UNIT 4

VALUATION OF GOODWILL & SHARES

4.1 Meaning of Goodwill

Goodwill is an intangible but not fictitious assets which means it has some realisable value. From the accountants’ point of view goodwill, in the sense of attracting custom, has little significance unless it has a saleable value. To the accountant, therefore, goodwill may be said to be that element arising from the reputation, connection, or other advantages possessed by a business which enables it to earn greater profits than the return normally to be expected on the capital represented by the net tangible assets employed in the business. In considering the return normally to be expected, regard must be had to the nature of the business, the risks involved, fair management remuneration and any other relevant circumstances.

The goodwill possessed by a firm may be due, inter alia, to the following:

1. The location of the business premises, the nature of the firm’s products or the reputation of its service.
2. The possession of favorable contracts, complete or partial monopoly, etc.
3. The personal reputation of the promoters.
4. The possession of efficient and contented employees.
5. The possession of trademarks, patents or a well-known business name.
6. The continuance of advertising campaigns.
7. The maintenance of the quality of the firm’s product and development of the business with changing conditions

The need for evaluating goodwill may arise in the following cases:

1. When the business or when the company is to be sold to another company or when the company is to be amalgamated with another company;
2. When, stock exchange quotations not being available, shares have to be valued for taxation purposes, gift tax, etc.;
3. When a large block of shares, so as to enable the holder to exercise control over the company concerned, has to be bought or sold; and
4. When the company has previously written off goodwill and wants its write back. In valuation of goodwill, consideration of the following factors will have a bearing:

(a)  Nature of the industry, its history and the risks to which it is subject to.

(b)  Prospects of the industry in the future.

(c)  The company’s history — its past performance and its record of past profits and dividends.

(d)  The basis of valuation of asset of the company and their value.

(e)  The ratio of liabilities to capital.

(f)   The nature of management and the chance for its continuation.

(g)  Capital structure or gearing.

(h)  Size, location and reputation of the company’s products.

(i)   The incidence of taxation.

(j)   The number of shareholders.

(k)  Yield on shares of companies engaged in the same industry, which are listed in the Stock Exchanges.

(l)   Composition of purchasers of the products of the company.

(m)  Size of block of shares offered for sale since large blocks very few buyers would be available and that has a depressing effect on the valuation. Question of control, however, may become important, when large blocks of shares are involved.

(n)  The major factor of valuation of goodwill is the profits of the company. One who pays for goodwill looks to the future profit. The profits that are expected to be earned in future are extremely important for valuation of goodwill. The following are the important factors that have a bearing on future profits:

(i)     Personal skill in management

(ii)     Nature of business

(iii)     Favorable location

(iv)     Access to supplies

(v)     Patents and trademarks protection

(vi)     Exceptionally favorable contracts.

(vii)     Capital requirements and arrangement of capital.

(o)  Estimation of the profits expected to be earned by the firm and the amount of  capital employed to earn such profits, are to be computed carefully.

(p)  Market reputation which the company and its management enjoys.

(q)  Returns expected by investors in the industry to which the firm or company belongs.

4.2 Concept of Goodwill

When one company buys another company, the purchasing company may pay more for the acquired company than the fair market value of its net identifiable assets (tangible assets plus identifiable intangibles, net of any liabilities assumed by the purchaser). The amount by which the purchase  price  exceeds  the  fair  value  of  the  net  identifiable  assets  is  recorded  as an  asset  of the acquiring company. Although sometimes reported on the balance sheet with a descriptive title such as “excess of acquisition cost over net assets acquired”, the amount is customarily called goodwill.

Goodwill arises only part of a purchase transaction. In most cases, this is a transaction in which one company acquires all the assets of another company for some consideration other than an exchange of common stock. The buying company is willing to pay more than the fair value of the identifiable assets because the acquired company has a strong management team, a favorable reputation in the marketplace, superior production methods, or other unidentifiable intangibles.

The acquisition cost of the identifiable assets acquired is their fair market value at the time of acquisition. Usually, these values are determined by appraisal, but in some cases, the net book value of these assets is accepted as being their fair value. If there is evidence that the fair market value differs from net book value, either higher or lower, the market value governs.

