Valuation of Goodwill

What is Valuation of Goodwill?

The term “Goodwill” means the reputation of a business entity or organization in the market. It is to access the value of the firm. It is an invaluable and intangible asset of the company. Valuation of Goodwill means to find out the value of a company or organization’s brand name, good customer relations, good relation with employees, a solid customer base and any patent representing the company’s reputation or goodwill. Valuation of Goodwill is just like any other valuation service provided by a valuer only the factors differentiate.

Why there is a need for Valuation of Goodwill?

Usually, a company is required to value its goodwill at the time of dissolution of the business or the entity. But sometimes to know the worth or value of the business, valuation of goodwill is conducted. In the following cases the goodwill is required to be valued-

  • When a proprietorship firm is to be disposed or dissolved.
  • When a company is taking up an amalgamation.
  • When the government has taken over the management of a company and other similar events require valuation of goodwill.
  • At the time of addition or resignation or disposal of the firm.
  • When the shares are being converted to another class from its present class.
  • When a company is taken over by another company.
  • When the business of a company is being sold, valuation of goodwill is required.
  • When a company wants to reduce or write off the balance to be debited from its profit and loss account.
  • When an unlisted company is required to conduct valuation of shares.
  • When the controlling interest exercise is to be undertaken by one company in some other company.

What are the methods used for Valuation of Goodwill?

There are various methods and approaches that can be used for the valuation of goodwill of a company. A company can choose any method for valuating, its goodwill as per their requirement. These methods are-

  • Annuity Method: In this method the goodwill of the company is calculated through the present value of the super profits that a firm will earn in the future. The formula used for the same is Goodwill= Super Profits x Present Value Factor.
  • Average Profits Method: In this method of goodwill valuation the calculations are done based on the average profits made by the company in the past few years and the number of years agreed upon by the company. The formula for the same is

Goodwill = Average Profits x Number of Purchase Years’

Since this method requires profits accrued in the previous years’, a newly registered or started firm cannot use it for valuating its goodwill. A modified version of this method is the Weighted Average Profit Method. The formula used in this method is

Weighted Average Profit = Total of the Profits of the Products/ Total of the Weights

  • Capitalization Method: The Capitalization method is used for the calculation of both average profits and the super profits. In the Capitalization of Average Profit, the formula used on the basis of the normal rate of return is

Goodwill = Actual Capital Employed- Capitalized Value of Average Profit.

Whereas, to calculate the value through the Capitalization of Super Profit is

Goodwill = Super Profits x Required Rate of Return.

  • Super Profits Method: For the valuation of goodwill through the super profit method, the ingredients like normal rate of return of a similar or comparable business, the average of the profits of the previous year and the fair and true value of the employed capital, is required. The formula for valuating is

Goodwill = Super Profit x Number of Years’ Purchase

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    Author: Anil Agrawal
    EZYBIZ India Consulting LLP, New Delhi. The firm is business and tax consultancy firm providing consultancy in Taxation, Regulatory, Transfer pricing, Valuation, Corporate funding and Business set up matters. He may be reached at 9899217778 or anil@ezybizindia.in.