1. Chapter 12 Appendix 12A Valuing Goodwill Prepared by:
Dragan Stojanovic, CA Rotman School of Management, University of Toronto

2. The Excess Earnings Approach
A widely used method to estimate goodwill in a business is the excess-earnings approach
Steps:
1. Calculate company’s expected annual average “normalized” earnings
2. Calculate annual average earnings if company earned same return as the industry average
3. Calculate company’s excess earnings
4. Estimate the value of goodwill based on excess earnings

3. Company’s Average “Normalized” Earnings
Given the following for Tractorling Corp.:
Identifiable net assets (FV): $ 350,000
Earnings history (2006–2010):
2006: $ 60,000
2007: $ 55,000
2008: $110,000
2009: $ 70,000
20010: $ 80,000
Total earnings for the five years = $375,000

4. Company’s Average “Normalized” Earnings
Average earnings: $375,000 = $75,000
5 years
We now need to normalize the earnings for Tractorling Corp.

5. Company’s 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)

6. Company’s Average “Normalized” Earnings
Average previous earnings $75,000
Add:
Adjust for Inventory $2,000
Adjust for Amortization 3, ,000
80,000
Less:
Gain on Discontinued
Operations (average) 5,000
Patent amortization 1, ,000
Expected Future Earnings $74,000

7. 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 %
Normal earnings (if no goodwill) $ 52,500

8. Excess Earnings
Expected future earnings $74,000
Normal earnings ,500
Excess earnings $21,500
Excess earnings must now be discounted to their present value

9. 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

10. Discount Period Discount period based on: Professional judgement
Estimation of how long the excess earnings are expected to last

11. 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

12. 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

13. 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 , Goodwill $ 143,333

14. 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

15. Other Valuation Methods
Discounted Free Cash Flow Method
Project the free cash flow over a 10–20 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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