What is the basis of the Average Profits Method for valuing goodwill?

Average profits of the past few years

The correct answer is option 3- Average profits of the past few years.

Average profits of the past few years is the basis of the Average Profits Method for valuing goodwill.

Average Profits Method- Under this method, the goodwill is valued at agreed number of ‘years’ purchase of the average profits of the past few years. It is based on the assumption that a new business will not be able to earn any profits during the first few years of its operations.

The correct sequence of calculating goodwill through average profit method is-
* Adjust each year's profits if there are any abnormal profits or losses - Firstly if there is any abnormal gain or loss then it is deducted or added respectively from the particular year's profit.
* Total the profit of all years- After adjusting the profit of all years then the total of all adjusted profit is done.
* Divide the total of all year's profit by The number of years- Now just divide the total profit by the no of years for which profit is taken to find out the average profit of the firm.
* Multiply average profit with the Number of years purchase- At last multiply the average profit with no of years purchase to get value of goodwill.