Goodwill In M&A

Goodwill In M&A

Most valuations in #mergersandacquisitions use discounted cash flow analysis. Still, when the balance sheets of the target and the acquirer get combined post-acquisition, the accountants resort to the #purchaseaccounting method to value the assets of the combined companies. The accountants initially readjust the target company’s book value of its tangible and intangible assets/liabilities to its fair market value and then allocate the difference between the price paid by the acquiring company and the reassessed value for existing assets to #Goodwill. Thus, Goodwill is a plug variable used to justify acquisitions and needs to get assessed annually to check for impairment.

I do not subscribe to the accounting measures of valuation for the following reasons:

1)Goodwill does not tell if the buyer has overpaid for the acquisition as it does not segregate the synergies and control premium. In my view, an easier way would be to inform investors of the additional synergies that the buyer intends to derive from the acquisition (though synergies do not consistently deliver) and the balance attributed to overpayment.

Goodwill (Overpayment) = Final Purchase price – Fair market value of Target assets – Premium paid for Synergies and control.

Thus investors can review annually if the buyer delivers the synergies; else, the buyer’s stock price should decline. For instance, if a buyer pays $10 billion for a target with an adjusted book value of $3 billion and sees its market cap drop by $4 billion on the announcement, we can assume the investors have impaired the Goodwill of the acquisition by $4 billion.

2)Goodwill inflates the value of assets for acquisitive companies, which reduces its Price to Book value or EV/Invested capital compared to non-acquisitive companies. Accountants eliminate this anomaly by deducting Goodwill from the assets of acquisitive companies to compare different firms. However, this practice further confuses the investors as it does not discount the cash flows that acquisitive companies earn due to acquisitions. Thus it inflates the value of these companies to companies that do not acquire.