Lesson 4 of 8
Acquisitions, and what they earn
Judge an acquisition by the return on the whole price paid, goodwill included, not by the return on the tangible assets alone.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Judge an acquisition on the return earned against the whole price paid, goodwill included, not against the tangible assets alone.
- The purchase-price note splits the price into tangible assets, identified intangibles and goodwill, and goodwill is what was paid above everything that can be named.
- Goodwill is not amortized, so a bad acquisition shows up years later as an impairment charge rather than as a steady expense.
An acquisition is a purchase like any other, and the question is the same one: does the target's profit justify the price paid for the whole company, not just for the assets it can be broken into.
Where a $1,000 purchase price went
Identified and valued
- Net tangible assets$30030%
- Identified intangibles · brands, customer relationships, patents$20020%
- Goodwill · paid for what could not be named$50050%
The residue
Total$1,000
The return is on the whole price
A target's own return on its own assets is not the return an acquirer earns. The acquirer paid $1,000 for a business that may sit on only $300 of net tangible assets. Every dollar above that, including the $500 of goodwill, came out of the acquirer's cash or new shares. Return on invested capital computed with goodwill left in the denominator is the number that judges the purchase; the return on tangible capital judges the business, because the goodwill is money that was actually spent.
What the purchase-price note tells you
ASC 805 spreads the price across identifiable assets and liabilities at fair value; the rest is goodwill. That allocation covers working capital, property, patents, customer relationships and brands, filed as a note in the quarter the deal closes. It is the page where "we acquired a company" becomes a list of specific things paid for, and a residual that is not any of them.
Why goodwill does not just fade away
Under ASC 350, Intangibles, Goodwill and Other, goodwill is not amortized on a schedule the way a patent is. It sits on the balance sheet at its original value until an annual impairment test finds the reporting unit is worth less than its carrying amount, at which point it is written down all at once as an impairment charge. Buffett's goodwill appendix to the 1983 letter separates accounting goodwill, the residue booked at purchase, from economic goodwill, the capacity to earn high returns on tangible assets. In 1983 accounting goodwill was amortized over up to 40 years; today it is only impaired. Either way, the entry records what was paid, not what the franchise is worth.
Why the price so often does not earn its keep
Sirower's The Synergy Trap, 1997, argued that an acquisition premium is a bet on synergies. Synergies are gains beyond what the target was already expected to deliver, which the acquirer must now produce. A premium paid for savings that never arrive is value handed to the seller. An impairment reports some of that loss, late. Goodwill is tested once a year at the reporting unit, and a failed deal inside a healthy unit may never be charged at all.
Check yourself
An acquirer pays $1,000 for a target with $300 of net tangible assets and $80 of after-tax earnings. What return should the deal be judged against?
- 80 ÷ 1,000, the return on the whole price paid
- The target's return before the acquisition, unadjusted
- 80 ÷ 300, the return on tangible assets
Show the answer
Answer: A.
The acquirer spent $1,000, not $300, so the return that matters is earnings over the full price, goodwill included.What does the purchase-price note under ASC 805 actually show?
- The target's stock price history
- The acquirer's total debt after the deal
- The price allocated across identified assets, with the remainder booked as goodwill
Show the answer
Answer: C.
ASC 805 requires the price to be allocated across every identifiable asset acquired; what is left over becomes goodwill.Why might a bad acquisition take years to show up in the numbers?
- Because ASC 805 delays recognition of the purchase price by several years
- Because goodwill is not amortized and only appears as a loss when it is later written down
- Because acquisitions are not disclosed until sold
Show the answer
Answer: B.
Goodwill sits at its original value until an impairment test finds it is worth less, so an overpayment can show up as a large charge well after the deal closed.Sources
- ASC 805, Business Combinations.
- ASC 350, Intangibles, Goodwill and Other.
- Berkshire Hathaway shareholder letter, 1983, goodwill appendix, on economic goodwill against accounting goodwill.
- Sirower, The Synergy Trap, 1997.
What this leaves out
- The purchase price note and the return example use round invented numbers so the arithmetic can be checked by hand.
- An acquisition funded partly with new debt or new shares changes the cost of capital the return is measured against, and that adjustment is not shown here.
- A goodwill impairment reports that a past price looks too high today. It does not restate what should have been paid at the time.
- Nothing here is advice about any security.