Most CFOs dismiss the notion that goodwill affects the price they’re willing to pay in an acquisition. After all, goodwill is a noncash item, and most companies value assets based on discounted cash flow.
Nevertheless, the Financial Accounting Standards Board’s new rule concerning goodwill in business combinations is having an impact on deal- making. One provision of FAS 141, as the rule is known, requires the separation and valuation of certain intangible assets from goodwill (see cfo.com, “Goodwill Games II: Reports from the Field,” www.cfo.com/fasboct01. The provision requires intangibles with determinable lives, such as patents and backlog, to be amortized over the lifetime of the asset. And the resulting earnings dilution is a definite turnoff, according to Alfred King, vice chairman of consultancy Valuation Research Corp., who says companies are fighting “tooth and nail” to get intangibles grouped with goodwill or classified with indefinite lives so amortization does not apply. He concludes that despite protestations to the contrary, CFOs care as much about EPS as they do about cash flow. “What is becoming crystal clear is that CFOs are vitally concerned about reported earnings,” asserts the consultant.
King cites the example of one client that is in the process of completing an acquisition. “They have not closed the deal yet,” he says, “but they are already recognizing that the intangibles have a short life. It’s giving them heartburn.” Although King says that isn’t enough to make the buyer back out of the deal, he says it is very likely that the client will seek to negotiate a lower price.
More Than Accounting
Some CFOs concede that earnings dilution is an important consideration. “When you announce an acquisition, you talk to investors about accretion or dilution. An acquisition that includes intangibles would generally be less accretive to earnings,” says Mary Kabacinski, CFO of School Specialty Inc., in Greenville, Wis. “If you’re sensitive to extreme dilution, that might affect your decision to buy the target.” However, she adds that although the dilution effect is a consideration, “it would not influence us one way or another regarding whether we buy a company,” because cash flow is most
Martin Headley, CFO and treasurer of Bogart, Ga.-based Roper Industries, agrees. Although Headley says “the amortization of intangibles has little if any impact on our valuation as we are considering the cash returns,” he does concede that amortization could be an issue when intangibles are large enough to turn an acquisition that would increase earnings into one that reduces them. “If this were the case for Roper,” acknowledges Headley, “this might well have an impact on our valuation conclusions.”
Investment bankers appear to support the notion that EPS dilution relating to intangible assets does indeed matter. “Public companies, and even initial public offerings, are often priced by analysts as a multiple of earnings per share, not cash flow,” notes Doug Rogers, executive vice president at CBIZ Valuation Counselors. He says that many clients “are asking CBIZ to view acquisitions based on the old allocation rules versus the new rules.”
Dealmakers may also want to look more closely at another new accounting rule, FAS 142, which concerns the conditions under which goodwill and other intangible assets must be written down because of impairment. The rule, warn some experts, makes it dicey to pay a high premium for intangibles, especially when market conditions are as volatile as they have been recently. “There’s a potential impact on pricing because of the impairment write-down risk in the future,” explains Pete Nachtwey, national managing partner for valuation with Deloitte & Touche LLC.
Impact of new goodwill rules on corporate profits:
Source: “No More Foolin’ With Poolin’,” July 2, 2001, UBS Warburg, New York