All about Valuation of Goodwill

CS Deepak Pratap Singh

A. VALUATION OF GOOWILL;

A firms’ reputation of generally assessed by Goodwill earned by the firm during its tenure. The Goodwill has been defined by many, but no one has given a crystal clear definition.” Goodwill” is generally used in business world, to access the value of a firm. It an intangible, invaluable asset. A business, which has earned a good reputation during its tenure, gets credit of “Goodwill”. The people are started trusting in the products or services of that firm. It is a common notion that if a firm is a profitable one it is valued high and in turn attracts goodwill. Now we can say that the reputation of a firm coupled with its going profitability represents “Goodwill”. But goodwill can be realised and quantified in money’s worth when the firm is disposed off.

We may define Goodwill as;

“The capacity of a business to earn profits in future is basically what it meant by the term “Goodwill”. “ Goodwill” is a present value of a firms’ anticipated excess earnings.”

“The established reputation of a business regarded as quantifiable asset and calculated as part of its value when it is sold.”

INVESTOPEDIA;

Goodwill is an intangible asset that arises as a result of the acquisition of one company by another for a premium value. The value of a company’s brand name, solid customer base, good customer relations, good employee relations and any patents or proprietary represent goodwill. Goodwill is considered an intangible asset because it is not a physical asset like buildings or equipment. The goodwill account can be found in the assets portion of a company’s balance sheet.

WIKIPEDIA;
Goodwill is a special type of intangible assets that represents that portion of the entire business value that cannot be attributed to other income producing business assets, tangible or intangible.

NEED FOR VALUATION OF GOODWILL; Generally goodwill may be valued at the time of disposal of business of the firm. But in many cases the goodwill may be valued to find out value of the firm. In case of proprietorship business it will be valued at the time of disposal of business, in case of firm it may be calculated at the time of addition, resignation and disposal of firm. Now in case of companies the need for valuation of goodwill arises in the following circumstances;

1. In case of Amalgamation of company;

2. In case of takeover of one company by another or sold of business of one company;

3. In case of a company wants to write off or reduce debit balance in its profit and loss account;

4. In case of a company wants to exercise controlling interest in other company;

5. In case of valuation of shares of an Unlisted Company;

6. In case of conversion of shares from one class to another class;

7. In case of company’s management has been taken over by Government and some other events in which valuation of Goodwill held.

FACTORS AFFECTING THE VALUE OF GOODWILL;

1. The profitability of company is past and expected profit in future will affects value of Goodwill;

2. Capital Employed to earn profit;

3. The yield from business as expected by the investors;

4. The longevity of existence of business concern;

5. Market share of products of entity;

6. Quality of services rendered;

7. The edge of concern over its competitions in the market;

8. Relationship between management and staffs;

9. Location of business enterprise;

10. Brand position and efforts taken to establish brand of the concern;

11. Technical innovation, modern technology, patents, etc,;

12. Tax Planning;

13. Relationship with Government, Local Bodies;

14. There are some other factors affecting the value of Goodwill.

LET US CONSIDER MAIN COMPONENTS OF GOODWILL;

1. PROFITABILITY;

The profitability is the most important factor in valuation of Goodwill. The main emphasis is on future profits of the concern. Whether concern will able to increase in its profit in future. Since the profit earned in past provides a base for the concern’s future profit. The process of assessment, whether a concern will maintain its profits in the future is otherwise called “Future Maintenance Profit”.

Following factors are to be considered, while estimating the “Future Maintenance Profit”;

(i) All normal working expenses should be included;

(ii) Any appreciation in the fixed assets should be excluded;

(iii)Any appreciation in the value of Current Assets should be included;

(iv) Provision for taxes should be included;

(v) Income from non trading assets should not be taken into account;

(vi) Transfer to General Reserve should be excluded;

(vii) Dividend to Preference Shareholders should be excluded;

(viii) Non –recurring expenses should be included;

(ix) Average profits of past years should be considered.

2. NORMAL RATE OF RETURN;

Every person investing his/her/its funds in companies needs a fair return; this is referred as “Rate of Earnings”. The rate return is depend on the nature of industry and other factors such as bank rate, risk, type of management, etc., it consists of following elements;

(i) Return at Zero Risk Level; in this case the risk to the investor is nil or zero, the concern in which it has invested , do not has any risk in its activities. But at the same time the return will be lower than expected. Such as investment in Government securities, Bonds, NSCs etc.

(ii) Premium for business risk; it refers to risky investment. If a concern faces more risk in its business transactions, then the rate of return or earning will be high. The profit will vary in proportion to risk covered in the industry. The more is risk, higher is the Premium.

(iii) Premium for financial risk; it refers to risk connected with the Capital Structure. A concern having higher debt/equity ratio is considered more risky. There are other factors that affects the Rate of Returns are;

(a) The bank rate;

(b) Period of investment;

(c) Risk ( due to nature of business or capital structure);

(d) Economic and Political Scenario, etc.

