Goodwill Valuation

Goodwill valuation is the systematic evaluation of the company’s goodwill to be shown in the company’s balance under the head intangible assets. It is important to evaluate a company’s goodwill in certain situations, be it to prove its worth in the market or use it as a defense.

Business goodwill valuation plays a critical role in instances where one business looks forward to purchasing another business to get the most of out of its brand name or image. When the goodwill value is significant, companies are ready to pay even more than what the business with positive goodwill are worth.

Goodwill valuation is an important metric when it comes to potential mergers and acquisitions (M&A). The goodwill value helps other businesses assess where the other one stands in the market. The valuation of goodwill may be done to find out the worth of an individual or an entity for a purpose. Goodwill is based on institutional performance, professional practice, celebrity status, etc.  The US generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) divides goodwill into two categories – purchased and inherent.

Purchased goodwill refers to the goodwill for which a price is paid. This is the event where a business pays extra, i.e., more than its fair value, to own the good will that another business acquires. This is what makes purchased version of the goodwill an asset entry in the balance sheet. On the other hand, the inherent goodwill, which is a non-purchased form, is an internally developed goodwill that is accumulated over time. It is synonymously used with reputation, which can be both positive and negative. This type rarely finds place in the financial statements that businesses prepare.

Some of the key aspects surrounding goodwill valuation are as follows:

• One or two years of profit is taken for goodwill valuation if the retiring chairman of the business is the main source of the business’s success. Otherwise, three to five years of purchase is usually considered.

• A large number of years may be taken if the super profit is large or business is highly profitable.
• Sometimes goodwill also increases if many parties are bidding on the business, and the seller wants to increase the business’s premium irrespective of super-profits or average profits.
• Sometimes a business may be making losses. Even then, goodwill may be paid if the business prospects are very high.
•  It depends on the synergies an acquiring company gets due to the merger and not solely on profits.
• Sometimes, goodwill valuation also depends on the technology or R&D a company possesses or a specific set of customers a company may have, or specific sectors a company may be operating in.

Goodwill valuation is used as an important metric to check how reputed an individual or entity is. There are various reasons that make it important to study and evaluate the goodwill. Let us have a look at some of them:

• Goodwill valuation plays a vital role in the valuation of a business. Hence, it is important to know the worth of the business with respect to the goodwill value.
• Goodwill valuation in partnership is important so that the profit sharing among the partners is equal and proportionate. The profit sharing ratio becomes clear when the goodwill is effectively calculated.
• When a business thinks of including an additional partner, valuation of its goodwill is required.
• In the event of the death of a partner, there is a need for goodwill valuation.
• Valuing goodwill is crucial for economic damage analysis. When a business faces an economic damage, it compares the before and after situation to examine the goodwill reduction, if any.
• When there is a merger expected, the valuation of goodwill is carried out so that the equity of the acquired company can be merged well with that of the merging entity.
• Valuing a goodwill is not only important when two business practices merge, but also when they separate. This enables businesses conduct divisions accordingly.
• It also enables conducting solvency and insolvency tests to check how capable a business is to handle its debt liabilities or what are the chances of it to get bankrupt in worst cases.

There are numerous ways in which the goodwill valuation is carried out. Listed below are the most common methods of evaluating a goodwill, be it a personal goodwill valuation or goodwill valuation in partnership or for M&A. Let us have a look at the methods and the formulas associated with each of them:

#1 - Purchase of average profit

Under this goodwill valuation method, the average (mean or median) profit of the last few years is multiplied by a certain number of years to calculate the value of goodwill. The goodwill valuation formula related to this method is:

Goodwill = Average profit x Years of purchase.

Or, Average profit = Total profits of all or agreed years/Number of years

#2 - Purchase of weighted average profit method

This goodwill valuation method is simply an extension of the above method, where instead of a simple average, we use a weighted average. This method is used when the trend of profits is rising.

#3 - Capitalization Method

In this method, goodwill is calculated by ascertaining the difference between capitalizing the expected average net profit using the normal rate of return and the company's net tangible assets.

Goodwill = Capitalized average net profit –Net tangible assets

#4 - Super profit Goodwill Valuation Method

Under this goodwill method, super profit is calculated to determine the value of goodwill. Super profit is the excess profit earned by the company compared to its peers in the industry.

Goodwill = Super Profit x No of years of purchase

Let us consider the following instances to understand goodwill valuation meaning and also see how each of the methods help in calculating it:

Example 1

X & Co wants to sell the business to ABC & Co on 31^st Dec 2016. Profits of the business are as follows for the last five years.

ABC & Company proprietor Mr.A is currently employed at $1 million. The business of X & co, which is currently managed by salaried employee X at $0.5 million. Now ABC decided to replace the manager and decided to be managed by Mr.A.

Both companies agree to value goodwill based on four years of purchasing average profit for the last six years.

Example 2

Let us use the above example to understand this method. Weights attached are as follows 2011-1, 2012-1, 2013-2, 2014-2, 2015 & 2016-3

Example 3

Let us again continue the above example to calculate in this method. The normal rate of return is assumed at 10%, and an average profit of the X&Co as calculated above is $147 million and

Assuming assets of the company are $1850 million and liabilities are $600.

• Capitalised value of profit = 147 million/10%  = $1,470 million
• Net assets of the X&Co=  1850 million-600 million = $1,250 million US$
• Value of goodwill = 1470- 1250 = $220 million        

Example 4

The following are the details of XYZ &Co.

In this goodwill valuation example, average profit may be calculated using the weighted average method.

This article has been a guide to what is Goodwill Valuation. Here, we explain the concept along with its methods, examples, and reasons. You can learn more about accounting basics from the following articles –

• Steps for Goodwill Impairment Test
• Negative Goodwill
• Amortization of Intangibles