Cash and Cross holdings

I am sorry about the long break between posts but I was on the road for much of the last two weeks and grading exams prior to that. I started my road trip with sessions in Slovenia and Croatia and continued on to India to make a presentation to the Tata Group, one of India's premier family groups, with a long history of operating in every aspect of Indian business. As part of the preparation, I did value a Slovenian pharmaceutical company (Krka), a Croatian tobacco company (Adris Grupa) and four Tata companies (Tata Chemicals, Tata Steel, Tata Motors and Tata Consulting Services). The presentations and the spreadsheets containing the valuations are online and can be accessed by going to:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/country.htm

Without belaboring the details, there were two key issues that came up when valuing Adris Grupa and the Tata Companies.

1. Cash holdings: Adris Grupa, as a tobacco company with significant operating cash flows, has accumulated a very large cash balance; it amounts to 20% or greater of the overall value of the firm. Adris is clearly not the only company that accumulates cash and it is not a phenomenon just restricted to emerging markets. Technology companies in the United States, such as Apple and Microsoft, have also been avid cash accumulators. While the conventional valuation practice with cash has been to add the cash balance to the value of operating assets, thus adopting the common sense rule that a dollar in cash has to be worth a dollar, there is substantial evidence that markets do not always treat cash as a neutral asset. In particular, markets seem to view companies that generate poor returns on their operating assets (less than the cost of capital) and accumulate cash with disfavor, while being much more sanguine about companies with good investment track records and substantial cash. Apple, for instance, is clearly not being penalized (and may be even be rewarded) for its large cash balance; after the most recent decade, investors trust the company to find good uses for the cash. In the Adris valuation, one of the concerns I raised was that the company's return on capital has lagged its cost of capital.It is therefore possible that the market may be discounting the cash holdings; a Croatian kuna in cash may be valued at less than a kuna.


2. Cross holdings: The Tata companies that I valued, with the exception of Tata Consulting Services, shared a common feature. A third to half the value that I estimated for each company came from  holdings in other Tata companies. In effect, investing in any Tata company is a joint investment in that company and a portfolio of 25-30 other Tata companies. While one reason for this cross holding structure is corporate control - it allows the family to preserve its control of the group companies - there are also more benign reasons, rooted in history. In the decades before the 1990s, Indian investors had little access to financial information from the company, let alone analyst reports or investment analysis. In that period, these investors had to essentially buy companies based on how much they trusted the promoters of the company, and a trusted family name became a proxy for research. In addition, when capital markets are undeveloped, having an internal family group capital market, where excess cash at some companies can be redirected to other companies that need the cash can be a competitive advantage.

The Indian equity markets today are different. While Indian companies have their own share of scandals and investment advice/ equity research can be tainted, the market is wider (thousands of publicly traded companies) and much deeper (more investors both from Indian and from outside). The cross holdings at family group companies can now become a valuation problem for two reasons:

1. To value one company, you have to value dozens:  Consider a firm with holdings in 25 other companies. Even if we could access information on these companies (because they are public), a thorough analysis of the firm would require a valuation of 26 companies. (Using the book value of these holdings, which are not marked to market, will yield skewed estimates. Using the market values of these holdings risks feeding any market mistakes into your valuation).
2. Some cross holdings cannot be valued: With many family group companies, some of the companies in the group are privately owned and never go public. As a consequence, there is little or no information that can be used to value companies. We have no choice but to use book value.

If you carry these concerns through to their logical conclusion, it is possible that investors either unconsciously (by using book value) or consciously (by discounting the market value of the cross holdings) will reduce the values of family group companies below what they would have been worth as independent companies. In effect, the sum of the parts will be greater than the whole. I have a paper on valuing cash and cross holdings that explores the technical details of this discount:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=841485

In my next post, I hope to examine the link between corporate governance and the phenomenon of cash and cross holdings.