3. CAPITAL EMPLOYED; The quantum of profits earned with respect to the capital used is an important basis for valuation of goodwill. The Capital Employed represents Fixed Assets + Net Working Capital. This represents Equity Holders fund plus long terms borrowings. Following items to be included in determining Capital Employed;

(i) All Fixed Assets Less Depreciation written off;

(ii) Trade Investments;

(iii) All Current Assets

Following items should be excluded;

(i) Long term liabilities;

(ii) All Current Liabilities;

(iii) Intangible Assets including Goodwill;

(iv) Non Trading Assets;

(v) Fictitious Assets

Generally “Average Capital Employed” is used instead of “Capital Employed. Since profit earning is a continuous process during the year.

METHODS OF VALUATION OF GOODWILL;

Following are the methods;

1. Average Profits Method;

2. Super Profits Method;

3. Capitalization Method;

4. Annuity Method

1. AVERAGE PROFITS METHOD; the Goodwill will be valued in this method based on

(i) at agreed number of “ years” of purchase ; and

(ii) Of the average profits of the past few years.

As we know the new business does not earn profit during few years of its establishment. If a person wants to buy a business, which is running successfully from some years, is required to pay for Goodwill along with purchase price as agreed. Thus goodwill is to be calculated by multiplying the past average profits by the number of years during which the expected profits will accrue. Goodwill is paid for obtaining future advantage.

Goodwill= Average Profits* Number of years’ purchase

Weighted Average Profit Method; is modified version of Average Profits Method. In this method weighted average has to be found instead of simple average. For this each year’s profit is multiplied by the respective number of weights to determine the value of the product and it is totalled. This product is divided by the total weights assigned to different years’ profit.

Weighted Average Profit= Total of Products of profits/Total of Weights Goodwill= Weighted Average Profit* Agreed Number of Years’ Purchase.

2. SUPER PROFIT METHOD; We know that in the initial years of establishment of a business, concern may not able to earn any profits. Any person, who is buying an existing business, has to pay an amount equal to profits he is likely to earn in the next “few years”. What he has paid for is the capacity of a business to earn profits in future i.e. for Goodwill earned by the concern in previous years, on the basis of which it can earn profits in future also.

Now in case of Super Profit Method, we consider not the normal profits a concern is earning year to year under normal business conditions, it is the excess profits from the average or normal profit a firm is earning is the subject matter. We compare our business or entity with the other entities in the market in the same line of business. The Super Profit is the profit earned by a concern in excess of profit earned by its competitor in the same market under same business conditions.

Following ingredients are required in calculation of Super Profits;

(i) Normal Rate of Return in similar business;

(ii) The Fair Value of Capital Employed;

(iii) The Average of Profits earned in previous years.

Step-I Average Profit to be calculated. Step-II Normal Profit on Capital Employed on the Basis of Normal Rate of Return is calculated. Step-III Super Profit = Normal Profit if Deducted from Average Profit Step IV Goodwill=Super Profit* Number of years’ purchase

3. ANNUITY METHOD OF SUPER PROFIT;

Goodwill is determined by using following equation; Goodwill is the present value of future Super Profits to be earned by the firm.

Goodwill= Super Profit* Present Value Factor

Goodwill is calculated as follows;

Step-I Future Super Profits has to be calculated (generally for 5 to 7 years). Step-II Rate of Return has to be fixed. Step-III Present Value Factor has to be calculated by using Annuity Table. Step-IV Present Value Factor has to be multiplied by Super Profit Calculated in Step-I. Step-V Average Sum Total of Product of the Present Value Factor and Super Profits of the Goodwill.

4. CAPITALIZATION METHOD;

(1) Capitalization of Average Profits;

In this method the value of Goodwill is determined by deducting the Actual Capital Employed in the business from the Capitalized Value of Average Profits on the basis of Normal Rate of Return.

Step-I Average Profits are ascertained on the basis of Past Few Years’ Performance.

Step-II The Average Profits calculated in Step-I, are to be Capitalized on the basis of Normal Rate of Return as follows;

Average Profits Total Value of Business=——————— Normal Rate of return

Step-III Actual Capital Employed (Net Assets) is calculated by deducting Outside Liabilities from the Total Assets (Excluding Goodwill) as

Capital Employed= Total Assets (Excluding Goodwill) – Outside Liabilities

Step-IV Goodwill= Actual Capital Employed-Average Value of Business [Step III-Step]

(2) Capitalization of Super Profits.

Step-I Capital Employed in the business is calculated as follows Capital Employed= Total Assets- Outside Liabilities. Step-II required profit on Capital Employed is calculated as follows Required Profit =Capital Employed* required rate of return Step-III Average Profits for last few years is to be calculated Step-IV Super Profit= Required Profits- Average Profits [StepII-Step-III] Step-V Goodwill = Super Profits * Required Rate of Return

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