Methods of Valuation of Goodwill

Once the partners agree that an event (admission, retirement, death, or a change in the profit-sharing ratio) requires goodwill to be valued, one of three standard methods is used — the partnership deed itself usually specifies which method and how many "years' purchase" to apply, and BIEAP Intermediate Accountancy questions and answers set numericals on all three.

1. Average Profit Method. Goodwill is valued as a multiple (the agreed "number of years' purchase") of the firm's own average profit of a specified number of past years:

Average Profit = Total profits of the given years ÷ Number of years

Goodwill = Average Profit × Number of years' purchase

Before averaging, any genuinely ABNORMAL item (an exceptional loss from a fire or theft, or an exceptional one-off gain unrelated to normal trading) is usually adjusted out of the relevant year's profit first, so that the average reflects the firm's NORMAL earning capacity, not a distorted one-off year.

2. Super Profit Method. This method starts from the recognition that even an ordinary firm, with no special reputation at all, should earn SOME normal return on the capital employed in it — call this the "Normal Profit." Goodwill is then based only on the EXCESS the firm actually earns above that normal return — the "Super Profit":

Normal Profit = Capital Employed × Normal Rate of Return ÷ 100

Super Profit = Average Profit − Normal Profit

Goodwill = Super Profit × Number of years' purchase

3. Capitalization Method. This method asks: at the firm's own normal rate of return, how much TOTAL capital would an outside investor need to invest, in a business of this kind, to earn the SAME profit this firm actually earns? That imagined total is the firm's "capitalized value," and goodwill is simply the excess of that capitalized value over the capital the firm ACTUALLY employs:

Capitalized Value of the Business = Average Profit × 100 ÷ Normal Rate of Return

Goodwill = Capitalized Value of the Business − Actual Capital Employed

(A closely related variant, Capitalization of Super Profit, capitalizes only the SUPER profit directly — Goodwill = Super Profit × 100 ÷ Normal Rate of Return — and always arrives at exactly the same figure as the full capitalization method above, provided the same average profit, capital employed, and normal rate are used throughout.)