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"We are not in Kansas anymore"

It looks like that they have found the culprit for the 1000-point intraday swing on the Dow 30 on May 6. It turns out that rather than the hedge funds that were initially suspected, it was a Kansas-based money management firm, Waddell & Reed Financial, that traded 75000 e-mini S&P 500 contracts between 2.32 and 2.51 pm on May 6. That amounted to 9% of the trading volume on e-mini contracts during that period and all of the trading was executed by one trader at the firm. Incidentally, the CME report that uncovered this news also found that neither the trader nor the firm were acting imprudently or were at fault. This news item may still leave you a little bemused. How does one trader at a small money management firm cause a drop in market value of billions? And how can they not be at fault if they caused a market collapse? So, here is my attempt at providing an explanation.

What are e-mini contracts?
E-mini contracts are future contracts on the S&P 500. The "mini" in the name refers to the fact that each contract is $50 times the level of the index. (If the S&P 500 is at 1200, each contract is for a notional value of $60,000) E-mini contracts were introduced in the late 1990s by the Chicago Mercantile Exchange to provide a "smaller size" alternative to the long-standing S&P 500 futures contracts which were set to $500 times the level of the index; they have since been dropped to $250 times the level of the index.

How do investors use these contracts?
As with all futures contracts, there are speculators and hedgers in the e-mini market. The speculators buy or sell the e-mini to try to profit from overall market movements. Thus, a bullish (bearish) investor will buy (sell) e-mini contracts and make money if they are right on market direction. (If you buy 100 contracts and the S&P 500 moves up 80 points, you will make 100* 80 * 50 = $400,000; the 50 refers the fact that the futures contract is $50 times the index) The hedgers use the index to protect existing portfolio positions. Thus, a portfolio manager who wants to either protect profits already made or one who desires a floor on his or her losses will sell e-mini futures. (A portfolio manager who has $ 1 billion in equities can sell enough futures contracts to ensure that the value of the position does not drop below $ 900 million. Generally speaking, the more insurance you want, the more futures contracts you will have to sell. In more technical terms, you are creating a synthetic put on your portfolio, using options, and the number of futures contracts you will need to sell can be extracted using an option pricing model)

In many ways, the hedging position with futures is a lot more volatile than the speculative position, simply because the degree of selling is tailored to what the index does. As the index falls, the selling will often accelerate. partly because the point at which different portfolio managers hedge can vary. Thus, some portfolio managers may begin their hedging when the market drops 3%, others at 5% and still others at 10%.


How can futures affect the level of the index?
With financial futures, there is a third player that we have not mentioned in the section above, the arbitrageurs. Arbitrageurs have neither a market view nor do they have a portfolio to hedge. Instead, they are looking to make riskless profits, To prevent these profits, the futures price and the spot price are linked together in a rigid relationship:
Futures Price = Spot price (1 + riskfree rate - dividend yield)
To see why, assume that the S& P 500 is at 1000 right now, that the riskfree rate is 5% and that the dividend yield is 2%. Assume also that the one-year futures price on the index is 1045. Here is the arbitrage:
1. Borrow 1000 at the riskless rate and buy the index today at its spot price of 1000.
2. Sell the one-year futures contract at 1045.
3. During the next year collect dividends on the stocks in the index (2% of 1000 = 20). At the end of the year, deliver the stocks in the index in fulfillment of the futures contract and collect 1045. Pay the interest at the riskfree rate on the initial borrowing of 1000 (from step 1) and pocket the difference:
Profit = 1045 - 1000*.05 +20 = 15
To prevent this profit from occurring, the futures price has to be 1030. There are points at which you can quibble - being able to borrow at the riskfree rate and knowing the dividends for the next year - but they are minor ones, especially for the larger institutional players. The overall dividend yield on the S&P 500 index is very predictable and you can borrow at close to the riskfree rate, especially if you can back the borrowing up with marketable securities (as is the case here).

This futures-spot relationship creates the link. If one (spot or futures price) moves, the other has to follow. Thus, if there is an imbalance in the futures market, the futures price will change and the spot will follow. On May 6, here is how the script unfolded. The sell order placed by the trader at Waddell and Read was large enough to cause the e-mini futures price to drop significantly and the spot market had to follow. The fact that the trade was entirely driven by liquidity or hedging concerns (and not by information) resulted in a swift correction of both the spot and futures markets, with both reversing the losses by 3.30 pm.

