Company Accounts- Valuation of Shares and Goodwill

1. VALUATION OF GOODWILL AND
VALUATION OF SHARES
L. PRAKASH KANNAN,M.COM.,M.PHIL.,(PH.D.),
ASSISTANT PROFESSOR,
S.J. MONISHA, III B.COM.,

2. Goodwill – Meaning
■ Goodwill is an intangible and invisible asset. In the statutory form of Balance Sheet of
a company, goodwill is shown as the first item amongst fixed assets. Being the fixed
asset, it is attached to the business.
■ Thus goodwill may be understood as the reputation of a firm and enables to earn
profits. Goodwill and profits go together.
■ It is a valuable asset if the concern is profitable, on the other hand, it is valueless if the
concern is a losing one.
■ It represents the value of a firm’s reputation.

3. Valuation of Goodwill
■ A well-established firm earns a good name in the market, builds trust with the
customers and also has more business connections as compared to a newly set up
Goodwill.
■ The buyer who pays for Goodwill expects that he will be able to earn super profits as
compared to the profits earned by the other firms.
■ Thus, goodwill exists only in the case of firms making super profits and not in the case
of firms earning normal profits or losses.

4. Methods of valuating Goodwill

5. Average profit method
■ Under this method goodwill is valued on the basis of an agreed number of years’ purchase of
the average maintainable profits. When the maintainable free average profit is calculated, the
following factors are to be considered:
– Non-Operating profit or loss to be excluded.
– The loss, if any, in any year to be deducted.
– Deduct such incomes or special incomes which may not be continued in future.
– Past special type of expenses, which will not incur in future, or added.
– Provision may be made for managerial remuneration.
– Depreciation on fixed assets should be provided.
Formula
AVERAGE PROFIT METHOD =
𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟𝑠
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
VALUE OF GOODWILL = AVERAGE PROFIT ×YEARS’ PURCHASE

6. Super profit method
■ Super profit refers to that average profit which is earned by a business in excess of normal
earnings. Really speaking the super profit is the difference between actual average profit and
normal profit. That is, the term super profit means the profit over and above the normal
profit.
■ Formula
– SUPER PROFIT = AVERAGE PROFIT (ADJUSTED) − NORMAL PROFIT
– VALUEOF GOODWILL = SUPER PROFIT ×YEARS’ PURCHASE
■ An assumption is made regarding the percentage of profit earned on a certain investment of
capital in similar industries. This is considered as the normal expected profit in similar
concerns. This normal profit is compared with the actual profit. When the actual profit is
more, there will be goodwill. To arrive at the value of goodwill, the super profit is multiply by
the number of years.

7. Capitalisation of Profit Method
■ There are two methods under this:
a) Capitalisation of Super Profit
– Under this method, it is estimated as to how much capital will be required to earn super profit
at normal rate of profit. This capitalized value of super profit is treated as goodwill.
b) Capitalisation of Average Profit
– Under this method, the average annual profit is to be ascertained after providing for reasonable
management remuneration. This profit should be capitalized at the rate of reasonable return to
find out the total value of the business. Now the value of goodwill will be the total value of the
business minus its net assets. If, however, the net asset is greater, there will be no goodwill but
badwill.
■ Formula
CAPITALISEDVALUE OF PROFIT =
𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑
𝑁𝑜𝑟𝑚𝑎𝑙 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛
× 100
VALUE OF GOODWILL = CAPITALISEDVALUR OF GOODWILL − NETTANGIBLE ASSETS

8. Annuity method
■ Under this method, super profit (excess of actual profit over normal profit) is being considered
as the value of annuity over a certain number of years and, for this purpose, compound
interest is calculated at a certain respective percentage. The present value of the said annuity
will be the value of goodwill.
■ Formula
r% =
1− 1+
𝒓
100
−𝑛
𝒓
100
– V = present value of Annuity
– a = Annual Super Profit
– n = Number ofYears
– I = Rate of Interest

9. Shares
■ A share is an indivisible unit of capital, expressing the ownership relationship between
the company and the shareholder.
■ The denominated value of a share is its face value, and the total of the face value of
issued shares represent the capital of a company, which may not reflect the market
value of those shares.

10. Valuation of Shares
■ Valuation of shares is the process of knowing the value of company shares.
■ Share valuation is done based on quantitative techniques and share value will vary
depending on the market demand and supply.
■ The share price of the listed companies which are traded publicly can be known easily.
■ But private companies whose shares are not publicly traded, valuation of shares is really
important and challenging.

11. Methods of Valuation of Shares
Net Asset
Method
(Intrinsic
Value)
Yield
Method
Earning
Capacity

12. Net Asset Method
■ This is also known as Balance Sheet Method or Intrinsic Method or Break-upValue Method
orValuation of Equity basis or Asset Backing Method. Here the emphasis is on the safety of
investment as the investors always need safety for their investments. Under this method,
net assets of the company or divided by the number of shares to arrive at the net asset value
of each share. The following points may be borne in mind:
■ The value of goodwill will be ascertain.
■ Fixed asset of the company, disclosed or undisclosed in Balance Sheet, or taken at their
realisable values.
■ Floating assets are to be taken at market value.
■ Remember to exclude fictitious assets, such as Preliminary Expenses,Accumulated Losses,
etc.,

13. ■ Provision for depreciation, bad debts provision etc., must be considered.
■ Find out the external liabilities of a company payable to outsiders including contingent
liabilities.
■ Thus the value of net asset is:
– Net Assets =Total of realisable value of assets –TotalValue of Equity shares
– Total value of Equity Shares = Net assets – Preference Share Capital
– Value of Equity Share =
𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 −𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑆ℎ𝑎𝑟𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒𝑠

14. Yield Method
■ Under the Net Asset Method, the weightage is given on the safety of the investment. One,
who invests money on shares, always needs safety. Even if the return is low, safety is always
looked upon. At the same time under the yield method, the emphasis goes to the yield that an
investor expects from his investment. The yield, here we mean is the possible return that an
investor gets our of his holdings – dividend, bonus shares, right issue. If the return is more, the
price of the share is also more. Under this method the valuation of shares is obtained by
comparing the expected rate of return with normal rate of return.
■ Calculation of Expected Return
– Expected Return =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡𝑠
𝐸𝑞𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑠
×100
■ Calculation ofYield value of Share
– Value of Share =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑎𝑡𝑒
𝑁𝑜𝑟𝑚𝑎𝑙 𝑅𝑎𝑡𝑒
×100

15. Earning Capacity
■ When someone is interested to have majority of shares of a company in order to have
controlling interest in it, he makes use of earning capacity method for the purpose of
valuation of shares. He is interested to know the disposable profits of the company. The
profit is found out by deducting reserves and taxes from the net profit of the company. Thus
profits earned by the company are compared with the amount of capital employed in the
business and rete of earning is found out in the following manner:
– Rate of Earnings =
𝑃𝑟𝑜𝑓𝑖𝑡 𝐸𝑎𝑟𝑛𝑒𝑑
𝐶𝑎𝑝𝑡𝑖𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
× 100

16. Thank you