Methods of Valuation of Goodwill

Goodwill is an intangible asset which is not visible or cannot be touched but can be purchased and traded and is real. The value of an enterprise’s brand name, solid consumer base, functional consumer associations, good employee associations and any patents or proprietary technology represent some instances of goodwill.

In other words, goodwill is a firm worth or reputation established over time. In partnership, the valuation of goodwill is very significant. In this article, we will discuss the meaning of the valuation of goodwill and its different methods of assessment.

Also Check: What is Goodwill?

What is the valuation of Goodwill?

The valuation of goodwill is based on the assumption obtained by the valuer. A successful business earns a reputation in the industry, develops trust with its clients, and has more extensive business links, unlike new companies. All these points contribute while evaluating the business, and its financial worth that a customer is eager to give is knowns as goodwill.

Customers who buy a company looking at its goodwill hopes to gain super-profits. Hence, goodwill applies to only firms that make super-profits and not to those who earn regular losses or profits.

Methods of Valuation of Goodwill

Various ways are used in the valuation of goodwill. However, the valuation methods are based on the situation of an individual company and different practices of the trade. The top three processes of valuation of goodwill are mentioned below.

⇨ Average Profits Method – This method is divided into two sub-division.

  • Simple Average – In this process, goodwill evaluation is done by calculating the average profit by the number of years it is called years purchase. It can be calculated by using the formula. Goodwill = Average Profit x No. of years’ of purchase.
  • Weighted Average – Here, last year’s profit is calculated by a specific number of weights. It is used to obtain the value of goods, which is divided by the total number of weights for determining the average weight profit. This technique is used when there is a change in profits and giving high importance to the present year’s profit. It is evaluated by using the formula. Goodwill = Weighted Average Profit x No. of years’ of purchaseWeighted Average Profit = Sum of Profits multiplied by weights/ Sum of weights

⇨ Super Profits Method – It is a surplus of expected future maintainable profits over normal profits. The two methods of these methods are.

  • The Purchase Method by Number of Years – The goodwill is established by evaluating super-profits by a specific number of the purchase year. It can be estimated by applying the below formula. Super Profit = Actual or Average profit – Normal Profit
  • Annuity Method –Here, the average super profit is taken as an annuity value over a definite number of years. A discounted amount of super profit calculates the current value of an annuity at the given rate of interest. The formula to be used here is.
  • Goodwill = Super Profit x Discounting Factor

⇨ Capitalization Method – Under this method, goodwill can be evaluated by two methods.

  • Average Profits Method – In this process, goodwill is measured by subtracting the original capital applied from the capitalized amount of the average profits based on the average return rate. The formula used is mentioned below.
  • Capitalized Average profits = Average Profits x (100/average return rate)
  • Super Profits Method- Here, the super profit is capitalized, and the goodwill is calculated. The formula applied is.  Goodwill = Super Profits x (100/ Normal Rate of Return)

The above mentioned is the concept that is explained in detail about methods of valuation of goodwill. To know more, stay tuned to BYJUS.