The problems with overemphasizing goodwill in PPAs

Researchers from University of Bath (UK) and University of Hong Kong have studied the impact of high goodwill (goodwill-to-sales ratio) on performance. They found that investors underreact to high goodwill-to-sales. Stocks with high goodwill-to-sales underperform stocks with low goodwill-to-sales. This negative relation decays over time and disappears after three years since portfolio formation (M&A). Moreover, a high goodwill-to-sale positively predicts future goodwill impairment and negatively predicts future profitability.

Accordingly, appraisers doing purchase price allocations should be cautious to account for abnormally high goodwill which is often referred to for reasons of earnings and tax management.

[see Xin Liu, Chengxi Yin and Weinan Zheng: The Invisible Burden: Goodwill and the Cross-Section of Stock Returns, January 2019]

Similarly, researchers from ESSEC Business School, HEC Business School, and University Paris East (including Prof Luc Paugam, member or MARKABLES’s advisory board) recently found that high goodwill is associated with downward revisions of analysts’ earnings forecasts, indicating that goodwill is informative about the extent of overpayment. Also, the magnitude of revisions of analysts’ forecasts is positively associated with levels of disclosures about intangible assets, illustrating the need for greater disclosures on intangible assets and a more complete recognition of intangibles.

[see Anne Jeny, Luc Paugam, Pierre Astolfi: The usefulness of intangible assets’ disclosure for financial analysts. Insights from Purchase Price Allocation conditional on deal quality, February 2019].