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Measuring Acquisition Performance

Any finance textbook will tell us that many, perhaps the majority of acquisitions fail. Failure is defined as the acquirer’s inability to recover economic value at least equal to the purchase price. Accurate analysis of acquisition outcomes is often complex. US GAAP addresses the issue by providing investors with:

 

•  intangible asset amortization as a benchmark for how much profit an acquired entity should enable through synergies or new profits to render the transaction accretive, and

•  goodwill and long-lived asset impairment testing.

Suppose Company A acquires Company B’s intangible assets (e.g. technology) for $50 million, with a useful life of 5 years. In financial reporting, the view is that the acquirer has 5 years to recover $50 million, or $10 million a year, from higher profits. The acquisition has to lift EBITDA by $10 million annually for the acquisition to break even, i.e. to keep EBIT the same.

Company A Before Acquisition After Acquisition (Breakeeven) After Acquisition (Failed)
 EBITDA  $10 $20 $15
Amortization $-  ($10) ($10)
EBIT $10 $10 $5

 

In our example, while Company A increased its EBITDA in both scenarios, the acquisition is breakeven or failing.  To recover its capital, Company A has to generate an additional $10 million in cash flow each year.  $20 million EBITDA is a minimally acceptable profitability that, at least in accounting terms, does not signal decreasing valuation for Company A due to a failing transaction.

Q&A

Amortization is a non-cash expense, so why does it matter? 

The $50 million purchase price was “real.” If an acquirer does not recover this amount, its valuation will fall.  There is no debate that an acquirer has to improve its cash flow to justify the investment. Amortization is that notional, and rather forgiving, benchmark for how much cash flow (or EBITDA) has to improve following the acquisition.

Aren’t companies valued on EBITDA multiples, making amortization irrelevant?

Valuation multiples are not set in stone.  Higher multiples are paid for more desirable companies.  Any diligent analyst will reduce the applicable EBITDA multiple for companies with large amortization expense.

Doesn’t a company also benefit from increased valuation, not just cash flow? 

Maybe, but in theory any higher valuation has to come from improved cash flow. Valuation approaches that rely on market multiples such as those of revenue or EBITDA are shortcuts; the income approach is the only fundamental measure of value.

Is it relevant that Company B was acquired for strategic reasons?

No, regardless of what “strategic” means, an acquirer has to be able to demonstrate improved cash flow.

Is the US GAAP view of amortization limited when a large portion of the purchase price is goodwill and not amortized?

Maybe.

Big Picture

US GAAP does not require amortization of goodwill, partly because goodwill is not well defined. The FASB Private Company Council now allows companies to amortize goodwill over 10 years. Although this is an arbitrary number, it may be better in certain situations than no amortization at all. A true strategic assessment of an acquisition’s success may include goodwill amortization, even when accounting rules don’t require it.

Idea #1: Under accounting rules, make it harder to qualify smaller tactical acquisitions as “business combinations” where a substantial portion of the purchase price is recorded as goodwill.  “Asset acquisitions” is an alternative that allocates the full purchase consideration to identifiable intangibles.  What do you think?

Amortization amounts ignore required return on capital.  No one would spend $50 million only to receive 5 instalments of $10 million back without any investment return attached to it.  In some cases, economic return can be found in increased value of Company A. However, if the acquisition solves short-term tactical issues, the proper economic amortization has to include return on capital. In our example, assuming 20% cost of capital, economic amortization will increase the required EBITDA improvement from $10 million to $17 million annually.

Ideal #2: In annual goodwill impairment testing, take a retrospective look at both the EBITDA and the EBIT trajectory in conjunction with an acquirer’s overall valuation.  Valuations can be obtained from publicly traded stock prices or #409Avaluations for privately held acquisitions.

 

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