Valuation of Goodwill

We saw how to go about valuation of business. One of the important pre-requisites for valuation of shares/business by the Net Assets method is the valuation of goodwill. We all know how important a asset goodwill is. We normally say that an enterprise enjoys goodwill if that enterprise performs better than others in the same industry. What do we mean when we say an enterprise "performs better"? It should either return more profit on the same capital employed or return same profit on lower capital employed as compared to other enterprises. This then is the logic behind the two main methods of goodwill valuation – Super Profit method and the Capitalisation method

Super Profit Method

The Super Profit Method measures how much more profit the enterprise earns as compared to others in the industry – hence the formula:

Super Profit = Enterprise’s Profit less Profit that would have been earned by others in the industry

The enterprise’s profit is calculated by arriving at the Future Maintainable Profit (FMP) for the enterprise; the profit that would have been earned by others in the industry is arrived at by multiplying the enterprise’s average capital employed (ACE) by the normal rate of return (NRR) applicable to the industry. Now let us substitute these terms in the above formula:

Super Profit = FMP – (ACE * NRR)

This is only the super profit earned by the enterprise. Goodwill is what is paid to the owners (sellers) of the enterprise to compensate them for the super profit that would have otherwise been earned by their enterprise. So, if it is expected that the particular advantage which has made it possible for the enterprise to earn Super Profits would continue to give it an added edge over the next, say 3 years, then goodwill is calculated at 3 times the Super Profit. Therefore, Goodwill is (Super Profit * n), where n is the number of years of purchase of Super profit. This n would normally be specified in the problem. If nothing is said, the student can make his own assumptions; say 3 or 5 for the value of n.

Annuity Method

The Annuity Method is only a refinement of the Super profit method. The logic here is simple. The owners pay for the super profits that they expect the enterprise to earn over the n years upfront, i.e. right at the time of purchase of the enterprise. But the profits will accrue only over the n years at the end of each of the n years. Given that money has a time value, what is paid out at the beginning is the sum total of the absolute values of the super profit which is expected to recur over the n years. This results in a mismatch of the values paid, and values received. Rs. 100/- received at the end of year 1 is worth less than Rs. 100/- at the beginning. So the Annuity method brings down the absolute value of the recurring super profits (since they are equal in value and accrue annually, they are called annuities) to the present value at the beginning of the period, by discounting the flows. By adding up the discounted values, we will arrive at the value of goodwill. If this has to be given by a formula, then

Goodwill = Sum of (Present Values of each years’ super profits, or SPs) i.e.
 and so on for the n years. (n and r would be given).

A simpler way would be to look up the annuity tables if they are made available in the exam.

A common error that is made by students is to discount the goodwill figure that is arrived at by the Super Profit methods, instead of the Super Profits. Remember, that the goodwill that you will arrive at as a result of the Annuity method will be smaller than the goodwill that is arrived at by the Super Profits method.

Capitalisation Method

Now let us look at the logic of the Capitalisation Method. An enterprise makes profits, say Rs. 10,000. If the industry normally returns a rate of say 10% on Capital Employed, then the capital that should have been employed by this enterprise should be Rs. 100,000 (10,000/10%). Now let us assume, that the enterprise has actually used only Rs. 80,000. This implies that the enterprise has been more efficient (same profit on lower capital base). Therefore the enterprise enjoys goodwill. The value of goodwill is Rs. 20,000 (Rs.100,000 minus Rs. 80,000). To put it differently, if normally one should have used Rs. 100,000 as the capital to earn profit of Rs. 10,000, and enterprise has actually used only Rs. 80,000, it implies that the enterprise has an invisible asset of Rs. 20,000 working for it. This invisible asset is Goodwill. The formula then for the capitalisation method is

Goodwill = Value of Capital that should have been employed
Less: Value of Capital that is actually employed
= FMP  minus ACE (10,000 minus 80,000)
NRR                        10%

Now go back and look through the formulae for the Super Profit methods and the Capitalisation method. What are the three terms that are repeated? FMP (Future Maintainable Profits), ACE (Average Capital Employed) and NRR (Normal Rate of Return). The NRR is the rate of trading profits that is expected to be earned by enterprises in the industry. This would be given in the problem. You would therefore have to calculate only FMP and ACE. We will now see how to go about it.

