WHAT IS GOODWILL
Goodwill is the difference between the market
price paid for a target company and the fair value
of its assets. Thus, if company A pays $ 10 billion
for company B, and the Fair value of company
B's assets is $ 4 billion, there will be goodwill of $
6 billion on company A's balance sheet after the
acquisition.
WHY IS GOODWILL THERE
Because balance sheets need to balance. There are
two key differences between the market value and
accounting book value that create the need for
goodwill:
HISTORICAL COST VS. CURRENT VALUE:
Accounting record the values of assets based on their
historical cost, not their current market value. When a
company acquires another company, the acquisition
price is based on the current market value and needs to
be recorded as such. If the acquired company's assets
cannot be adjusted to reflect the price paid, the
difference is recorded as goodwill.
VALUE OF GROWTH POTENTIAL
Accounting balance sheets only capture the value of a
company's existing assets. However, the market value of
a company includes the expected value of future growth
potential.This premium paid above the book value is
also recorded as goodwill.
WHAT GOODWILL MEASURES
Misvaluation of existing assets: If the value of existing
assets in a company is not accurately assessed, goodwill
will be present, even if there is no growth. The more
misvalued the existing assets are, the higher the goodwill
will be.
GROWTH POTENTIAL
Goodwill increases when a company acquires another
company with greater growth potential. The market
value of the acquired company reflects this growth
potential, while the book value does not. So, the
difference is recorded as goodwill.
OVERPAYMENT BY THE ACQUIRING FIRM
Research shows that acquiring companies often pay
more than the actual value of the target company. This
overpayment, due to various factors like self-interest or
overconfidence, is recorded as goodwill.
CAN GOODWILL CHANGE OVER TIME
Yes, the value of goodwill can change over time. Since
goodwill is based on market values, it can vary from
period to period. The value of existing assets and growth
potential can change, and any overpayment needs to be
recognized at some point. However, in recent years,
accountants have argued for more timely reassessments
to reflect changes in the components of goodwill.
WHY GOODWILL HAS LOST ITS RELEVANCE
Goodwill impairment has become an earnings
management tool for many companies rather than a test
of fair value changes. In the process, it has lost its
informational content and is of little help to investors.
HOW TO VALUE A FIRM WITH GOODWILL
Goodwill affects book equity, capital, and earnings. Book
equity and capital change when a company acquires
another, as they now include the market values of the
acquired company's assets. Earnings can be influenced
by goodwill impairments, which can cause significant
fluctuations. Some analysts choose to ignore goodwill
when calculating ROIC, but it's debated whether
overpayment should be excluded.
HOW TO VALUE A FIRM WITH GOODWILL
In a DCF valuation, goodwill really has no direct effect,
since we estimate the value from expected future cash
flows.Thus, it is in incorrect to add goodwill on to a
DCF value, since it double counts these values.
HOW TO VALUE A FIRM WITH GOODWILL
In relative valuation, goodwill does not really affect
much if you are using EBIT multiples but it can affect
PE/PEG multiples, since EPS can be affected by
goodwill charges. Goodwill can become a problem with
BV multiples. When you do not adjust for goodwill,
companies that do a lot of acquisitions will have lower
price to book and EV to Book ratios than companies
that grow with internal investments.
FINAL SUMMARY ON GOODWILL
In conclusion, Goodwill does not change the underlying
value of assets, and analysts should not base their
decisions solely on accounting measurements of goodwill.
If a company pays too much for an acquisition,
accounting treatment of goodwill cannot undo the
negative consequences.