What should be done about this?
I think that the May 6 collapse was an aberration. In what sense? The trade by the W&R trader occurred at a point in the day when the market was already skittish - it was down 250 points as worries about Greek default were rampant. When traders get antsy, they look for clues in trading by others. In other words, they assume that large trades, especially anonymous ones, must be coming from more informed traders (such as the Greek central banker) and they follow the trade.

While there is always the potential for this type of panic with or without futures markets, the existence of futures contracts has made it easier to create this type of panic. To the regulatory-minded, the solution seems simple. Ban futures trading or add more restrictions to the trading.  I disagree with the sentiment and think more harm than good will come out of it. As an investor who uses futures contracts very rarely and only to hedge, I still benefit from the liquidity created by these markets and bear little or no cost, simply because I choose not to trade frequently. In fact, as an intrinsic-value driven, long term investor, selling panics such as these can actually be opportunities to take positions in companies that I have always wanted to buy. For short term traders, though, futures markets may increase intraday volatility and thus their perception of risk in equities. I cannot speak for them but they are short term traders by choice!!

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The Goldman indictment

I waited a couple of after the indictment of Goldman to post my thoughts on it, since I have mixed feelings on the topic. If you want to take a look at the indictment, you can go here:
www.sec.gov/litigation/complaints/2010/comp-pr2010-59.pdf
As most of you who have followed my work know, I have been been more negative on the products and practices of investment banks than most of my academic brethren. I think that investment bankers promise more than they can deliver and that there is far less value in most of the products that they sell than they claim in their sales pitch. On the Goldman indictment, my sympathies lies with Goldman because I feel that this it is selective prosecution, based upon 20/20 hindsight, designed to advance a larger agenda of "financial regulation and oversight" by the Federal government and Goldman happens to be (at the moment) every one's favorite bogeyman.

First, the background. The deal that has Goldman in hot water is titled Abacus and was a multi-billion dollar Collateralized Debt Obligation (CDO), a fancy terms for a bond backed up by assets, and in this case, the backing came from real estate mortgages. On the face of it, the deal looks unremarkable. In fact, Business Insider was able to get its hand on the pitchbook used by Goldman for the deal:
http://www.businessinsider.com/check-out-the-66-page-presentation-on-goldmans-abacus-cdo-deal-2010-4
The pitchbook has all the hallmarks of a standard sales presentation - the obligatory disclaimer that runs 3 pages, 63 more pages that reveal less than they should, uninformative (but colorful) graphs, and tables filled with enough numbers to numb the brain (which is the objective).

So, what made this deal stand out? Here are some of the factors for its being singled out:
1. A "big loser": The securities bundled in the Abacus deal were priced at the height of the housing bubble. Like other housing backed securities it did lose money. However, it was one of the "biggest losers", with losses exceeding in the billions.
2. The John Paulson connection: The seller of the securities in the Abacus deal was the hedge fund headed by John Paulson, one of the few winners in the housing bubble. His subsequent notoriety, chronicled in a book, has made him into a sage, at least in hindsight, about the housing bubble and its implosion.
3. Goldman was the intermediary: Among investment banks, Goldman Sachs was viewed as the only one that was able to cut its losses in the mortgage backed securities debacle and escape relatively unscathed. The fact that it was the broker in this transaction has evoked suspicion that is was partnering with Paulson to take advantage of the suckers on the other side.

The indictment of Goldman seems to rest of two claims:
1. According to the SEC, Goldman Sachs claimed wrongly that Paulson was buying the securities (packaged under Abacus), when it was the seller. I checked through the sales presentation that I linked to earlier to see if there was an explicit mention of Paulson but I did not find any. It is entirely possible that Goldman left the implicit understanding that it was a buyer (I assume that the SEC has something - emails, phone calls, phone video - to back up its claim).