Let us take FMP first. How do we arrive at profits expected in an uncertain future? We base our estimation on past results of the enterprise. You would be given, normally, the results of a few immediately preceding years. These figures have however to be adjusted in order to arrive at an estimation of future profits.

  1. We know that NRR is indicative of normal returns. So we should eliminate the effects of extra-ordinary items that are included in the profits (windfall gains/losses etc.)

  2. Goodwill is a measure of operating efficiencies. So income/losses on non-trading assets will have to go.

  3. We aim to arrive at the future maintainable profits. So adjustments will have to be made for:
    1. accounting policies that are expected to prevail in future (new Accounting Standards that would have to be followed eg. FIFO method of stock valuation, revaluation of monetary payables and receivables of foreign currency at the rate prevailing on the Balance Sheet date, change in the method of depreciation, etc.).
    2. the tax rate that is expected to prevail in future.

  4. For arriving at ACE, we use the current cost of fixed assets and stock. So, in the FMP calculations, also, depreciation should be calculated on the current cost of fixed assets and the adjustments for accretion/decrease in the value of stock should be made on the current cost of stock. (Obviously, this adjustment can be made only if relevant information on the current cost of fixed assets, stock, and the rate of depreciation are made available).
    Adjustments 3 and 4 involve substitution of new figures for existing ones. So remember, first, the old figures have to be added back to or subtracted from the past profits and then the new figures should be substituted. To illustrate, if we expect WDV method of depreciation to be followed in future, while SLM has been followed so far, we must first add back the SLM figure and then deduct the WDV depreciation.
    At the end of all these adjustments, we will arrive at a set of adjusted past profit figures. The next step is to use the trend reflected in these figures to arrive at the future profits. How? Simple, just follow these rules:
    1. if the past profits show no trend, use a simple average
    2. if the past profits show a rising trend, use a weighted average
    3. if the past profits show a falling trend, use the trend equation

Your study material gives a few illustrations on the use of the above techniques. Take a break and try these problems now.

Well, those problems were easy to follow, isn’t it? Shall we now try to understand how to go about ACE calculations?

  1. The ACE is a simple average of Opening and Closing Capital Employed (where both are given).

  2. If only the Closing Capital Employed is given in the problem, along with the current year’s profits, then:
    ACE = Closing CE - ½ Current Year’s Profits
    ACE = Half (Opening + Closing CE).

    Closing CE [Capital Employed] is nothing but opening Capital Employed plus current year’s profits.
    Take pen and paper and reason out why ACE = Closing CE – Half current year’s profits.

  3. A third possibility is that even details of current year’s profits are not given, in which case the closing capital employed may be used as the ACE.

Now, let’s see what goes to make capital employed. Since goodwill accrues to the owners' of an enterprise, by Capital Employed, we mean the shareholders’ Capital Employed. Now, visualise a balance sheet. Let us start from the Assets side.

  1. Since the CE calculations are for arriving at the correct value of goodwill, whatever appears as goodwill in the Balance sheet will have to be ignored.

  2. Other fixed assets would be taken, at current cost. Why?
    Remember, we are trying to compare efficiencies of all enterprises in an industry. For this comparison to be equitable, we cannot use the historical cost of fixed assets acquired at different points of time by different enterprises. Therefore, we substitute current cost.

  3. Only trading investments are to be included.

  4. Stock is to be valued at current cost.

  5. Debtors should be taken at their realisable figure and adjustments for fluctuations in foreign exchange rates needs to be done.

  6. Other current assets should be included, as given in the problem.

  7. Miscellaneous expenditure should be ignored.

  8. From the sum of total assets arrived at as above, we will reduce all outside liabilities except proposed dividend (which is treated as part of shareholders’ funds). Here again, no adjustment needs to be made to the given figures, except for adjustment in foreign exchange rates.

Now, using the logic given above, try to arrive at CE from the Liabilities side. However, it would be better to arrive at CE from assets side, since it will reduce chances of errors. An important point that the student should remember at this stage is that FMP is the profits that you expect to earn in the future, with the present level of capital employed. Crudely put, all adjustments you make to the CE would affect FMP calculations, but not vice versa.

So now we have learnt to calculate FMP and ACE. Along with NRR (which would be given), and using any of the three methods described above, you should now be able to calculate goodwill.

Why don’t you try out the illustration problems in the material?

By now, you would have understood why valuation is a subjective exercise. This means that, in the exam, you should very clearly list out all assumptions you are making while tackling a valuation problem.