Goodwill Valuation: Average and Super Profits Methods

1. The Average Profit Method

The logic behind this method is straightforward: a business's value is tied to its ability to earn profits. Therefore, we can estimate goodwill by looking at its average profits over the last few years.

The formula is:
$\text{Goodwill}=\text{Average Profit}\times \text{Number of Years’ Purchase}$

• Average Profit is the average of the profits of the last few years.
• Number of Years' Purchase is the number of years for which the firm is expected to earn the same amount of profit after the change in ownership because of past efforts. This value will almost always be given to you in the problem.

Here is a simple illustration of the calculation:

Adjusting Profits for Accurate Valuation

The most critical step in this method is ensuring the profits you use are the firm's normal operating profits. The profits reported in the Profit & Loss Account can often include unusual gains or losses that don't reflect the firm's true, repeatable earning capacity. To find the true average, we must adjust for these.

As you saw, to calculate the Adjusted Normal Profit for each year, we make the following adjustments to the given Net Profit:

• Add back any Abnormal Losses (e.g., loss by fire, theft, loss on sale of a fixed asset). These are one-time losses and are not expected to recur.
• Subtract any Abnormal Gains (e.g., profit on sale of a fixed asset, lottery income). These are one-time gains and are not part of regular business operations.
• Subtract any Income from Non-Trade Investments. This income is earned from outside the core business operations and should not be included when valuing the business's goodwill.
• Correct for Capital/Revenue Expenditure Errors. This is a very common type of adjustment.

For a detailed look at these adjustments, especially the tricky capital vs. revenue expenditure error, let's watch another video.

2. The Super Profit Method

This method refines the concept of goodwill. It argues that goodwill should only be based on profits that are in excess of what is considered normal for the industry. This excess profit is called Super Profit. No business would pay extra for profits that they could have earned anyway by simply investing their capital elsewhere in the same industry.

The formula for goodwill under this method is:
$\text{Goodwill}=\text{Super Profit}\times \text{Number of Years’ Purchase}$

To calculate this, we need to follow a few steps:

1. Calculate Average Adjusted Profit: This is the same as we did in the Average Profit method.
2. Calculate Normal Profit: This is the profit expected on the capital invested in the business.
   $\text{Normal Profit}=\text{Capital Employed}\times \frac{\text{Normal Rate of Return}}{100}$
3. Calculate Super Profit: This is the excess of our average profit over the normal profit.
   $\text{Super Profit}=\text{Average Profit}-\text{Normal Profit}$

Key Terms:

• Capital Employed: The total funds invested in the business to run its operations. It's usually calculated as:
  • Total Assets (excluding goodwill and non-trade investments) - Outside Liabilities
• Normal Rate of Return (NRR): The rate of profit that an average firm in the same industry is expected to earn. This will be given in the problem.

If Super Profit is negative or zero, it means the firm is not earning any excess profits, and therefore, its goodwill is nil.

Now, let's see how this method is applied.

A Walkthrough Example

Let's apply these steps using a comprehensive example.

Conclusion

In this lesson, we transitioned from the theory of goodwill to its practical calculation. You have learned two essential methods for placing a monetary value on a firm's reputation.

Key Takeaways:

• Average Profit Method: Values goodwill based on the average historical profits. The key is to use adjusted normal profits by removing abnormal gains and losses.
  • Formula: Goodwill = Average Adjusted Profit × No. of Years' Purchase
• Super Profit Method: Values goodwill based only on profits earned above the industry norm. This is often considered a more refined approach.
  • Formula: Goodwill = Super Profit × No. of Years' Purchase
  • Where Super Profit = Average Adjusted Profit - Normal Profit

Preview of the Next Lesson:

We've covered a lot of ground, but there's one more valuation technique to learn. In the next lesson, we will cover the Capitalization Method, which approaches valuation from a different angle. We'll learn how to calculate goodwill using both the Capitalization of Average Profits and the Capitalization of Super Profits. Once we complete that, you'll have a full set of tools for valuing goodwill in any scenario.