Corporate Financial Reporting · Valuation of Shares (including Determination of Goodwill)

Goodwill: Meaning and Methods of Valuation

Updated 11 October 2026 · Fact-checked

Goodwill is the value of a business above its net identifiable assets, arising from reputation, location and earning power. You value it by average profit, super profit, annuity or capitalisation methods. Find normal and future maintainable profit, compare it with normal return on capital employed, then apply the method asked.

Understand Goodwill: Meaning and Methods of Valuation

Goodwill is the extra amount a buyer pays for a business over the value of its net identifiable assets. The reason is simple. A business that earns more than the normal return for its industry has something extra: customers, brand, location, skilled management. That extra earning power is goodwill.

Factors that raise goodwill: good location, strong brand and reputation, efficient management, loyal customers, patents and licences, limited competition, and a stable earnings record. Factors that reduce it: poor management, labour trouble, heavy competition and dependence on a few customers.

Purchased goodwill is paid for in an acquisition and appears in the books. Inherent (self-generated) goodwill builds up over time through the business's own efforts. It is not recorded in the books, but you may be asked to value it for a share sale, a partner's admission or a takeover. Ind AS 38 does not allow internally generated goodwill to be recognised as an asset.

Goodwill cannot be measured directly, so you estimate it from profits. The methods are: average profit, super profit, annuity and capitalisation (of average or of super profit). All of them depend on first finding a reliable future maintainable profit by adjusting past profits for abnormal items.

Key rules to remember

Capital employed (net assets): Capital employed = Fixed assets (excluding goodwill) + Current assets (excluding fictitious assets and non-trade investments) − Outside liabilities; Use values at the date of valuation. Decide whether to use opening, closing or average capital employed as the question directs.
Average profit method: Goodwill = Average maintainable profit × Number of years' purchase; Number of years' purchase is given in the question.
Super profit: Super profit = Average maintainable profit − Normal profit; Normal profit = Capital employed × Normal rate of return; If super profit is negative or nil, goodwill is nil under this method.
Super profit method: Goodwill = Super profit × Number of years' purchase; Years' purchase is a judgement given in the question.
Annuity method: Goodwill = Super profit × Present value annuity factor; Treats super profit as a stream received for a limited number of years. The rate and the number of years are given in the question, and the annuity factor is taken for that rate and those years from the present value annuity table supplied.
Capitalisation of average profit: Capitalised value = Average profit × 100 ÷ Normal rate; Goodwill = Capitalised value − Capital employed; The result is the value of the whole business less its net assets.
Capitalisation of super profit: Goodwill = Super profit × 100 ÷ Normal rate; This gives the same goodwill as the capitalisation of average profit method only when the same capital employed and the same normal rate are used in both.

How to solve Goodwill: Meaning and Methods of Valuation questions

Follow this order for any goodwill question. Show each step so you earn working marks even if one figure is wrong.

1Read which method the question names. If none, choose the one that fits the data and state why.
2Compute the profit of each year after adjustments: remove abnormal gains and losses, non-trade income, and fictitious items. Adjust for omitted expenses such as manager's remuneration or extra depreciation, and for tax if asked.
3Find the average maintainable profit. Use a simple average unless weights or a trend are given.
4Find capital employed on the basis stated. Exclude goodwill itself, fictitious assets and non-trade investments.
5Compute normal profit as capital employed × normal rate, then super profit as average profit − normal profit.
6Apply the method: years' purchase, annuity factor or capitalisation.
7State goodwill clearly, and add the value of the share or business if the question continues.

Quickest way: Super profit shortcut

When to use it: Use when the question gives average profit, capital employed and normal rate and asks for goodwill by more than one method.

Write average profit, normal profit and super profit in three lines.
Goodwill by super profit = super profit × years.
Goodwill by capitalisation of super profit = super profit ÷ normal rate.
Cross-check: capitalised average profit − capital employed should equal the second result.
If super profit is negative, write goodwill as nil and stop.

