Home/Financial Accounting/What are various methods of valuation of goodwill?Financial Accounting
What are various methods of valuation of goodwill?
Raj Maurya1 week ago1 6,593 3 minutes read
Goodwill is valued based on the valuers assumptions. The methods used to value goodwill vary according to the facts of each case and are frequently based on industry conventions. The following are the methods of valuation of goodwill:-
- 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 threeto 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 follow-Related Articles
Introduction to Treasury Bills | Duration of Issue5 days ago
IFRS 17 Insurance ContractsMarch 17, 2022
IFRS 2 Share-Based Payment | Meaning and ScopeOctober 30, 2021
Primary Market and Secondary MarketNovember 4, 2021
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.
Super Profits Method
Super profit method of valuation of goodwill is one of the most popular methods of valuation of Goodwill. Under the super-profits 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
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 firms 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
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 follow-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%
Under this method, goodwill is calculated by taking the average of the super profit as the valueof 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
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:-
- Total capital= New partner capital * Reverse of new partners share
- Deduct from the total capital, the combined capital of all the partners
- 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.TagsMethods of valuation of goodwill valuation of goodwill
Raj Maurya1 week ago1 6,593 3 minutes readShow More