Goodwill and its valuation

Goodwill is the value of a firm's reputation: its ability to earn profits above the normal rate, thanks to its good name, loyal customers, location and skills. It is an intangible asset: you cannot touch it, but it has value. A firm that earns only normal profits has no goodwill.

Factors that affect it: the nature of the business, its location, the quality of its management, the market situation (little competition helps), and special advantages such as patents, licences or cheap power.

Methods of valuing goodwill:

• Average profits method: find the average profit of the past few years (or a weighted average, giving more weight to recent years), and multiply by the agreed number of years' purchase: goodwill = average profit × years' purchase.
• Super profits method: first find the normal profit, the profit a firm in the same line should normally earn: capital employed × normal rate of return. The super profit is the extra: average profit − normal profit. Then goodwill = super profit × years' purchase.
• Capitalisation of average profits: work out the capital that would be needed to earn the average profit at the normal rate: average profit × 100/normal rate. Goodwill = that capitalised value − actual net assets (capital employed).
• Capitalisation of super profits: goodwill = super profit × 100/normal rate. It gives the same answer as the method above.

For example: average profit 1,00,000, normal rate 10%, net assets 8,20,000. Capitalised value = 1,00,000 × 100/10 = 10,00,000; goodwill = 10,00,000 − 8,20,000 = 1,80,000.