Valuation of Goodwill

Methods of Goodwill
1. Average Profits Method: Under this metod goodwill is calculated on the basis of the average of some agreed number of past years. The average is then multiplied by the agreed number of years. This is the simplest and the most commonly used method of the valuation of goodwill.
Goodwill = Average Profits X Number of years of Puchase
Before calculating the average profits the following adjustments should be made in the profits of the firm:
a. Any abnormal profits shoulld be deducted from the net profits of that year.
b. Any abnormal loss should be added back to the nat profits of that year.
c. Non operating incomes eg. income from investments etc should be deducted from the net profits of that year.
2. Super profits method: Under this method Goodwill is calculated on the basis of Super Profits i.e. the excess of actual profits over the average profits. For examplle if the normal rate of return in a particular type of business is 20% and your investment in the business is Rs.10,00,000 then your normal profits should be Rs.2,00,000. But if you earned a net profit of Rs. 2,30,000 then Rs.2,30,000 – Rs.2,00,000= Rs.30,000 are your super profits.
For calculating Goodwill Super Profits are multiplied by the number of years of purchase.
For calculating Goodwill:-
i) Normal Profits = Capital Invested X Normal rate of return/100
ii) Super Profits = Actual Profits – Normal Profits
iii) Goodwill = Super Profits x No. of years purchased
3. Capitalisation Method: There are two ways of calculating Goodwill under this method:
(i) Capitalisation of Average Profits Method
(ii) Capitalisation of Super Profits Method
(i) Capitalisation of Average Profits Method: Under this method we calculate the average profits and then assess the capital needed for earning such average profits on the basis of normal rate of return. Such capital is called capitalised value of average profits.
The formula is:- Capitalised Value of Average Profits = Average Profits X (100 / Normal Rate of Return)
Capital Employed = Assets – Liabilities
Goodwill = Capitalised Value of Average Profits – Capital Employed
(ii) Capitalisation of Super Profits: Under this method first of all we calculate the Super Profits and then calculate the capital needed for earning such super profits on the basis of normal rate of return. This Capital is the value of our Goodwill.
The formula is:- Goddwill = Super Profits X (100/ Normal Rate of Return