What is number of years’ purchase?
Quite frequently, when we are going to evaluate the Goodwill of a company, we come across the term , ‘ Number of years purchase’.
What is this ‘ number of years purchase’ and why do we take this into account while calculating Goodwill of an enterprise?
The answer to this question is very simple.
As we all know, establishing a new business and purchasing an established business are quite different phenomenons. When we start a new business, a lot of hard work is required to bring this business at par with other competitors in the industry. In the initial years, sometimes, many losses are suffered and many priliminary expenses are incurred. The business does not start reaping profits in the beginning itself. A lot of extra efforts and patience is required for a business to start showing results.
When somebody purchases the Goodwill of an established enterprise, he is going to get the benefits of the hardwork of the seller of the Goodwill that he has done to establish the business and bring it to the level where it now stands. Hence he compensates the seller for his hard work and efforts that he has put in the business to establish it. For this he pays an amount equal to a few years of the future profits he would be getting because of the existing reputation of the business largely due to seller’s past effrots.
The number of year’s purchase indicates the time required by the new business to come at a level equal to the old settled business. And the selection of the number of years is based purely on an estimate or the trend of the industry concerned. For example, A purchases B’s business and he estimates that had he started a new business it would have taken him around 3 years to start earning a profit of $ 10 million p.a. But since he has purchased B’s business he will be able to earn this profit right from the beginning and that is due to B’s past hard work. Hence in order to compensate B for this he pay a lumpsum of $ 30 millions(i.e. the equivalent profits of the 3 years) to B at the time of purchase as the price for Goodwill.