2. Goldman had advance knowledge of the collapse of the housing market and took advantage of their clients: Even the SEC seems to recognize that this is a much weaker legal argument, but the Senate committee investigating Goldman Sachs had no qualms about making this the center piece of its accusations. Using emails from from Fabrice Tourre, who in addition to being an employee of Goldman seems to have forgotten that emails are not erased on the server when you delete them on your computer, senators accused Goldman of knowing that the housing market was going to collapse and actively exploiting investors by selling them securities that would be destroyed by this collapse.

I know that these are legal issues subject to the legal rules on what comprises reasonable. However, if this case were subject to what the rest of us (who are not lawyers and have the benefit of common sense) think as reasonable, it just does not stand up to scrutiny:

1. What if Paulson were the seller rather than the buyer and why should the buyer of these bonds (ACA) have cared? Implicit in the SEC's argument that holding back on the identity of the seller (Paulson) was somehow a deal breaker for the buyers of the securities involved in the Abacus deal. Notwithstanding the halo that Paulson might have acquired as a soothsayer in the housing bubble, he was a voice in the wilderness in 2007 on housing prices. I seriously doubt that ACA would have not bought these securities, even if they had known that Paulson was the seller. In addition, I don't think any intermediary in this market (securities) is required to reveal to the buyer the identity and motives of the seller.

2. Goldman knew the housing market was going to collapse and took advantage of its clients: I find this argument to be beyond absurd, especially given the evidence to back it up. In fact, let's take this argument at face value. If Goldman were that prescient about the housing market in 2007, there was a dozen other ways (most of them more profitable and less work than Abacus) that they could have made money on this belief. So, why construct this convoluted way to make money? Furthermore, investment banks are not monolithic when it comes to views about markets. Having worked with investment banks for almost 30 years, I can guarantee you that at any point in time, views about whether a particular market is under or over priced (equity, bonds, real estate) diverge across an investment bank. For every strategist/analyst at the bank who is bullish, there is one who is just as strongly bearish. Thus, I find Tourre's emails (about what he thinks about the market) to be sensational but completely irrelevant to this discussion. (As an analogy, think of the following: If you were a real estate broker who believes that houses are over priced, should you stop selling houses to clients who want to buy houses?)

Did Goldman take advantage of "naive" clients"? Probably, but that is the nature of trading. All trading is predicated on exploiting the lack of information or good sense on the part of the the investor on the other side of the trade. I don't like what they did because it is bad business practice, in general, to take advantage of your customers. However, it is not illegal. If it were, home buyers should be suing brokers who sold them houses in 2007 and 2008 while secretly believing that these houses were overpriced, customers should be suing electronics salesmen who sold them video disc players, knowing that DVD players were the standard of the future, and voters should be suing politicians who told them that their pension and health care benefits were secure, while undercutting the basis for these benefits.

I know that a lot of people would like to see Goldman fall, and that some of them work at Goldman's competitors. While I understand the urge to bring the mighty back to earth, I think that failing to support Goldman at this time is a huge mistake. To me, this case reveals everything that is wrong with both politics and law - the use of ex-post evidence to back up a case (Paulson made money of the housing crash.. so, he must have known that the crash was coming), suspicious timing (just in time for the new law on regulating bank) and scapegoating.

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Currency Choices in Valuation

I am currently in Bogota, Colombia, doing a seminar in risk. One of the topics that came up yesterday was about the choice of currency to do a valuation in, and how it affects your inputs. In particular, the question that I was asked was whether an analyst should value a Colombian company in Colombian pesos or US dollars, and the implications of this choice. Here is how I responded:

Which currency should I do my valuation in?
If you do your valuation right, it should not matter. Your value for a company should be the same, no matter what currency you choose to value it in. Thus, a company that is under valued by 20%, when you do your valuation in pesos, should remain under valued by 20%, when you do your valuation in US dollars.
Given this proposition, you should pick the currency with which you are most comfortable with and where it is easiest to get the financial information. My instinct, given the latter requirement, is to do valuations in the local currency since most financial statements are richer and more detailed in the local currency. Your choice of currency should not be a function of the investor for whom you are doing the valuation. Thus, you should not try to value a Colombian company in US dollars, just because the investor for whom you are doing the valuation is dollar based.
 