4.3 Methods of Valuing Goodwill

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

(a) Simple/Average 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)

Calculation of Average profit:

(a)      Simple Average Profit =

(b)      Weighted Average profit:

Total profit of (past years)

Total number of past years

Weighted Avg Profit = Total of Product

Total of Weight

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):

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

(ii)    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.

Calculation of Capital Employed and Average Capital Employed

Average Capital Employed = Opening Capital Employed + Closing Capital Employed

2

= Closing Capital Employed – ½ of Current Years’ Profit+ Current Years’ Dividend

(b) Super Profit Method: The future maintainable profits of the firm are compared with the normal profits for the firm. Normal earnings of a business can be judged only in the light of normal rate of earning and the capital employed in the business. Hence, this method of valuing goodwill  would require the following information:

(i)    A normal rate of return for representative firms in the industry.

(ii)    The fair value of capital employed.

The normal rate of earning is that rate of return which investors in general expect on their investments in the particular type of industry. Normal rate of return depends upon the risk attached to the investment, bank rate, market, need, inflation and the period of investment.

Normal Rate of Returns (NRR)

It is the rate at which profit is earned by normal business under normal circumstances or from similar course of business. Normal Rate of Returns means rate of profit on capital employed which is normally earned by others in a similar type of business. It will always be given in the problem in form of percentage.

Or NRR = Rate of Risk + Rate of Returns or Dividend per Share x 100

Market price per Share

As the capital employed may be expressed as aggregate of share capital and reserves less the amount of non-trading assets such as investments. The capital employed may also be ascertained by adding up the present values of trading assets and deducting all liabilities. Super profit is the simple difference between future maintainable operating profit and normal profit.

Future Profitability Projections: Project is more a matter of intelligent guesswork since it is essentially an estimation of what will happen in the risky and uncertain future. The average profit earned by a company in the past could be normally taken as the average profit that would be maintainable by it in the future, if the future is considered basically as a continuation of the past. If future performance is viewed as departing significantly from the past, then appropriate adjustments will be called for before accepting the past average profit as the future maintainable profit of the company.

There are three methods of calculating goodwill based on super profit. The methods and formulae are as follows:

Purchase of Super Profit Method

Goodwill as per this method is: Super profit multiplied by a certain number of years. Under this method, an important point to note is that the number of years of purchase as goodwill will differ from industry to industry and from firm to firm. Theoretically, the number of years is to be determined with reference to the probability of a new business catching up with an old business. Suppose it is estimated that in two years’ time, a business, if started now will be earning about the same profits as an old business is earning now, goodwill will be equivalent to two times the super profits. In the example given above, goodwill will be Rs 12.12 1akhs, i.e., Rs 6.06 1akhs × 2 years.

Annuity Method of Super Profit

Goodwill, in this case, is the discounted value of the total amount calculated as per purchase method. The idea behind super profits methods is that the amount paid for goodwill will be recouped during the coming few years. But in this case, there is a heavy loss of interest. Hence, properly speaking what should be paid now is only the present value of super profits paid annually at the proper rate of interest. Tables show that the present value 18% of Re. 1 received annually two years is 1.566. In the above example, the value of goodwill under this method will be 1.3 × Rs 6.06 1akhs or Rs 9.49 lakhs.

Capitalisation of Super Profit Method

This method tries to find out the amount of capital needed for earning the super profit.

The formula is Super Profit x 100

NRR

Given in the Problems

1. Information of old firms assets and liabilities.
2. Information regarding past or profit.
3. Adjustment valuation of goodwill.

Required to Prepare

Valuation of goodwill by different methods.

Steps, Method and Formula for Calculation of Goodwill

(I)   Goodwill by purchase of average profit method: Steps:

(a)   Find out average trading profit.

(b)  Find out the number of year purchase (it will always be given in problem).

(c)   Goodwill: Number of year purchase × Average trading profit.

(II)   Goodwill by purchase of future maintainable profit method: Steps:

(a)   Find out future maintainable profit.

(b)  Number of year purchase (given in problem).

(c)   Goodwill: No of years purchase × Future maintainable profit.

