Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Role of Goodwill on Stock Price

 How should balance sheet goodwill be viewed by the equity analyst?

Goodwill is measured as the excess of the purchase price of a purchased business over the fair value of the tangible and intangible assets acquired, minus liabilities assumed. If there is a bargain purchase where the acquirer pays less for the assets than the stated amount, “negative goodwill’ occurs and the buyer is required to recognize such excess in earnings as a gain. This would be recognized as a non-cash event in operating activities.

Goodwill has measurable value to the extent the assets it represents can produce free cash flow in excess of the firm’s cost of capital.  Since goodwill represents an economic benefit, to the extent this benefit is impaired, so too must its value, including an increase in instability metrics related to the firm’s cash flows. But because the value of goodwill is included in the calculation of return on invested capital, its write-down could distort the analysis of management’s ability to spend and earn a rate of return in excess of its cost of capital. In theory, an entity should in fact write down all assets that do not produce a cash return at least equal to its cost of capital, so those assets reflect economic reality.  Impairments, by itself, do not affect free cash flow, and why we look to growth rates in that measure when selecting an investment portfolio.

For the cash flow analyst, the governing rule, FAS 109, Accounting for Income Taxes, does not permit the recognition of deferred taxes related to goodwill that is not deductible for tax purposes. If the assets creating the goodwill are expected to be of indefinite value, the goodwill is not amortized and the related deferred tax liabilities will not reverse until those assets become impaired. The tax treatment of the goodwill depends on the expenditures that created the goodwill. If an acquisition is structured as a stock purchase, no amortization of goodwill is permitted. If the purchase is structured as an asset purchase, goodwill is amortized over 15 years using straight line depreciation. For shareholder reporting, goodwill is not normally amortized unless the assets are deemed impaired.

When goodwill is not tax deductible, any book/tax difference is considered a permanent difference and no deferred taxes are recognized.  When goodwill is tax deductible and is being amortized on the corporate return, it creates a deferred tax liability once the amortization period is up. When a company makes an acquisition, it may be required to reclassify its acquired intangible assets as goodwill if the intangibles are not tax deductible, and any deferred tax liability associated with those intangibles will be reversed as a reduction to goodwill.

To see if investors penalize entities which have large amounts of goodwill relative to shareholders equity, all companies (including companies which became inactive through merger or bankruptcy) which had greater goodwill than equity were studied, with no other financial considerations taken into account; if goodwill had been valued at zero for these entities, shareholders equity would have turned negative. For the five years ending November, 2009, this group had a median stock return of 1.4%, virtually in line with the average return of each sector these companies are a member of. The companies had a median market value of $ 1.5 bn., $918 mil in goodwill and $ 436 mil in shareholders’ equity.  Based on this one study, it appears investors do not penalize firms having excessive goodwill when making buy/sell decisions.

Because FAS 109 requires for periodic testing for impairment of goodwill, the analyst should consider it in their calculation of shareholders equity. If these assets fail to produce cash flows in excess of the firms cost of capital, it will quickly show in the reporting periods and effect the free cash flow multiple, growth rate in free cash flow, stability of cash flows and associated metrics including cash flow/debt  and return on invested capital. Given the above study, any write-down is most likely already reflected in the market price.

For additional information, please visit credittrends.com

Disclosure: No positions