How is my discount rate affected by my currency choice?
In the context of discount rates, the input that is most influenced by the currency choice is the riskfree rate. If you work with a higher inflation currency, the riskfree rate will be higher. In the Colombian context, the Colombian peso riskfree rate was 6.5% and the US dollar riskfree rate was 4% last week. The difference of 2.5% is entirely attributable to differences in expected inflation.

Just as a side note, while getting a US dollar riskfree rate is easy (I used the T.Bond rate), I had to work a little harder to get the riskfree rate in pesos, since the peso-denominated Colombian government bond does have some default risk embedded in it. In particular, I subtracted out the default spread for the Colombian government (about 2%) from the bond rate (8.5%) to get to the riskfree rate.

The other inputs remain pretty stable. Betas should measure the business risk of the company. I have never understood the rationale of a widely used practice of using betas against the S&P 500, when doing dollar based analysis, and switching to betas against local indices, for local currency analysis. Those of you who follow my work know that I am firm believer in using sector or bottom up betas. For Ecopetrol, the Colombian company, I estimated a beta of about 0.80, based on the fact that it was an oil company, and used that beta for both US dollar and Colombian peso analysis. Even more dangerous is the practice of using the US equity risk premium, for US dollar analysis, and the much larger Colombian equity risk premium, for peso analysis. The company is a Colombian company and you cannot make the country risk go away by switching currencies. Both the dollar and the peso analysis therefore should use the higher Colombian risk premium.

As a final note, the cost of debt should be in the same currency that you estimate the cost of equity in and this is true no matter what currency the company actually borrows in. Therefore, if the company borrows in US dollars but you are doing your analysis in pesos, you will have to restate the cost of debt in peso terms.

How are my cash flows affected by my choice of currency?
The key rule here is that your cash flows have to be in the same currency as your discount rate. Thus, if you decide to do your analysis in pesos, you cash flows have to be in nominal pesos. If you decide to do your analysis in dollars, your cash flows have to be in nominal dollars. If it is a company with Colombian operations, this will often mean that you have estimate the cash flows in pesos and convert them into dollars. You have to use forward or expected exchange rates (and not the current spot rate) to make the conversion. In fact, if you want to preserve consistency, your expected exchange rate has to be computed from either interest rate or purchasing power parity. In the context of Colombia, for instance, the 2.5% higher inflation in Colombia that I have built into the riskfree rate will translate into an expected devaluation in the peso of about 2.5% a year.


Can I avoid this currency choice altogether?
You could, if you do your analysis in real terms. Thus, your discount rate has to be a real discount rate; the real riskfree rate is about 2% (I used the inflation-indexed US treasury to get this) and you can build the rest of the inputs on top of this rate. Your expected cash flows should be real cash flows; thus, you cannot count the inflation component of growth. Again, if you do it right, you should get the same value.

The bottom line: Make your choice of currencies at the start of the process and stay consistent with that choice all the way through. If you are wrong about expected inflation, it will cancel out - both your discount rates and cash flows will change. If you are inconsistent about inflation, applying one rate to cash flows and another to discount rates, your valuation cannot be salvaged.

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Stock versus Flow: My thoughts

When analyzing companies, the three financial statements that we primarily use are the income statement, the balance sheet and the statement of cash flows. We obtain the inputs for earnings and cash flows from the income and cash flow statements and the numbers for debt, cash and working capital from the balance sheet.

While all three statements are governed by accounting standards and are audited, there is a key difference between them. Income and cash flow statements represent flow statements: they measure how much the company earned and spent over the period. Balance sheets capture the values of assets and liabilities at a point in time and thus represent "stock" statements.

So what? Stock statements are inherently less trustworthy than flow statements, because the numbers may not be representative of what the company did over the course of the year. This can be manifested in almost every number extracted from a balance sheet:

a. Debt: The debt that is reported on December 31 of a fiscal year will reflect what was owed on that day. A company can therefore pay down debt on December 30 and borrow again early the next year, manipulating its debt figures. In fact, there is a story in the Wall Street Journal about banks doing exactly this to make themselves look less indebted and thus safer.
http://online.wsj.com/article/SB10001424052702304830104575172280848939898.html 
Another common way in which debt can be kept off the books is by using lines of credit or seasonal financing during the course of the year but to pay them down by the end of the year.

