Goodwill is a type of intangible asset, that is, an asset that has no physical and is often difficult to value. Some types of intangible assets other than goodwill include intellectual property, brand, location, and other factors. Goodwill refers to a premium to the company's fair market price paid by buyers, and this premium can often be attached to intangibles, such as reputation, future growth, brand popularity, or human resources. This is the part of the business value that cannot be attributed to other business assets. The method of calculating goodwill can be used to justify a business's market value being higher than its book value. Although there are several ways to calculate goodwill, the profit-based method is most commonly used. Know that goodwill arises only when the value the buyer paid to acquire the asset exceeds the original value of the asset, and not before.
Step
Method 1 of 3: Calculating Goodwill Using Average Profit
Step 1. Understand how average profit applies
With this method, the value of goodwill is equal to the average profit over a certain period of time, multiplied by the number of years. This is the simplest and most common way to calculate goodwill.
- In summary, the formula is as follows: Goodwill = Average Profit X Number of Years.
- For example, if you use the average annual profit for 2010-2014, multiply by the number of years 5 to obtain goodwill.
Step 2. Adjust the numbers before performing calculations
Make sure you make the following adjustments before calculating your average profit:
- All abnormal profits must be deducted from net income in the year in which they were earned.
- All abnormal losses must be added to net income in the year in which they are incurred.
- Non-operating profit (profit on investment) must be deducted from net income in the year in which it was earned.
Step 3. Calculate goodwill
Begin by determining the average profit for the year being calculated. The trick is to add up the profit in each related year and divide it by the number of years.
Step 4. Say there is a company that made the following profits (in the relevant year):
2010: IDR 200,000,000; 2011: IDR 220,000,000; 2012: IDR 190,000,000; 2013: IDR 210,000,000. All of these profits are added up to get a total profit of IDR 820,000,000.
- Divide the total ($820,000,000) by the number of years, which in this example is 4. The result is the average profit. Thus, the average profit is IDR 205,000,000.
- Since goodwill is equal to the average profit for a given year multiplied by the number of related years, in the example above the goodwill is $820,000,000. Thus, goodwill is simply the accumulated total profit from the related years. In fact, abnormal costs and profits will change the results.
Step 5. Add goodwill to the fair market value of the business
When making an offer to a business, the amount of goodwill can be added to the fair market value of the business, aka assets minus liabilities. In this case, goodwill is a premium to the fair market value of the business that reflects the average profit of the business over several years.
Method 2 of 3: Calculating Goodwill Using Super Profit
Step 1. Find the average profit
In this method, you need to understand your average profit from previous years. Add up the profits from previous years, and divide by the number of years.
For example, a company could make a profit of Rp200,000,000 in 2010, Rp220,000,000 in 2011, Rp190,000,000 in 2012, and Rp210,000,000 in 2013. Add them all up to get Rp820,000,000 and divide by the number of years, which is in this case it is 4. The result is an average profit of IDR 205,000,000
Step 2. Subtract the original profit by the average profit
Super profit (super profit) is a profit that exceeds the average profit. To better understand superprofits, find the company's original profit for this year and subtract the average profit from the previous year. For example, let's say the average profit for the business is $200,000. In one year you get a net profit of Rp230,000,000. The difference between the acquisition profit and the average profit is called super profit, which in the example above is IDR 30,000,000.
Step 3. Learn the super profit formula for finding goodwill
To calculate goodwill, add up the year's superprofits, then multiply by the number of years of the agreed purchase. In summary, Goodwill = Super Profit X Number of Years.”
Step 4. Pay attention to how the model is implemented
Here we provide an example to explain how to apply the super profit formula.
- Say the average profit is $200,000,000, but the original profit over a four-year span is as follows: 2010: $210,000,000; 2011: Rp230,000,000; 2012: Rp210,000,000; 2013: Rp.200,000,000.
- Super profit for each year is calculated by subtracting the original profit by the average profit. For 2010, the super profit is IDR 10,000,000; for 2011 is IDR 30,000,000, and so on.
- Add up the super profit from the related years. In this example, you add up $10,000,000 + $30,000,000 + $10,000,000 + 0 = $50,000,000.
- Finally, the super profit is multiplied by the number of years. In this case goodwill = $50,000,000 X 4 or $200,000,000.
Step 5. Add up the goodwill to the fair market value of the business
In this case, goodwill will reflect the company's ability to earn more profit. By adding up the super profit with the fair market value of the business unit, the purchase price will reflect the company's ability to generate profit.
Method 3 of 3: Calculating Goodwill Using Profit Capitalization
Step 1. Understand the capitalization method
This method starts with the result of one of the two methods above. Starting from the average profit or super profit method, the capitalization method determines the amount of capital needed to generate the average profit or super profit, assuming the business obtains a normal rate of return (ROR) for a particular industry. This amount of capital is known as the capitalized profit value, and the difference with the total capital used can be considered as goodwill.
Step 2. Calculate the total capital used
To find the amount of capital used, simply subtract assets from liabilities. In summary, the formula is: Capital Used = Assets - Liabilities.
Step 3. Learn how to calculate profit capitalization value
To be able to use the profit capitalization method, you first need to know how to calculate the profit capitalization value.
To find the profit capitalization value, you must first multiply the average or super profit by 100 (both work fine). Then, divide the total by the normal rate of return. In summary, the formula is as follows: Average/Super Profit Capitalization Value = Average Profit or Super Profit X (100 / Normal Rate of Return). This formula calculates the amount of capital required to earn the average profit or super profit of the business, assuming a normal rate of return
Step 4. Calculate goodwill
Just subtract the average/super profit capitalization value from the amount of capital used from Step 2. The formula is as follows: Goodwill = Average/Super Profit Capitalized Value - Capital Used.
- Try to understand the following example. Say the company has an average profit of $40,000,000 in an industry where the normal rate of return is 10%. The Company also has assets of Rp1,000,000,000 and liabilities of Rp500,000,000. The total capitalization value of the company is CU40,000,000 × 100/10, which is equal to CU400,000. Used capital = IDR 1,000,000,000 IDR 700,000,000, which is IDR 300,000,000. Finally, goodwill equals the capitalized profit less capital used, or Rp400,000,000 Rp300,000,000. Goodwill is Rp100,000,000.
- Using this method, goodwill is a reflection of the difference between a business's rate of return in relation to the normal rate of return. For example, in this scenario, the business earns a return on capital used of 13% (Rp40,000,000/Rp300,000,000). However, the normal rate of return is 10%. This method simply recognizes a 3% premium, and "capitalizes" it, or determines the amount of capital needed to generate a return of IDR 40,000,000 based on a 10% rate of return. In this case, it costs $400,000, or $100,000 more than the fair market value of the business assets. A value of CU100,000,000 can be added to the fair value of the business when it is sold or purchased to reflect the company's high rate of return.
Tips
- All of the above methods can be used, and usually the method that gives the best price is chosen.
- This article was created for informational purposes only. Use a certified public accountant or attorney if you want to check the goodwill calculations performed, or if you don't know the best way to assess business goodwill.
- Several other calculation methods include market-based and cost-based methods, although both are rarely used.
