Valuation of Goodwill

VALUATION OF GOODWILL
Meaning 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.
Valuation of Goodwill Meaning:
First, In the case of a partnership, when there is an admission,
retirement, death or amalgamation, or a change in the profit-sharing
ratio take place, the valuation of goodwill becomes necessary.
Secondly, In the case of a company, when two or more companies

amalgamate, or one company absorbs another company, or one
company wants to acquire controlling interest in another company or
when the Government takes over the business, valuation of goodwill
becomes necessary.
Third, In the case of a sole trader concern, goodwill is valued at the

time of selling die business, to decide the purchase consideration.
Finally, In the case of individuals, goodwill is valued for Estate Duty,

Death Duty, etc. On the death of a person.
Need for Valuation of Goodwill:
Valuation of goodwill may make due to any one of the following reasons:
A Company or Firm:
If the goodwill has already been written-off in the past but the value of the
same is to records further in the books of accounts.
An existing company taking with or amalgamated with another existing

company.
The Stock Exchange Quotation of the value of shares of the company is not
available to compute gift tax, wealth tax, etc., and.
The shares are valued based on intrinsic values, market value or fair value
methods.
Factors Affecting the Value of Goodwill:
The following factors affect the value of goodwill:
• Location
• Time
• Nature of Business
• Capital Required
• Owner’s Reputation
• Market Situation
• The trend of Profit
• The efficiency of Management
• Special Advantages
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.
A) 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.

Steps Involved under Average Profits Method:
(i) Calculate past profits before tax.
(ii) Calculate future-maintainable profit before tax

after making past adjustments.
(iii) Calculate Average Past adjusted Profits (taking

simple average or weighted average as applicable).
(iv) Multiply Future Maintainable Profits by number

of years’ purchase.
Illustration 1: X Ltd. agreed to purchase business of a sole trader.
For that purpose, goodwill is to be valued at 3 years’ purchase of
average profits of last 5 years.
Weighted Average
In this method, 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

purchase Weighted Average Profit = Sum of Profits
multiplied by weights/ Sum of weights
Illustration 2: Y Ltd. proposed to purchase business carried on by Mr. A. Goodwill
for this purpose is agreed to be valued at 3 year’s purchase of the weighted
average profits of the past four years. The profit for these years and respective
weights to be assigned are as follows:
On a scrutiny of the accounts, the following matters are revealed:

(a) On 1st September, 2012 a major repair was made in respect of plant incurring Rs.
6,000 which was charged to revenue, the said sum is agreed to be capitalized for goodwill
calculation subject to adjustment of depreciation of 10% p.a. on reducing balance
method.
(b) The closing stock for the year 2011 was over valued by Rs. 2,400; and
(c) To cover management cost an annual charge of Rs. 4,000 should be made for the
purpose of goodwill valuation.
Required: Compute the value of goodwill of the firm.
Solution:
B) 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
Goodwill = Super Profit x Number of years purchased

Steps Involved in Calculating Goodwill under
Super Profit Method:
Step 1: Calculate capital employed (it is the aggregate of Shareholders’
equity and long term debt or fixed assets and net current assets).
Step 2: Calculate Normal Profits by multiplying capital employed with

normal rate of return.
Step 3: Calculate average maintainable profit.

Step 4: Calculate Super Profit as follows:
Super Profit = Average maintainable profits – Normal Profits.
Step 5: Calculate goodwill by multiplying super profit by number of

year’s purchase.
Illustration 3:From the following information calculate the value of
goodwill on the basis of 3 years purchase of super profits of the
business calculated on the average profit of the last four years (simple
average and weighted average):
(i) Capital employed – Rs. 50,000
(ii) Trading profit (after tax):
2010 Rs. 12,200;
2011 Rs. 15,000;
2012 Rs. 2,000 (loss); and
2013 Rs. 21,000
(iii) Rate of interest expected from capital having regard to the risk involved is
10%.
(iv) Remuneration from alternative employment of the proprietor (if not

engaged in business) Rs. 3,600 p.a.
Solution:
C) Capitalization Method
1. Capitalization of Average Profit
2. Capitalization of Super Profit
1. Capitalization of 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)
Capital Employed (Net Assets) = Total Assets – Outside

Liabilities
Goodwill = Capitalized Value – Net Assets

Illustration 4: From the following calculate the value of goodwill
according to capitalisation of Average Profits Method:
2. Capitalization of Super Profits Method- Here, the
super profit is capitalized, and the goodwill is
calculated. The formula applied is.
• Super Profit = Actual or Average profit – Normal

Profit
• Goodwill = Super Profits x (100/ Normal Rate of

Return)
Illustration 5: Balance Sheet of X Ltd. on 31st
March, 2013 was as under:
4. Annuity Method:
Under this method, goodwill is calculated by taking
average super profit as the value of an annuity over a
certain number of years. The present value of this
annuity is computed by discounting at the given rate of
interest (normal rate of return). This discounted present
value of the annuity is the value of goodwill. The value
of annuity for Rupee 1 can be known by reference to the
annuity tables.
Illustration 6: The net profit of a company after providing for
taxation for the past five years is:
The net tangible assets in the business are Rs. 4, 00,000 on

which the normal rate of return is expected to be 10%. It is
also expected that the company will be able to maintain its
super profits for next five years. Calculate the value of
goodwill of the business on the basis of an annuity of super
profits, taking present value of an annuity of Rs. 1 for five
years at 10% interest is Rs. 3.78.

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VALUATION OF GOODWILL

Secondly, In the case of a company, when two or more companies

Third, In the case of a sole trader concern, goodwill is valued at the

Finally, In the case of individuals, goodwill is valued for Estate Duty,

An existing company taking with or amalgamated with another existing

The following factors affect the value of goodwill:

• The trend of Profit

• The efficiency of Management

A) Average Profits Method – This method is divided into two sub-

Simple Average – In this process, goodwill evaluation is done by

Goodwill = Average Profit x No. of years’ of purchase.

(i) Calculate past profits before tax.

(ii) Calculate future-maintainable profit before tax

(iii) Calculate Average Past adjusted Profits (taking

(iv) Multiply Future Maintainable Profits by number

Goodwill = Weighted Average Profit x No. of years’ of

On a scrutiny of the accounts, the following matters are revealed:

The Purchase Method by Number of Years

The goodwill is established by evaluating super-profits by a

Super Profit = Actual or Average profit – Normal Profit

Goodwill = Super Profit x Number of years purchased

Step 2: Calculate Normal Profits by multiplying capital employed with

Step 3: Calculate average maintainable profit.

Super Profit = Average maintainable profits – Normal Profits.

Step 5: Calculate goodwill by multiplying super profit by number of

(iv) Remuneration from alternative employment of the proprietor (if not

1. Capitalization of Average Profits Method – In this process,

Capitalized Average profits = Average Profits x (100/average

Capital Employed (Net Assets) = Total Assets – Outside

Goodwill = Capitalized Value – Net Assets

• Super Profit = Actual or Average profit – Normal

• Goodwill = Super Profits x (100/ Normal Rate of

The net tangible assets in the business are Rs. 4, 00,000 on

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