Methods of Valuation of Goodwill
The following are the methods of valuation of goodwill:-
- Average maintainable profits method
- Super profit method
- Capitalisation method
- Annuity method
- Hidden method
Average Maintainable Profit Method: – Under this method, average profit means average profits of actual profits of past three to five years depending upon the nature of business. The average of actual profits must be adjusted in the light of future events that may affect the future profits so this method is also known as” future maintainable profits”. Under this method, we can calculate the value of goodwill by multiplying the average future maintainable profits by a certain number of years. The following formula used for calculating the value of goodwill:
1 Steps:- In the first step we have to calculate average maintainable profits of past few years are as follow-
Average maintainable profits= Total adjusted profits / No. Of years
- Step:- calculate the Value of goodwill by using the following formula-
Goodwill= Average maintainable profits* Number of years purchased.
To calculate the total adjusted profits, the following adjustments should be made in the profits.
- Any abnormal losses such as strikes, floods, and accidents etc. added back to the past profits.
- Any abnormal profits should be deducted from the past profits.
- Interest, remuneration, commission etc should be adjusted.
- The past average profits should be calculated after deducting tax at current rates.
Super profits method: – under super profits method, the value of goodwill on the basis of super profits. Super profits are the profits that earned above the normal profits i.e. Excess the actual profits over the normal profits. For calculating the value of goodwill, following formula should be followed:-
Super Profits = Actual Profits – Normal Profits
Normal Profits = Capital Invested X Normal rate of return/100
Goodwill = Super Profits x No. of years purchased
Capitalisation Method: under this method, the value of goodwill is calculated by two ways such as-
- Capitalisation of average profits method
- Capitalisation super profits method
Capitalisation of average profit method: – The formula for calculating the value of goodwill under capitalization of average profits method is as follow-
| · 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
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Capitalisation of Super Profits: For calculating the value of goodwill, the formula is such as follow-
| Goodwill = Super Profits X (100/ Normal Rate of Return) |
Annuity method:- Under this method, take into consideration the time value of money. Annuity method is a variation of a number of years purchased method. Under this method, to calculate the value of goodwill of the firm the following formula is used:
| Goodwill= Super profits per annum *Relevant annuity value |
Hidden Goodwill: – Under hidden goodwill method, the value of goodwill is calculated on the basis of capital contributed by the partners and their respective share in the firm. Hidden goodwill method is used in such case when no particular method of valuation of goodwill or information is provided in the question. The following steps are followed to calculate the value of hidden goodwill:-
First of all, find out the total capital of the firm by using formula:-
- Total capital= New partner capital * Reverse of new partner’s share
- Deduct from the total capital, the combined capital of the all the partners
- Balance is the value of goodwill