Valuation of goodwill: the four methods with one example

Average profit, weighted average, super profit and capitalisation — what each method means and how to calculate it, using the same figures.

Goodwill is the value of a firm's reputation: its ability to earn more than a normal firm with the same capital. The CBSE syllabus asks for four methods. Let us use one set of figures for all of them.

Profits of the last three years: ₹40,000, ₹50,000 and ₹60,000. Capital employed ₹4,00,000. Normal rate of return 10%.

1. Average profit method

Average profit = (40,000 + 50,000 + 60,000) ÷ 3 = ₹50,000. If goodwill is valued at 2 years' purchase, goodwill = 50,000 × 2 = ₹1,00,000.

2. Weighted average profit method

Used when profits show a trend. Give weights 1, 2 and 3 to the three years: (40,000 × 1 + 50,000 × 2 + 60,000 × 3) ÷ 6 = 3,20,000 ÷ 6 = ₹53,333. At 2 years' purchase, goodwill = ₹1,06,667.

3. Super profit method

Normal profit = 4,00,000 × 10% = ₹40,000. Super profit = average profit − normal profit = 50,000 − 40,000 = ₹10,000. At 3 years' purchase, goodwill = ₹30,000.

4. Capitalisation method

• Capitalisation of average profit: capitalised value = 50,000 × 100 ÷ 10 = ₹5,00,000; goodwill = capitalised value − capital employed = 5,00,000 − 4,00,000 = ₹1,00,000.
• Capitalisation of super profit: goodwill = 10,000 × 100 ÷ 10 = ₹1,00,000.

Notice that both capitalisation methods give the same answer. That is not a coincidence — it is a good check for your working.

Adjustments to watch for

Before averaging, adjust past profits for abnormal gains or losses, an undervalued asset, a partner's salary that should have been charged, and non-recurring income. Questions that hide these adjustments are where most marks are lost.