Chapter 12

Appendix 12A
Valuing Goodwill

Prepared by:
Patricia Zima, CA
Mohawk College of Applied Arts and Technology
 The Excess Earnings
Approach
A widely used method to estimate goodwill in a
business is the excess-earnings approach
Steps:
1. Calculate companys expected annual
average normalized earnings
2. Calculate annual average earnings if company
earned same return as the industry average
3. Calculate companys excess earnings
4. Estimate the value of goodwill based on
excess earnings

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 Companys Average
Normalized Earnings

Given the following for Tractorling Corp.:

Identifiable net assets (FV): $ 350,000
Earnings history (20032007):
2003: $ 60,000
2004: $ 55,000
2005: $110,000
2006: $ 70,000
2007: $ 80,000
Total earnings for the five years = $375,000
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 Companys Average
Normalized Earnings

Average earnings: $375,000 = $75,000

5 years
We now need to normalize the earnings for
Tractorling Corp.

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 Companys Average
Normalized Earnings
Normalized earnings is representative of
future earnings
Accounting policies applied should be
consistent with that of the purchaser
Future earnings should be based on fair
value of the net assets rather than the
carrying amount of the net assets
Non-recurring amounts are adjusted out
(e.g., extraordinary gains/losses, unusual
items)
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 Companys Average
Normalized Earnings
Average previous earnings $75,000
Add:
Adjust for Inventory $2,000
Adjust for Amortization 3,000 5,000
80,000
Less:
Average Extraordinary
Gain 5,000
Patent amortization 1,000 6,000
Expected Future Earnings $74,000

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 Average Earnings Using
Industry Average

Expected earnings without goodwill

Industry average rate of return: 15%

Fair value of net identifiable assets $350,000

Industry average rate of return 15%
Normal earnings (if no goodwill) $ 52,500

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 Excess Earnings

Expected future earnings $74,000

Normal earnings 52,500
Excess earnings $21,500

Excess earnings must now be discounted to

their present value

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 Discount Rate
Higher discount rate normally used:
discounting future cash inflows that may be
riskier
higher discount rate will lower goodwill
Factors to consider when determining
discount rate:
Stability of past earnings
Speculative nature of business
General economic conditions

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 Discount Period

Discount period based on:

Professional judgement
Estimation of how long the excess earnings
are expected to last

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 Value of Goodwill-
Excess-Earnings Approach

Rate of return required by purchaser = 15%

Discount period = perpetuity
Expected earnings = $74,000
Normal return = $52,500
Excess earnings = $21,500

Goodwill = $ 21,500 0.15

= $143,333
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 Total-Earnings Approach

Total-earnings approach is an alternative

approach to estimating goodwill
The value of the company as a whole is
determined
Based on total expected earnings
Fair value of identifiable net assets deducted
from the value of the company
Difference is goodwill

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 Total-Earnings Approach

Goodwill = Fair value of company

Fair value of identifiable net assets

FV of Co. = $74,000 0.15 = $ 493,333

FV of identifiable net assets 350,000
Goodwill $ 143,333

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 Other Valuation Methods

Number of Years Method

Excess earnings multiplied by the number of
years excess earnings expected to last
Advantage: simple
Disadvantage: does not consider time value
of money

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 Other Valuation Methods
Discounted Free Cash Flow Method
Project the free cash flow over a 1020
year period
Free cash flow: that amount of cash from
operations in excess of what is needed to
maintain existing capacity
Discount this amount
Result is the value of the business

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