Business Worth – How Do You Calculate Goodwill?

Business sellers and buyers have different approaches to the valuation of goodwill.  The seller will likely inflate goodwill due mainly to his or her emotional attachment to the business whereas the buyer is likely to deflate its value.  Goodwill, being an intangible asset, is not easily identified or measured. It is what attracts customers to continually patronize a certain business. It helps a business to earn more profits in the future.  It can be any or all of the following: customer lists and relationships, brand name and logo recognition, business connections, reputation, trademarks, patents, inventions, employees and their skills, and vendor relationships. All these intangible but very valuable assets contribute to a business’s worth.

Wikipedia defines Goodwill as “the value of an entity over and above the value of its assets”.  If you have to put a monetary value on goodwill, it is the amount you pay in acquiring a business that is in excess of the fair market value of its net assets.

Goodwill = Purchase Price – Fair Market Value of Net Assets of the Business

Once the value of goodwill is established, this is listed as an asset (aside from the tangible assets) in the business’s balance sheet. 

Below are some popular methods of goodwill valuation.

Goodwill Calculation:  How to Calculate Goodwill

1.  Net Asset Method
Add up the fair market value of all tangible assets of the business and subtract this from the purchase price to determine the value of goodwill.
Goodwill = Purchase Price – Fair Market Value of Net Assets of the Business

2.  Average Profit Method
Calculate the average profit from previous years and multiply this figure with the number of purchase years.  Purchase years is defined as the number of years required for a business to yield its purchase price.
Goodwill = Average Profit X Number of Purchase Years

3.  Super Profit Method
You obtain Super Profit when the actual profit is more than the expected or normal profit of a business.  In this method, you calculate the normal profit with the normal rate on investment.  Then calculate Super Profit using the following formula:
Super Profit = Actual Profit – Normal Profit
Or Super Profit = Average Profit – Normal Profit
And Goodwill = Super Profit X Number of Purchase Years

4.  Market Value Method
Study records of comparative business sales data in the area and industry similar to the business for sale to get the market value or cash basis purchase price of the business.  Subtract the total value of all assets from this amount to calculate the value of goodwill.
Goodwill = Cash Basis Purchase Price – Total Assets Value

5.  Capitalization of Average Profit Method or simply Capitalization Method
In this method, you calculate capitalized value of the business by using the following formula:
Capitalized Value of the Company = Average Profit or Normal Profit X 100/Normal Rate of Return
Net Assets = Total Assets – External Liabilities
Goodwill is the difference between the total capitalized value of the business and the net assets.
Goodwill = Capitalized Value – Net Assets

Think of the future income or potential earnings of the business when calculating goodwill.  Value goodwill high is there is a high probability that the business will continue to profit in the future.  On the other hand, goodwill is valued low if the projected future earnings are less than in previous years.  Goodwill keeps bringing the customers to the business.

Seek a professional such as a Certified Public Accountant (CPA) or a Certified Valuation Analyst (CVA) to help you in business valuation and its tax implications. Which calculation method will you use to get the best valuation of business goodwill?

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