1.3.3. Methods of Valuation

1. Average Profit Method: Goodwill = Average Profit × Number of Years’ Purchase

The Average Profit Method is a straightforward way to value goodwill. It calculates goodwill by taking the average profit of the business and multiplying it by a specific number that reflects the expected duration of the profit stream. Essentially, if a business has averaged a profit of a certain amount over the past years, and you anticipate that this level of profit will continue, you can determine goodwill by multiplying that average profit by the number of years you expect to maintain that profit.

Imagine a bakery that has been making an average profit of $50,000 a year. If the owner believes that they can sustain this profit for the next 5 years, the goodwill of the bakery would be valued at$50,000 × 5 = $250,000. This value reflects the business's reputation for profitability.

2. Super Profit Method: Super Profit = Average Profit − Normal Profit Goodwill = Super Profit × Years’ Purchase

The Super Profit Method provides a more nuanced approach to valuing goodwill by considering what is known as 'super profit'. Super profit refers to the profit that exceeds the normal profit, which is the minimum expected return on investment. To calculate goodwill using this method, you first determine the average profit of the business, subtract the normal profit (the return that investors expect from similar businesses), and then multiply the resulting super profit by the number of years of purchase. This method emphasizes the unique strengths of the business in generating profits above the norm.

For example, if a software company has an average profit of $200,000, and the normal profit expected in the industry is$100,000, the super profit would be $200,000 -$100,000 = $100,000. If the company is expected to sustain this super profit for 4 years, the goodwill would be valued at$100,000 × 4 = $400,000. This figure represents the company's additional earning potential compared to ordinary firms.

3. Capitalisation Method:

• Capitalisation of Average Profit: Goodwill = (Average Profit × 100) / Normal Rate of Return

The Capitalization Method assesses the value of goodwill based on the average profits and the expected return on capital. By capitalizing the average profit, you can derive the goodwill amount by dividing the product of average profit and 100 by the normal rate of return. This method essentially reflects how much capital would be required to generate the average profit at the normal rate of return. It helps in evaluating the business's ability to generate profits relative to the invested capital.

Consider a restaurant that averages a profit of $120,000 a year, with a normal rate of return in the industry of 15$120,000 × 100) / 15 = $800,000. This indicates that$800,000 would be required as invested capital to earn the same average profit at the standard return.

• Capitalisation of Super Profit: Goodwill = Super Profit × 100 / Normal Rate of Return

This aspect of the Capitalization Method centers around super profit, similar to the earlier super profit method. Instead of focusing on the average profit, it targets the excess profit earned over the normal expected profit. By calculating goodwill as the super profit multiplied by 100 and then divided by the normal rate of return, businesses can gauge their premium value based on the extra profits they earn, distinguishing them from the competition.

If a consulting firm earns an average profit of $300,000, with a normal profit in the sector estimated at$150,000, the super profit amounts to $150,000. Using the industry norm of an expected 10$150,000 × 100) / 10 = $1,500,000. This calculation shows the firm’s true worth as it highlights the excess profits they can generate.

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