Goodwill valuation

Goodwill valuation

Goodwill is a key intangible asset that represents the portion of the business value that cannot be attributed to other business assets.

For example, Facebook Inc. FB bought the domain name fb.com for USD 8.5 million from American Farm Bureau Federation. Apparently, this domain name did not have any other benefit than name. Thus whole amount paid can be considered as goodwill and Facebook would recognize it on its balance sheet. However, before the acquisition American Farm Bureau Federation could not recognize it on its balance sheet.

Goodwill is, therefore, something which cannot be described easily but in general refers to good name, reputation, and wide ranging business connections which are helpful for the business in gaining more profits than what could have been otherwise earned. Moreover, goodwill is an attractive force aiming at bringing back the customers to old place of business.

Goodwill calculation

General formula to calculate goodwill under IFRS follows:

  • Goodwill = Consideration transferred
  • Amount of non-controlling interests+
  • Fair value of previous equity interests+
  • Net assets recognized

Valuation Methods

The methods used for valuation of goodwill of a firm are mentioned below:

Average profit method
This method of goodwill valuation takes the average profit of previous years as its basis. This average profit is multiplied by the number of purchases made in that year.
Goodwill = Average Profit x Number of Purchases in the year

Weighted average profit method
This method of goodwill evaluation can be explained as a modified side of the he average profit method. This method involves the relevant number of weights, i.e. 1, 2, 3, 4 multiples profit of each year so as to find out value product. The total of products is thereafter divided by the total of weights so as to calculate the weighted average profits.
Goodwill = Weighted Average Profits x No. of years Purchase Weighted Average Profit = Total of Products of Profits/ Total of Weights

Super profit method
Super profit refers to a situation where in the actual profit is higher than what is expected. Under this method:
Goodwill = super profit x number of years’ purchase

for example if the net assets (assets less liabilities) were £100,000 and the usual return for investing in that industry was 8 per cent (being the bank base rate plus an allowance for added risk) you would normally expect a return of £8,000.

Capitalization of average profit method
As per this method
Goodwill = Capitalized Value the firm - Net Assets Capitalized Value of the firm = Average Profit x 100/ Normal Rate of Return Net Assets = Total Assets - External Liabilities

Capitalization of super profit method
Goodwill = Super Profit x 100/Normal Rate of Return

Conclusion

But valuations, although often presented as precise calculations need to be viewed with caution. In the end a business is only worth what a willing buyer is prepared to pay and a willing seller is prepared to accept.

Once a goodwill valuation has been arrived at and the net assets specified you should view the total of the net assets and goodwill and to work out whether, all things considered, the business represents good value, in terms of its future earnings potential.

You also need to consider how much finance you can raise. Often the goodwill is the price the seller will accept for the business less the net assets which are usually capable of more precise valuation.

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