Annuity Method of Goodwill Valuation: Formula, Calculation, and Benefits
The valuation of intangible assets, particularly goodwill, has traditionally been considered one of the most complex in business valuation, strategic financial planning, and investment decision-making. Goodwill is an intangible asset that can form one of the essential parts of a business's total value, summing up those things which are not material but contribute significantly to the company's profit and competitive position in the market. Of the various valuation methods, the annuity method rests on substantial grounds due to its structured way of defining the value of goodwill. This article thoroughly explains the annuity technique and illustrates its use in company valuation using real-world examples.
Goodwill in Business
To do an Annuity Method, an individual must know what goodwill implies. Goodwill indicates the difference between the company's value to which the title "goodwill" is attached and the value of its tangible assets and liabilities. This category includes brand reputation, customer loyalty, employee relations, proprietary technologies or patents, and other elements that make up the business. Intangible as these elements are, they contribute to the future income earnings in the industry and, based on the estimate, are beyond the capacity of the tangible assets to produce.
Goodwill can be categorised into two types:
Inherent Goodwill: This is generated within the enterprise by the business's operations. This comes from customer satisfaction, brand strength, and operational efficiencies.
Purchased Goodwill: This is the goodwill arising from acquiring another company where the purchase consideration transferred is greater than the fair net value of the net identifiable assets. The difference between the purchase consideration transferred and the acquired company's net fair value is attributed to that company's goodwill.
Valuation Methods for Goodwill
Valuation of goodwill is a complex procedure with several methods, and each of them is applicable in different situations in business.
Some of the standard techniques are:
Average Profit Method: It calculates the amount of goodwill according to the average profits made over the years.
Super Profit Method: According to this method, super profit represents the profit surplus to be generated over and above the average expected return on investment.
Capitalisation Method: According to this method, the business's future expected profits or super profits are capitalised at a specific rate of return.
Annuity Method: Capitalizes the excess earnings expected from the business into a present value.
What is the Annuity Method of Good Will?
The Annuity Method best applies to businesses where earning is anticipated to remain unchanged and stable throughout a specific period. Later, to present the value, the value of the annuity excess earnings is found to be applicable. The annuity method of goodwill formula is as follows:
Goodwill Value = Average Super Profit × Present Value of an Annuity at a Specified Interest Rate (A)
Where:
A = [1 - (1 + r/100) ^(-n)] / (r/100)
In this equation,
A = Present Value of a one-rupee annuity
r = Standard rate of return
n = Number of years considered for valuation.
This method requires the computation of super profit, i.e., the profit that exceeds the expected average profit. Net profit is computed as the actual or average profit less than the average profit (the standard rate of return multiplied by the capital employed).
A Practical Example for the calculation of annuity method of goodwill
Given Data:
Net profit after tax for the last five years:
2022: ₹90,000
2021: ₹70,000
2020: ₹50,000
2019: ₹60,000
2018: ₹40,000
Net tangible assets: ₹6,00,000
Expected normal rate of return: 12%
Present value of an annuity of ₹1 for five years at 10% interest: ₹3.10
Step 1: Calculate Average Profit
Total Profit = ₹90,000 + ₹70,000 + ₹50,000 + ₹60,000 + ₹40,000 = ₹3,10,000
Average Profit = Total Profit / 5 = ₹3,10,000 / 5 = ₹62,000
Step 2: Calculate Normal Profit
Normal Profit = Net tangible assets * Expected normal rate of return
Normal Profit = ₹6,00,000 * 10% = ₹60,000
Step 3: Calculate Super Profit
Super Profit = Average Profit - Normal Profit
Super Profit = ₹62,000 - ₹60,000 = ₹2000
Step 4: Value of Goodwill
Value of Goodwill = Super Profit * Value of Annuity
Value of Goodwill = ₹2000 * ₹3.10 = ₹6,200
In the above example, it is evident that the Annuity Method includes a formal mechanism for valuing goodwill, considering the value of future additional earnings to be generated.
Benefits of the Annuity Method of Goodwill
The Annuity Method is the method of choice for the following reasons:
Future-Oriented: It considers the business's earning potential in the future, a matter very much under concern by the investor or the buyer.
Structured Approach: It gives a specific formula to compute goodwill, which provides a
Flexibility: The approach can be varied for different rates of return and periods, making it a flexible tool for different business scenarios.
Conclusion
Goodwill forms a key component in any business transaction and the cases of mergers and acquisitions. The annuity method gives a sound model to value the business's goodwill concerning its intangible assets under consideration for capitalising over future excess earnings. This is an added benefit to the structured approach and flexibility with which one can adapt the model to different business models and projections. Therefore, stakeholders make informed decisions by understanding and applying the Annuity Method, ensuring that the businesses they engage with maintain financial health and grow in the competitive landscape.