Types of Valuing Goodwill ~ Simple Profit Method

Types of Valuing Goodwill

There are basically two types of valuing goodwill: (a) Simple profit method and (b) Super profit method.

(a)    Simple Profit Method: Goodwill is generally valued on the basis of a certain number of years’ purchase of the average business profits of the past few years. While calculating average profits for the purposes of valuation of goodwill, certain adjustments are made. Some of the adjustments are  as follows:

Trading Profit/Business Profit/Recurring Profit/Normal Profit (of Past Year)

Notes: If past profits are in increasing trend, then calculate Average Profit by weighted average method or otherwise simple average method.

Calculation of F.M.P. (Future Maintainable Profit):

·         All actual expenses and losses not likely to occur in the future are added back to profits.

·         All actual expenses and losses not likely to occur in the future are added back to profits.

·         All profits likely to come in the future are added.

After adjusting profit in the light of future possibilities, average profit are estimated and then the value of goodwill is estimated. If goodwill is to be valued at 3 years’ purchase of the average profits which come to Rs. 50,000, the goodwill will be Rs. 1,50,000, i.e., 3 × Rs. 50,000.

This method is a simple one and has nothing to recommend since goodwill is attached to profits over and above what one can earn by starting a new business and not to total profits.

It ignores the amount of capital employed for earning the profit. However, it is usual to adopt this method for valuing the goodwill of the practice of a professional person such as a chartered accountant or a doctor.

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