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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