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© Copyright 2002-2003. All rights reserved.
Page 40
How To Investigate Any Business Opportunity
From the accounting point of view, goodwill is the ability of a business to realize above-normal profits as
a result of these factors. By above-normal profit is meant a higher rate of return on the investment than
that ordinarily necessary to attract investors to that type of business. The value of goodwill can be com-
puted in either of the following ways :
1. Capitalization of average net earnings. As explained above, the amount to be paid for a business
may be determined by capitalizing expected future earnings at a rate that represents the required return
on investment. The difference between this amount and the appraised value of the physical assets may
be considered the price of goodwill.
This method uses only earnings in computing the price to be paid for the business, For that part of the
calculation, it ignores the appraised value of the assets.
2. Capitalization of average excess earnings. This method recognizes both earnings and asset contri-
butions. It starts with the appraised value of the assets and computes what would be a fair return on that
value. If the estimated future earnings are higher than this "fair return," the difference between the two
figures - the "excess earnings" - is capitalized at a higher rate, and the amount thus obtained is consid-
ered the goodwill value. This figure is added to the appraised value of the assets to give a price for the
business.
Payment of excess earnings is often stated in terms of "years of purchase" instead of in terms of capitali-
zation at a certain interest rate. Capitalization of average earnings at 20 percent is the same as payment
for 5 years' excess earnings.
As the above discussion shows, the determination of goodwill usually reflects the value of profits that will
be realized by the buyer above the normal rate of return; that is, the excess profits. But most small busi-
nesses that are for sale do not have excess profits. They usually show nominal profit or none at all. Of-
ten the seller makes an offer that seems quite good, but the buyer must be able to eliminate the seller's
emotions and reduce all facts to workable relationships.
If there are excess profits, goodwill is usually valued by capitalizing them at a fixed percentage estab-
lished by bargaining between the seller and the buyer. The capitalization percentage needs to be high
because profits higher than a normal return are difficult to maintain. Excess profits of $4,000 capitalized
at 10 percent will give a goodwill value of $40,000 ( $4,000 / 0.10 ). Capitalizing the same excess profits
at 20 percent gives a goodwill value of $20,000 ( $4,000 / 0.20 ).
Though goodwill valuation is the first asset valuation to be discussed here, it is normally the last to be
computed. Since few small businesses being sold are producing excess profits, the problem of goodwill
value is not a pressing one in most buy-sell transactions.
Merchandise inventory. In a service business, placing a value on the inventories is a minor problem;
but in distributive and manufacturing businesses, the inventory is likely to be the largest single asset. A
manufacturer, for example, has three inventories - raw material, work in process, and finished goods -
and each of them presents different problems in valuation. The distributive company has only one inven-
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