Methods of Valuation of Goodwill

Introduction: What is Goodwill in Finance?

Goodwill refers to the reputation a firm builds over time. It is associated with a company’s brand value, functional consumer association, palpable consumer base, outstanding employee association, and any other patent or proprietary technology the company has.

Goodwill is an intangible asset as it cannot be seen or touched but it has a real value and its contribution to the company’s overall value is outstanding. Thus, goodwill has a given value and it can be bought or sold depending on its value in a particular market. The importance of goodwill can be understood from the fact that for some companies, the value of goodwill exceeds the total value of the assets of the company.

It is often seen that some companies based in a chosen geographical area and working in a specific industry earn goodwill. This may be due to various factors. The product that the firm produces may be exceptionally good. The customer service a company provides may be outstanding or the technology the products have may be revolutionary. In all such cases, one thing that is common is that all of these companies offer something unique that is impossible to copy by other companies in the given industry.

In accounting terms, goodwill is considered an asset although it is not physical. It is considered to be an intangible asset because it has all the qualities that must be met to be an asset in accounting standards.

What is Valuation of Goodwill?

Valuation of goodwill refers to the value of a company as assumed by a valuer. This is applicable during the time of sale of a company. An established business has a reputation in the industry, builds links, and creates networks while in business. It also earns the trust of the clients who avail the goods and services from the company. These attributes are not available in new companies. Therefore, the valuation of goodwill means the extra and intangible value of a company that is built due to the good reputation of the company.

Customer who intend to buy a company usually looks at the super-profits of the company. Therefore, goodwill is a phenomenon that is related to companies that earn super-profits and not to the firms that go through regular profits and losses. It is easy to see why this is so. Normal companies that make losses or earn intermittent profits are not attractive to buyers, as well as to customers. Therefore, their value is less than the companies that have super-profits which makes these companies more valuable than the others.

Methods of Valuation of Goodwill

There are numerous methods to calculate the value of goodwill of a company depending on the status of the company and the different trade practices. However, there are three most common methods that are used by economists to calculate the value of goodwill. These are as follows:

Average Profits Method

There are two categories of average profits methods for goodwill valuation. This is dependent on two types of averages, namely, the simple average and the weighted average methods.

Simple Average Profit Method

In this method, the average profit of a company is evaluated by the simple average formula. Here, the number of years is used to calculate the average profit for the years’. This is also known as the years’ purchase. In this method, the equation that is used for goodwill valuation is –

$$\mathrm{Goodwill\:=\:Average\:Profit\:\times\:No.\:of\:Years\:of\:Purchase}$$

Weighted Average Profit Method

Here, specific weights are used to determine the value of goods. This value is divided by the total number of weights to find the average weighted profit. This gives the profit of the last year. This method is good for calculating goodwill when there is a change in profits in different years. It gives a high weight to the present year’s profit. The equation that is used for goodwill valuation is −

$$\mathrm{Goodwill\:=\:Weighted\:Average\:Profit\:\times\:No.\:of\:Years\:of\:Purchase}$$

Here, Weighted Average Profit = Sum of Profits multiplied by weights/ Sum of weights

Super Profits Method

Super profits refer to the excess surplus profit that can be maintained by a firm above the general profits earned by the company. There are two categories of this method as explained below −

Method depending on the number of years

In this method, the super profit is measured by selecting the year in which the super profit is made. The super profits are evaluated by a select number of the purchase year. The equation used for the valuation of goodwill in this method is -

$$\mathrm{Super\:Profit\:=\:Actual\:Or\:Average\:Profit\:-\:Normal\:Profit}$$

Annuity Method

In this method, the annuity value of a definite number of years is used. In general, the average value of the super profits is taken as an annuity value. The discounted value of super profits gives the value of the annuity at a given interest rate. The formula that is used in this method to calculate the goodwill valuation is -

$$\mathrm{Goodwill\:=\:Super\:Profit\:\times\:Discounting\:Factor}$$

Capitalization Method

There are two categories of capitalization methods that can be used to calculate the goodwill of a firm. These are - the average profits method and the super profit method.

Average profit method

In this method, the difference between the capitalized amount of the average profits is based on the average rate of return and the original capital obtained from the capitalized amount. The applicable equation here is –

$$\mathrm{Capitalized\:Average\:Profits\:=\:Average\:Profits\:\times\:\frac{100}{average\:return\:rate}}$$

Super profits method

Unlike the average profit method, in the super profits method, the super profits are capitalized and the goodwill is measured. The applicable formula for calculating goodwill in the super profits method is –

$$\mathrm{Goodwill\:=\:Super\:Profits\:\times\:\frac{100}{Normal\:\:Rate\:of\:return}}$$

Note − Goodwill is nothing else but the reputation of a firm that is earned by companies that offer exceptional goods and services. It is important to note that all companies do not have goodwill. This is so because to earn goodwill, a company must earn super profits which is impossible for all firms to earn.

Conclusion

Goodwill valuation is important because it shows the hidden potential of a firm that makes it valuable in terms of reputation. Knowing the value of goodwill of a company helps potential buyers derive the value of a firm. That is why it is of prime priority for investors and buyers to consider the valuation of the goodwill of a company.

FAQs

Qns 1. What is goodwill? What are the factors that are associated with goodwill?

Ans. Goodwill refers to the reputation that a firm builds over time. It is associated with a company’s brand value, functional consumer association, palpable consumer base, outstanding employee association, and any other patent or proprietary technology the company has.

Qns 2. What is meant by the valuation of goodwill?

Ans. Valuation of goodwill refers to the value of a company as assumed by a valuer. The valuation of goodwill means the extra and intangible value of a company that is built due to the good reputation of the company.

Qns 3. How many types of measures are there to value goodwill?

Ans. There are mainly three measures for goodwill valuation which are the average profits method, super profits method, and capitalization method.