GOODWILL AND ITS VALUATION

 

 

A person wishing to commence business has to decide whether to purchase one already established or start a completely new enterprise. 

Should he wish to adopt the first alternative he must reach an agreement with the vendor on the consideration or contract price and the vendor may seek a price that is more than the total valuation of the physical assets less liabilities acquired. 

This relates to goodwill  and is commonly defined as the value attached to the probability that customers will come back.   People develop habits of shopping in stores which are convenient and have proved satisfactory in the past.    Provided that circumstances do not change, these people become regular customers of these stores.

 This amount charged for goodwill could be the consequence of:

Taking over a business already set up and therefore setting up costs will not have to be incurred.
A business with a good reputation
Being part of a franchise group which offers a known and established name association and other benefits
A good site
Established customers
A good record of profits or other proven advantages
Manufacturing efficiency
Satisfactory relations between the employees and the management, which contribute to earnings through effective employee service and the reduction of loss through labour turnover
Adequate sources of capital and a credit standing which is reflected in low money costs
Monopolistic privileges
Good business management
 

Nobody can determine an exact value for goodwill.   An asset such as cash on hand, stock, investments or plant can be valued exactly, but goodwill is invariably valued as a consequence of bargaining between buyer and seller.    It will depend how keen the purchaser is to buy the business, or how desperate the owner is to sell. 

On the other hand it may be calculated on the basis of past or anticipated earnings (Net Profit before Taxation) of the business.   When a purchaser of the business pays a price for goodwill he is not paying for the earnings of the past, but for probable earnings of the future, however the earnings of the past may furnish the best available evidence of the earnings of the future.   Three such goodwill valuation bases are illustrated below:

 

Some multiple of the average past annual net profits after adjustment for unusual and non-recurring items and anticipated changes affecting future revenue end expense

e.g. Assume that the average adjusted earnings for 5 years prior to the date of sale has been $10000, and that goodwill is to be valued at twice the average earnings 

Goodwill=   $10000 x 2 = $20000 

 

Some multiple of the average past earnings, as adjusted, in excess of a return at an agreed rate on the average investment.

e.g. assume average earnings for the last 5 years of $10,000, an average investment of $100,000, and an agreement to pay for goodwill 3 years purchase in excess of 8% on the average investment- the goodwill calculation would be: 

Average Earnings, as adjusted

10000

Less 8% on Average Investment

8000

Excess

2000

 

 

Multiply by number of year’s purchase

3

 

 

Goodwill

6000

 

 

  

The capitalised value of excess earnings

e.g. assuming the same facts as the immediate previous example with respect to average income and investment, and assuming an agreement to calculate goodwill by capitalising, at 10%, the average annual adjusted earnings in excess of 8% on the average investment- the goodwill calculation would be: 

Average Earnings, as adjusted

10000

Less 8% on Average Investment

8000

Excess

2000

 

 

 

 

Goodwill    ($2000 divided by 0.10)

20000

 

 

 

 

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