198 Valuing Goodwill

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  VIEWPOINT Valuing goodwill Purchased goodwill is normally the balancing figure between the purchase price of anacquired entity and the total fair value of the acquired assets,both tangible andintangible, and liabilities. Frequently, however, the goodwill represents over half of thetotal purchase price. (This is especially true when the recognisedintangible assets areundervalued, but that’s another story…) so shareholders and other stakeholders areentitled to ask what goodwill represents and whether a fair price is being paid for it.While UK GAAP and US GAAP do not require any explanation of the goodwillpurchased, under IFRS rules which now apply to all UK and European quotedcompanies, an explanation is required. IFRS 3, Business Combinations, definesgoodwill as follows “..a payment made by the acquirer in anticipation of future economicbenefits from assets that are not capable of being individually identified and separatelyrecognised”(IFRS 3, paragraph 52). It also requires disclosure of the nature of goodwillwith ”…a description of each intangible asset that was not recognisedseparately fromgoodwill and an explanation of why the intangible asset’s fair value could not bemeasured reliably…”(IFRS 3, paragraph 66(h)).In fact, research carried out by Intangible Business on the reporting of businesscombinations by FTSE100 companies in 2006, the first under IFRS,“IFRS 3: The FirstYear”, indicates a very poor level of compliance with the disclosure requirements of IFRS 3 with respect to the components of goodwill. Whether this is due to reluctance todivulge what management consider to be sensitive information or because themanagement simply doesn’t know what the goodwill represents is unclear.More important, however, than compliance with disclosure requirements, is the needfor an acquirer to identify the sources of value underlying goodwill as both a crosscheck on whether the purchase price represents good value and also to createbenchmarks for future performance to ensure that those sources are exploited in full.Goodwill can and must be broken down into its component parts orthe acquisition ishighly likely to erode value as lack of measurability leads to lack of attention.While it is difficult to generaliseabout the sources of goodwill, there are a number of typical sources that should be considered, including: Workforce Both US GAAP and IFRS specifically exclude workforce fromthe intangible assets that can be recognisedand reliablyvalued on the basis that an acquired workforce can vote withits feet if they don’t like the acquirer. For this reason, anypayment for the workforce will fall into goodwill. It is possibleto assign a value to the workforce, based on assumptionsabout the retention rate post acquisition. Where the skills of the workforce are critical to success, the acquirer had better recognise this and ensure that the acquired workforce isenticed to remain on board. Intangible Business Ltd   VIEWPOINT Valuing goodwill Synergies These come in many forms and can be quantitatively evaluated relatively easily. Theaddition of a strong brand will allow the sales force to leverage the strengthenedportfolio to grow sales of the acquirer’s existing brands and, by the way, the beneficiaryof the synergy may be either an acquired brand or one of the acquirer’s brands.Additional purchasing power may lead to improved purchase pricesof raw materials.Distribution costs can be shared by loading new products onto anexisting fleet of trucks. Cost Savings Usually one company’s head office disappears and part, at least, of the overhead costsof the two separate entities can be saved.The value of the various identified components of goodwill should be determined interms of future projected cash flows, discounted at the appropriate weighted cost of capital. This can then form the basis of allocation of goodwill to reporting unit (USGAAP) or cash generating unit (IFRS). This is critical in order to avoid problems withfuture impairment testing, so that the goodwill is correctly allocated to the reporting or cash generating unit where the cash flows will be generated. Thesame principleapplies if the acquirer is required to “push down”the goodwill to a subsidiary.Analysis of goodwill at the time of acquisition will help to identify risk of overpayment for an acquired entity leading, ultimately, to an impairment charge to profit. Numerousstudies have indicated that many acquisitions fail to deliver shareholder value and a fullevaluation of the components of goodwill helps to minimisethe risk. The goodwillevaluation process forces management to identify and quantify the sources of cashflows that support the value of goodwill. If this is a struggle, or the assumptions aboutthe cash flows are unrealistic, it probably means that the priceis too high and its time tore-negotiate or walk away. Vodafone’s acquisition of Mannesmann in 2001 for £101bnmight have benefited from a closer analysis of the resulting goodwill (£83bn). Fiveyears later, Vodafone reported a goodwill impairment charge to £23bn.  Allan Caldwell  Director at Intangible Business, the brand valuation, strategy and development consultancy.Intangible Business Ltd 
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