Question

Explain different methods of valuation of goodwill.

Hint:

Goodwill can vary significantly depending on the valuation method used, so it is important to understand the method and assumptions behind it.

Answer 1

Goodwill represents the intangible assets or value of a business over and above its net tangible assets. It can be valued using different methods, depending on the nature of the business and the purpose of valuation. The following are the commonly used methods of valuing goodwill:

Average Profit Method: Under this method, goodwill is calculated based on the average profit of the business over a certain number of years, typically 3 to 5 years. The formula is: \[ \text{Goodwill} = \text{Average Profit} \times \text{Number of Years' Purchase} \]
Super Profits Method: This method is used when a company is earning profits over and above the normal profits expected from similar businesses. The super profit is the excess profit over the normal profit. The formula is: \[ \text{Goodwill} = \text{Super Profit} \times \text{Number of Years' Purchase} \]
Capitalization of Average Profit Method: This method involves capitalizing the average profit by applying a capitalization rate (usually based on the rate of return expected in similar industries). The formula is: \[ \text{Goodwill} = \frac{\text{Average Profit}}{\text{Capitalization Rate}} \]
Discounted Cash Flow (DCF) Method: The DCF method values goodwill based on the present value of future cash flows generated by the business. The formula is: \[ \text{Goodwill} = \sum \frac{\text{Future Cash Flows}}{(1 + r)^n} \] where \( r \) is the discount rate and \( n \) is the number of years.
Net Assets Method: This method values goodwill as the difference between the business's total assets and liabilities, including tangible and intangible assets. This method is generally used when the business is being sold as a going concern.

Conclusion: The method of valuation of goodwill depends on the circumstances and the data available. The most appropriate method is chosen based on the nature of the business and the purpose of valuation.