Step by Step Valuation of Goodwill by Various Methods

Methods For Valuation of Goodwill

          First before valuation of Goodwill one should  understand Goodwill why should we evaluated goodwill and what are factors affecting goodwill. In one of my earlier article i have wrote over it. To understand Click Here.

           Today in this article let us see the methods to valuate the goodwill. Basically there are four major methods to valuate Goodwill

§  Average Profit Method

·        Simple Average Method

·        Weighted Average Method

§  Super Profit Method

§  Annuity Method

§  Capitalization Method

·        Super Profit Capitalization Method

·        Average Profit Capitalization Method

Now let understand in detail each of this method below

§  Average Profit Method

Average Profit Method has the following two types of methods under it. They are as follows

§  Simple Average Method:

 Under this method certain number of year purchased of the average annual profit a number of past years is taken as the value of goodwill of the business.

Ø Step 1 : Average Profit   =   Total Profit

 Number of Years

Ø Step 2 : Goodwill = Average Profit * Number of Years of Purchase

§   Weighted Average Method:

          In this method weights are being assigned to every years profit and the weights are multiplied with profit and the sum of the profits is taken for calculation of Goodwill. Following are the steps

Ø Step 1: Assigning the Weights To Every Year Profit

For Instance, 1^st Year Profit 15000, 2^nd Year Profit 10000, 3^rd Year Profit 20000. Now

1^st Year          15000 *1

2^nd Year         10000*2

3^rd Year          20000*3

Ø Step 2 : Multiple assigned values with the profits and Sum the total

1^st Year          15000 *1 = 15000

2^nd Year         10000*2  =  20000

3^rd Year          20000*3 =  60000

                                                     95000

Ø Step 3 : Calculation of Average Profit

 Average Profit   =   Total Profit

                            Number of Years

Ø  Step 4 : Calculation of Goodwill

Goodwill = Average Profit * Number of Years of Purchase

§  Super Profit Method:

                     Under this method, the maintainable profits of the business whose Goodwill is for sale is being compared with normal profits of the business or firm which an average firm or business have made with same capital and if the future estimated profits are more than the normal profit then it is called Super Profits. Goodwill is been calculated by multiplying the super profits by number of years of purchase. Below are the steps to calculate

Ø Step 1 :Calculation of capital Employed

Particular	Amount
Market Value of Realization asset (Except Investment and Goodwill) Outsider Liability	XXX XXX
Capital Employed	XXX

Ø Step 2 : Ascertainment of Average Capital Employed

ACE = Capital Employed @ the end + Capital Employed @ the beginning

                                                          2

In case of Capital Employed is not given, then

          ACE= Capital Employed @ the end – ½ of the current year profit

Ø Step 3 : Calculation of Normal Earning

Normal Earning = Average Capital Employed(ACE) * Normal Rate of Return

Ø Step 4 : Calculation of Average Adjusted Annual Profit(AAAP)

                             AAAP = Total Profit

                                      Number of Years

Ø Step 5 : Calculation of Super Profit

          Super Profit = AAAP – Normal Earning

Ø Step 6 : Calculation of Goodwill

          Goodwill = Super Profit * Number of Years Purchase

§  Annuity Method:

                   The idea behind the super profits is that the amount which is paid as Goodwill will be back in next four to five years. But the problem is that the value of money doesn’t remain the same over the period. Under this method the time value of money is also considered and Super profits and average adjusted annual profits are multiplied with annuity rate. Under this method following steps are followed for calculation of goodwill

Ø Step 1 :Calculation of capital Employed

Particular	Amount
Market Value of Realization asset (Except Investment and Goodwill) Outsider Liability	XXX XXX
Capital Employed	XXX

Ø Step 2 : Ascertainment of Average Capital Employed

ACE = Capital Employed @ the end + Capital Employed @ the beginning

                                                          2

In case of Capital Employed is not given, then

          ACE= Capital Employed @ the end – ½ of the current year profit

Ø Step 3 : Calculation of Normal Earning

Normal Earning = Average Capital Employed(ACE) * Normal Rate of Return

Ø Step 4 : Calculation of Average Adjusted Annual Profit(AAAP)

                             AAAP = Total Profit

                                      Number of Years

Ø Step 5 : Calculation of Super Profit

          Super Profit = AAAP – Normal Earning

Ø Step 6 : Calculation of Goodwill on basis of

·        Super Profit

Goodwill = Super Profit * Annuity Rate

·     Average Adjusted Annual Profit

Goodwill = Average Adjusted Annual Profit * Annuity Rate

§  Capitalization Method:

             Under this method Goodwill is calculated on the basis of average profit and normal rate of return.Under this method there are two methods . They are

·        Capitalization of Average Profit Method

·        Capitalization of Super Profit Method

·        Capitalization of Average Profit Method

Ø  Step 1 :Calculation of capital Employed

Particular	Amount
Market Value of Realization asset (Except Investment and Goodwill) Outsider Liability	XXX XXX
Capital Employed	XXX

Ø Step 2 : Ascertainment of Average Capital Employed

ACE = Capital Employed @ the end + Capital Employed @ the beginning

                                                          2

In case of Capital Employed is not given, then

          ACE= Capital Employed @ the end – ½ of the current year profit

Ø Step3 : Calculation of Normal Earning

Normal Earning = Average Capital Employed(ACE) * Normal Rate of Return

Ø Step 4 : Calculation of Average Adjusted Annual Profit(AAAP)

                             AAAP = Total Profit

                                      Number of Years

Ø Step 5 : Calculation of Capitalization of Average Profit

          Total Value of Business = AAAP *100

                                                    NRR

Ø Step 6 : Calculation of Goodwill

       Goodwill = Total Value of Business – NA or Capital Employed at the end of the year

Ø   Capitalization of Super Profit Method:

Ø Step 1 :Calculation of capital Employed

Particular	Amount
Market Value of Realization asset (Except Investment and Goodwill) Outsider Liability	XXX XXX
Capital Employed	XXX

Ø Step 2 : Ascertainment of Average Capital Employed

ACE = Capital Employed @ the end + Capital Employed @ the beginning

                                                          2

In case of Capital Employed is not given, then

          ACE= Capital Employed @ the end – ½ of the current year profit

Ø Step3 : Calculation of Normal Earning

Normal Earning = Average Capital Employed(ACE) * Normal Rate of Return

Ø Step 4 : Calculation of Average Adjusted Annual Profit(AAAP)

                             AAAP = Total Profit

                                      Number of Years

Ø Step 5 : Calculation of Super Profit

          Super Profit = AAAP – Normal Earning

Ø Step 6 : Calculation of Goodwill

          Goodwill =   Super Profit * 100

                               Normal Loss