Valuation of Goodwill

Valuation of Goodwill

Goodwill has been valued by accountants since ages especially during mergers and acquisitions. Although practically speaking, Value of Goodwill is the difference between the Actual Price paid for the business less the book value of the business. However, there have been some defined approaches to valuation of business by accountants.

Goodwill is defined as the super profit earning capacity of the business.

A simplified approach to valuation of goodwill is as follows:

Goodwill = Super Profit x Number of Years’ Purchase

Super Profit = Future Maintainable Profit – Normal Profit

Future Maintainable Profit: The buyer of business (or goodwill for that matter) is usually interested in what the business will be able to sustain as profits in future. Accordingly we adjust the historical profits to arrive at future maintainable profits.

Take the historical profits for the last few years (e.g. 5 years). Identify if there is a clear trend in profits

Add/Less: Eliminate the effects of non-trade or abnormal items. E.g. Income from sale of a large asset, loss due to fire, strike, etc.

Add/Less: Eliminate the effects of items which have occurred in the past but is not likely to occur in future.

Take the Average of this adjusted Profits

Add/Less: Items that have not occurred in the past but is likely to occur in future (e.g. acquisition of a likely business)

Add/Less: Tax Adjustments

Here you are! You’ve arrived at the Future Maintainable Profits

Normal Profit = Average Capital Employed x Normal Rate of Return

Average Capital Employed is the average of Opening and Closing Capital Employed. [Remember that Capital Employed is Total Assets Less Current Liabilities]

Normal Rate of Return is the expected rate of return of the investor/buyer or the market rate of return.

Number of Year’s purchase is the negotiated multiple (years’ of purchase) of years of super profits agreed between the buyer and seller.

PS: There are some other approaches followed by accountants as well such as Average Profits Method and Capitalisation Method.