For various reasons, it has been estimated that there could be as much as $300 billion sitting on the sidelines waiting to be invested. The sheer number of Mergers & Acquisitions over the last couple of years means that a great amount of capital has been taken out of the market and repaid to shareholders, such as the institutions. Similarly, interest rates are still at historically low levels and so it is still relatively cheap to borrow in order to fund future acquisitions.
Leading on from this is the simple but vital question of what a business is actually worth. Of course, there are the obvious assets – land, cash in the bank, equipment, fixtures and fittings and so on – the tangible assets. There are also, however, those “assets” on which it is harder to put a value. Reputation, strength of the brand, perhaps geographical location, exclusive rights to a product or service, even the morale of the workforce – the intangible assets, which clearly have a value but cannot easily be quantified.
So how do you value the intangible worth of the Disney franchise, the Porsche or Aston Martin name and the long established worth of the likes of BP, Shell, Tesco or HSBC?
The answer is goodwill. Even for goodwill though, there is an important distinction as to how it is treated.
In the examples of the companies mentioned above, goodwill will not appear on the companies’ balance sheets, since it is known as inherent goodwill, in other words an estimate of those intangible assets.
Clearly though, the balance sheet of any given company can accurately reflect the value of the business assets – but not the value of the business itself!
As in any market, value is determined by what a buyer is prepared to pay. When this happens, and an acquisition is made which is at a premium to the “bricks and mortar” this excess amount becomes purchased goodwill.
The general treatment of this as an accounting move has traditionally meant that this “overpayment” must be written off by the acquiring company over a period of time, since the power of the additional value will diminish as the acquired company is absorbed into the existing one.
There can also be problems along the way which result in this entire figure being revisited. Recently Vodafone has written down the value of its German and Italian operations by some £8 billion, citing higher interest rates, price erosion and regulatory costs. This is in addition to the £28 billion it wrote down earlier this year as a direct result of its purchase of the German giant Mannesmann in 2000, at the peak of the technology and telecoms boom. In other words, Vodafone overpaid for the company, even though at the time it clearly thought the valuation was accurate – but as the integration progressed and the market changed, so growth prospects for that part of the business did not materialise as hoped.
So what can be taken from this as the perceived M&A frenzy continues?
Clearly the balance sheet valuation of a company is not necessarily a reliable guide to the true value of the business.
From an individual investor’s perspective, this lends more weight to the old adage of investing in what you know and understand. Is there a particular sector or even share which you have been researching enough to appreciate that the value of the company extends far beyond physical assets and not just what they do, but how they do it? At worst you are looking at a company with good growth prospects and at best you may be looking at the next company to be acquired by a group of professional investors who have realised the same thing.
If you’d like to read more free research, comment and analysis from me and the rest of my colleagues at Hargreaves Lansdown please visit our website at www.hargreaveslansdown.co.uk
Richard J Hunter
Head of UK Equities
Hargreaves Lansdown
www.hargreaveslansdown.co.uk