Common mistakes in Goodwill: Meaning and Methods of Valuation

Not adjusting profits for abnormal items
Students take the profit figures directly from the question table.
Fix: Scan every year for non-recurring gains, losses, non-trade income and omitted expenses. Adjust each before averaging.
Including goodwill or fictitious assets in capital employed
Students total all assets on the balance sheet.
Fix: Exclude existing goodwill, preliminary expenses, debit balance of P&L and non-trade investments. Deduct outside liabilities.
Using the wrong capital employed base
The question may give closing capital, and profit earned during the year has already been added to it.
Fix: If asked for average or opening capital, compute it. Otherwise state your assumption clearly.
Treating negative super profit as negative goodwill
Students apply the formula mechanically.
Fix: Under the super profit method, goodwill cannot be negative. Write nil.
Confusing capitalisation of average profit with goodwill
The capitalised value is the value of the business, not goodwill.
Fix: Always subtract capital employed from the capitalised value to get goodwill.
Forgetting to deduct tax or remuneration when told to
Adjustments are hidden in notes below the data.
Fix: Read every note before computing. Tick off each note after using it.

Worked examples

Example 1

A firm's profits for the last four years were ₹2,40,000, ₹2,60,000, ₹3,00,000 and ₹3,20,000. Capital employed is ₹10,00,000 and the normal rate of return is 12%. Find goodwill by (a) 3 years' purchase of average profit and (b) 3 years' purchase of super profit.

Show the solution

Total profit = 2,40,000 + 2,60,000 + 3,00,000 + 3,20,000 = ₹11,20,000.
Average profit = 11,20,000 ÷ 4 = ₹2,80,000.
(a) Goodwill = 2,80,000 × 3 = ₹8,40,000.
Normal profit = 10,00,000 × 12% = ₹1,20,000.
Super profit = 2,80,000 − 1,20,000 = ₹1,60,000.
(b) Goodwill = 1,60,000 × 3 = ₹4,80,000.

Answer: (a) ₹8,40,000; (b) ₹4,80,000.

Example 2

Average maintainable profit of a company is ₹4,50,000. Capital employed is ₹30,00,000 and the normal rate of return is 10%. Find goodwill by (a) capitalisation of average profit and (b) capitalisation of super profit.

Show the solution

(a) Capitalised value = 4,50,000 × 100 ÷ 10 = ₹45,00,000.
Goodwill = 45,00,000 − 30,00,000 = ₹15,00,000.
(b) Normal profit = 30,00,000 × 10% = ₹3,00,000.
Super profit = 4,50,000 − 3,00,000 = ₹1,50,000.
Goodwill = 1,50,000 × 100 ÷ 10 = ₹15,00,000.

Answer: Goodwill is ₹15,00,000 by both methods.

Exam tips

Always list adjustments to profit in a neat table. Examiners award marks for each adjustment.
State your assumption when capital employed or the years' purchase is unclear. A stated assumption protects your marks.
Where the question asks for more than one method, do the common steps once and reuse them.
Link goodwill to share valuation. Many questions ask for the value per share after finding goodwill.
Be ready to explain in two lines the difference between purchased and inherent goodwill, since MCQs test it.

Practice questions from Valuation of Shares (including Determination of Goodwill)

Goodwill: Meaning and Methods of Valuation in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Goodwill: Meaning and Methods of Valuation: frequently asked questions

What is the difference between purchased and inherent goodwill?

Purchased goodwill is paid for when a business is acquired, so it is recorded in the books. Inherent goodwill is built up by the business itself and is not recorded. You may still value it for a sale or admission of a partner.

When is goodwill nil under the super profit method?

When average maintainable profit is equal to or less than normal profit, super profit is nil or negative. Goodwill is then taken as nil.

How do you calculate goodwill under the capitalisation method?

Divide average profit by the normal rate of return to get the capitalised value of the business. Subtract capital employed. Alternatively, capitalise super profit at the normal rate.

Which profit should I use for goodwill?

Use future maintainable profit. Start with past profits, remove abnormal and non-trade items, and add back omitted expenses before averaging.