(III)  Goodwill by capitalisation of future maintainable profit method: Steps:

1. Find out future maintainable profit.
2. Find out capitalised value of future maintainable profit.

Capitalisation Value of Future Maintainable Profit = FMP x 100

NRR

c.      Calculate capital employed.

d.     Goodwill = Capitalised Value of E.M.P. – Capital Employed

(IV)   Goodwill by purchase of super profit method: Steps:

(a)   Find out average trading profit.

(b)  Find out future maintainable profit.

(c)   Find out capital employed.

(d)  Find out Normal Rate of Return (always given in the problem in terms of %).

(e)  Find out number of year purchase (given in the problem).

(f)    Find out normal profit:= (Capital Employed x NRR) / 100

(g)  Find out super profit:

Super Profit = Future Maintainable Profit – Normal Profit

(h)   Goodwill = Number of year purchase × Super Profit.

(V)    Goodwill by capitalisation super profit method: Steps:

Calculate super profit as discussed above.

Goodwill = Annuity Rate × Super Profit

Notes: Annuity Rate will always be given in the problem

4.4 Valuation of Shares

In the cases of shares quoted in the recognised Stock Exchanges, the prices quoted in the Stock Exchanges are generally taken as the basis of valuation of those shares. However, the Stock Exchange prices are determined generally on the demand-supply position of the shares and on business cycle. The London Stock Exchange opines that the Stock Exchange may be linked to a scientific recording instrument which registers not its own actions and options but the actions and options of private institutional investors all over the country/world. These actions and options are the result of fear, guesswork, intelligent or otherwise, good or bad investment policy and many other considerations. The quotations what result definitely do not represent valuation of a company by reference to its assets and it’s earning potential. Therefore, the accountants are called upon to value the shares by following the other methods.

The value of share of a company depends on so many factors such as:

1. Nature of business.
2. Economic policies of the Government.
3. Demand and supply of shares.
4. Rate of dividend paid.
5. Yield of other related shares in the Stock Exchange, etc.
6. Net worth of the company.
7. Earning capacity.
8. Quoted price of the shares in the stock market.
9. Profits made over a number of years.
10. Dividend paid on the shares over a number of years.
11. Prospects of growth, enhanced earning per share, etc.

4.5 Need and Purpose of Valuation of Shares

The need for valuation of shares may be felt by any company in the following circumstances:

1. For assessment of Wealth Tax, Estate Duty, Gift Tax, etc.
2. Amalgamations, absorptions, etc.
3. For converting one class of shares to another class.
4. Advancing loans on the security of shares.
5. Compensating the shareholders on acquisition of shares by the Government under a scheme   of nationalisation.
6. Acquisition of interest of dissenting shareholder under the reconstruction scheme, etc.

4.6 Factors Influencing Valuation

The valuation of shares of a company is based, inter alia, on the following factors:

1. Current stock market price of the shares.
2. Profits earned and dividend paid over the years:
3. Availability of reserves and future prospects of the company.
4. Realisable value of the net assets of the company.
5. Current and deferred liabilities for the company.
6. Age and status of plant and machinery of the company.
7. Net worth of the company.
8. Record of efficiency, integrity and honesty of Board of Directors and other managerial personnel of the company.
9. Quality of top and middle management of the company and their professional competence.
10. Record of performance of the company in financial terms.

4.7 Methods of Valuation of Shares

Certain methods have come to be recognised for valuation of shares of a company, viz., (1) Open market price, (2) Stock exchange quotation, (3) Net assets basis, (4) Earnings per share method, (5)Yield or return method, (6) Net worth method, (7) Break-up value, etc.

Intrinsic Value Method

This method is also called as Assets Backing Method, Real Value Method, Balance Sheet Method or Break-up Value Method. Under this method, the net assets of the company including goodwill and non-trading assets are divided by the number of shares issued to arrive at the value of each share.

If the market value of the assets  is available,  the same  is to be considered  and in  the absence  of such information, the book values of the assets shall be taken  as  the  market  value.  While arriving at the net assets, the fictitious assets such as preliminary expenses, the debit balance in the Profit and Loss A/c should not be considered. The liabilities payable to the third parties and to the preference shareholders is to be deducted from the total asset to arrive at the net assets. The funds relating to equity shareholders such as General Reserve, Profit and Loss Account, Balance of Debenture Redemption Fund, Dividend Equalisation Reserve, Contingency Reserve,  etc  should not be deducted.