNet Profit(US$)Remarks2011100 million2012120 millionIncludes one-time profit of $5 million which is not expected in future201390 millionIncludes the extraordinary lossExtraordinary LossExtraordinary Items refer to those events which are considered to be unusual by the company as they are infrequent in nature. The gains or losses arising out of these items are disclosed separately in the financial statement of the company.read more of $10 million which is not expected in future2014150 million2015200 million2016220million
ABC & Company proprietor Mr.A, who is currently employed at $1 million. The business of X & co, which is currently managed by salaried employee X at $0.5 million. Now ABC decided to replace the manager and decided to be managed by Mr.A.
Both companies agree to value goodwill based on 4 years purchase of average profit for the last 6 years. Profit of 2011100 million100 million Profit of 2012120 million Less: One-time profit of 5million5million115million Profit of 201390million Add: Extraordinary loss of10million10million Profit of 2014150 million150 million Profit of 2015200 million200 million Profit of 2016220 million220 million Total$885 million Average profit(885 million/6)$147.5 million Add: Manager salary0.5 million Less: Mr.A Salary1 million Expected average Net Profit$147 million Goodwill(147X 4)$588 million
#2 Purchase of weighted average profit method
This goodwill valuation method is simply an extension of the above method, where instead of a simple average, we use a weighted average. This method is used when the trend of profits are rising.
Let us use the above example to understand this method. Weights attached are as follows 2011-1, 2012-1, 2013-2, 2014-2, 2015 & 2016-3 Profit of 2011100 million100 million Profit of 2012120 million Less: One-time profit of 5million5million115million Profit of 201390million Add: Extraordinary loss of10million10million110 million Profit of 2014150 million150 million Profit of 2015200 million200 million Profit of 2016220 million220 million Total$885 million Weighted Average profit[(100*1)+(115*1)+(100*2)+(150*2)+(200*3)+(220*3)]÷(1+1+2+2+3+3)164.5 million Add: Manager salary0.5 million Less: Mr.A Salary1 million Expected average Net Profit$164 million Goodwill(164 X 4)$656 million
#3 Capitalisation Method
In this method, goodwill is calculated by ascertaining the difference between capitalizing the expected average net profit using the normal rate of return and net tangible assets of the company.
- Goodwill = Capitalised average net profit Net tangible assets
Let us again continue the above example to calculate in this method. The normal rate of return is assumed at 10%, and an average profit of the X&Co as calculated above is $147 million and
Assuming assets of the company are $1850 million and liabilities are $600.
- Capitalised value of profit = 147 million/10% = $1,470 million
- Net assetsNet AssetsThe net asset on the balance sheet is the amount by which your total assets exceed your total liabilities and is calculated by simply adding what you own (assets) and subtract it from whatever you owe (liabilities). It is commonly known as net worth (NW).read more of the X&Co= 1850 million-600 million = $1,250 million US$
- Value of goodwill = 1470- 1250= $220 million
#4 Super profit Goodwill Valuation Method
Under this goodwill method, super profit is calculated to determine the value of goodwill. Super profit is the excess profit earned by the company compared to its peers in the industry.
Goodwill = Super Profit x No of years of purchase
Lets us take an example to understand it further.
The following are the details of XYZ &Co.US $ Capital Invested$60,000 Profits 2011$10,000 2012$11,000 2013$15,000 2014$21,000 2015$18,000 2016$19,000 The market rate of return on investmentRate Of Return On InvestmentRate of Return on Investment is the rate at which a company generates a return on investment during a period when compared to the cost of the investment made by the company. It is calculated by dividing the return on investment during the period by the cost of the investment.read more10% The rate of risk return on capital invested in the business2% Remuneration of alternative employment of the proprietor if not engaged in the business$2,000 Average profit (10000+11000+15000+21000+18000+19000)÷6$15,667 Less: Propeitor employeement remunaration$2,000 Normal rate ofcapital employedCapital EmployedCapital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital."read moreCapital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital."read moreCapital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital."read more10% +2% =12% on $60,000$7,200 Super profit(13,667-7200)$6,467 Goodwill ($ 6,467×4 years)(Assuming 4 years of purchase)$25,868
In this goodwill valuation example, average profit may be calculated by using the weighted average method as well.
Top Things to know about Goodwill Valuation
- One or two years of profit is taken for goodwill valuation if the retiring chairman of the business is the main source of the success of the business.Generally, three to five years of purchase is usually taken.
- A large number of years may be taken if the super profit is large or business is highly profitable.
- Sometimes goodwill also increases if many parties are bidding to the business, and the seller wants to increase the premium of business irrespective of super-profits or average profits.
- Sometimes a business may be making losses, even then goodwill may be paid if the prospects of the business are very high.
- It is also dependant on the synergies an acquiring company gets due to the merger and not solely depends on profits.
- Sometimes, goodwill valuation also depends on the technology or R&D a company possesses or a specific set of customers a company may have or specific sectors a company may be operating in.
Goodwill Valuation Video
This article has been a guide to Goodwill Valuation. Here we discuss the top 4 methods to value goodwill, including super profit, average profit, weighted average profit, and capitalization method. You can learn more about accounting basics from the following articles
- Steps for Goodwill Impairment Test
- Negative Goodwill
- Amortization of Intangibles