Valuing good-will for a purchaser is not so difficult. Two standard methods are in use, the one based on profits, the other on excess profits. According to the first, the value of the good-will is estimated as so many years’ purchase price of the net profits of the last year; or, better, the average of the last three or five years. This simply means multiplying the profits by the number of years’ purchase. The number of years to be used as a multiplier varies from one to fifteen, or twenty in some instances. Thus, if the agreement is to pay three years’ purchase of the average profit for the past five years and this average is $50,000, the price paid will be $150,000 and at that value good-will should be shown on the purchaser’s books.
Valuation of Good-Will Based on Excess Profits
The other method determines first the excess profits, i.e., the amount by which the profits of a particular business exceed the normal or average figures for that line of business. Thus, if the profits are $75,000 and normal profits are $50,000, the excess earning capacity per period is $25,000. This amount is then capitalized on some arbitrary basis, ranging in practice from the prevailing interest rate, say 5%, to 20% or even 50%. The effect of such capitalization is to apply a multiplier, as in the first method, ranging from 20 to 5 or less. Thus, if 20% is the agreed rate, the excess, $25,000 multiplied by 5 gives $125,000 as the value.
It is, of course, apparent that the valuation of good-will for prospective purchase is largely dependent upon the individual judgment of the buyer and that seldom will any two men arrive at the same valuation. As a matter of prudence, under either method the average profits for the past few years should be used rather than those of the last year. The latter may be sporadic and under conditions such as not to warrant their continuance. An average figure gives a better indication of what the business may be expected to do under normal conditions. Inasmuch as the value of good-will depends on excess earning capacity, the second method of valuation rests on better theoretical grounds than the first. Practically there is no preference, since valuation is largely a matter of personal judgment under either method.
Valuation of Good-Will Based on Capitalization of Profits
A slight variation of the second method is sometimes used. Under it the average net profits are capitalized at some agreed rate, giving the amount of money on which the average profits could be earned at the rate used. The difference between this amount and the amount of capital actually invested gives the value of the good-will. Thus, if on an investment of $250,000 net average profits are $60,000 and the normal rate for this business is 15%, $60,000 would represent a 15% income on $400,000. Good-will must therefore represent the difference between $400,000 and $250,000, or $150,000. This must evidently work out in exactly the same way as the second method if the rate used is the same. Therefore it constitutes not a distinct method, but only a variation. In the one case the difference between the average and normal profits is capitalized; in the other both are capitalized and the difference of their capitalizations is taken.
False Good-Will to Cover Capital Deficiency
A method of valuing good-will which makes it represent the difference between the value of tangible assets contributed or purchased and the par value of the stock issued cannot be countenanced at all. This use of good-will to cover up a capital deficiency is not only improper and misleading but often fraudulent. It is the favorite means by which “water” is injected into corporations. Thus, a concern desiring to capitalize at $500,000 and unable to sell its stock for more than $300,000, might carry an asset, good-will, to take care of the $200,000 discount on stock. A partnership desiring to incorporate might issue for the partnership assets stock with a par value much more than the assets taken over, and either inflate the asset values or set up a good-will account to care for the difference. This practice cannot be too severely criticized. In connection with this it should always be kept in mind that a newly organized company can never include good-will among its assets except by purchase.
Somewhat analogous to the above practice is that of increasing the capitalization of a company and issuing new shares in exchange for the old. Thus a company capitalized at $1,000,000 might increase its capital to $2,000,000, issuing two shares of the new for each share of the old. This will necessitate bringing onto the books an intangible asset, usually good-will, to cover the additional $1,000,000 of stock issued. Sometimes a real good-will may be existent as shown by the abnormal profits. In such cases, the effect of an increase of capital stock will be to keep down the rate of profit on the capital stock and so decrease the market value of each share, but not the real value of the total shares nor the amount of profit distributable to each of the holders of shares of the original issue. The purpose in such an increase of capital stock is usually an ulterior one, such as the desire to cover up real earnings in order to prevent a reduction of rates, as in the case of a public utility company. The purpose may sometimes seemingly justify the practice. The problem is mainly an ethical one and it is not proposed to discuss it here further than to say that the practice is usually to be condemned.
Periodic Revaluation of Good-Will