Acquisitions and the Aftermath

Acquisition accounting can wreak havoc on reported earnings and capital invested for years after an acquisition. The most common by-product of acquisitions is goodwill. This amortization of goodwill can reduce reported earnings in subsequent periods, though operating income should be unaffected. Goodwill, as an asset, can inflate capital invested in subsequent years and reduce both returns on equity and capital.

Should we consider amortization of goodwill to be an expense? We think not, since it is a non-cash charge, usually with no tax consequences. The safest route to follow with goodwill amortization is to look at earnings prior to the amortization of goodwill. But should goodwill be treated as part of capital invested? To answer this question, we need to examine what goes into goodwill in the first place. Note that goodwill is strictly a by-product of an acquisition and is defined to be the difference between the acquisition price for a company and the book value of its assets. Since the book value of a company usually measures the accounting value of assets in place, there are four components to goodwill:

a. Mismeasurement of value of assets in place of acquired company: The accounting book value represents capital invested in assets in place. The market value of these assets can be higher or lower than this value, depending in large part on whether these assets generate positive or excess returns.

b. Growth assets of target company: For most firms, growth assets are not captured in the balance sheet (or book value) since they represent excess returns from expected future investments. The market price includes the value of growth assets and goodwill should be a larger number for growth companies.

c. Value of synergy in merger: If there is any potential synergy in a merger, the price paid for a target firm may include some or all of this synergy.

d. Overpayment for target company: Acquirers sometimes over pay on acquisition and this overpayment is part of goodwill.

In summary, goodwill can be defined as follows:

The treatment of goodwill will depend in large part on what goes into it in the first place. If we accept the notion that return on capital measures the return on capital invested in existing assets, the one element of goodwill that clearly does not belong in capital invested is the value of growth assets. After all, a company cannot be asked to generate a return on investments it has not thought about yet. The other elements of goodwill, though, should remain part of capital invested. An acquisition premium paid for synergy because existing assets are undervalued should be reflected in earnings in the short term. Any overpayment should also be left as part of capital invested, even though it may lower measured returns, because it is a reflection of poor investment decisions made by the firm.

In theory, then, we would adjust the capital invested in an acquisitive company (with k acquisitions) as follows:

The tricky part, in practice, is working out how much of goodwill can be attributed to the growth assets of the acquired firms. It is not surprising that practitioners revert to one of two extremes. The first is to assume that all of the goodwill is due to growth assets, in which case we net all goodwill from capital invested.

The other is to assume that none of goodwill is for growth assets, in which case capital invested will include all goodwill.

See Technical Indicators