There a couple of clues that we can use to detect this practice. One is to look at quarterly balance sheets, in additional to the year-end balance sheet, with the intent of finding big changes in debt from quarter to quarter. While enterprising companies may still be able to hide debt, it is much more difficult to do so on a quarterly basis. The other is to look at interest expenses as a percentage of the year-end debt. If a firm has debt for the bulk of the year, it has to pay interest expenses on that debt, even if it retires the debt towards the end of the year. As a result, the book interest rate (interest expense/ book debt) will be disproportionately high (relative to what you would expect the company to pay.

b. Cash: The cash on a balance enters intrinsic valuations as an add-on to the estimated value of the operating assets and relative valuations when we use enterprise value multiples (where cash is netted out of debt). However, the cash balance on the balance sheet may bear little or no resemblance to the actual cash balance today (which is really the number we should be using in intrinsic and relative valuation). This is one reason why some firms actually trade at negative enterprise values, where market equity is updated to reflected today's value but debt and cash remain frozen at year-end values.

c. Working capital: Net working capital is the difference between non-cash current assets (inventory and receivables) and non-debt current liabilities (payables and other accrued liabilities). Any of these numbers can be altered over short periods. For instance, receivable collections can be stepped up and inventory cleared (how about those year end clearance sales) just before balance sheet dates to make working capital look smaller.

In closing, I am not suggesting dynamic balance sheets. That would be too expensive and not quite practical. However, I am suggesting that we be more careful about balance sheet based analysis. Never trust a single balance sheet; if you can get quarterly balance sheets, do so; if you have access to the current numbers (on cash, debt and working capital), even better. The last may seem unrealistic but if you are the acquirer in a friendly merger, you should be able to demand and get this information from the target company.

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Goodwill: Plug Variable or Real Asset?

Of all the items on a conventional accounting balance sheet, none gives me more trouble than goodwill. It is not an insignificant item for some companies, amounting to a large percentage of overall assets, but it does not show up on the balance sheets of other companies. To anyone who encounters it, there are five questions that follow: What is it? Why it is there? What does it measure? Can it change over time? What do we do with it?

What is it?
While goodwill connotes something substantial, it is a plug variable. Note that it shows up on a balance sheet only when a company does an acquisition. Some accounting text books define it as the difference between the price paid for a target company and the fair value of its assets, but that would be a lie. Stripped to basics, goodwill is the difference between the market price paid for a target company and the book value of its assets, with a little fair value modification thrown in for good measure. Thus, if company A pays $ 10 billion for company B, and the book value of company B's assets is $ 4 billion, there will be goodwill of $ 6 billion on company A's balance sheet after the acquisition.

Why is it there?
The answer to that is very simple. Because balance sheets need to balance. There are two fundamental disconnects between market value and accounting book value:
a. Book value reflects historical cost (not current value): An acquisition lays bare one of the fundamental problems with an accounting balance sheet, which is that the values of assets (at least operating ones) are recorded at historical cost, rather than current value. An acquisition of another company is at current market value and has to be recorded as such by the acquiring company. If you cannot write up the values of the acquired company's assets to reflect the price paid, you will have to record the difference as goodwill.
b. Value of growth potential:  The fair value of a company reflects both the value of its existing assets and the expected value of future growth potential. The former is what is captured in accounting balance sheets but market value includes the latter. Thus, when an acquirer buys a target company, it will have to pay a premium on book value (which reflects the value only of existing assets), even if existing assets were fairly valued.
In effect, acquisitions create an inconsistency in accounting. While internal investments made by a firm get recorded at historical cost, acquisitions are recorded at market value. Goodwill then reflects the accounting attempt to make things whole again.

What does it measure?
So, what does goodwill measure? Building on the last part, the goodwill in an acquiring company's balance sheet is a composite of three inputs:
a. Misvaluation of existing assets: As we noted in the last section, if existing assets are misvalued, there will be goodwill even in the absence of growth. Consequently, the more existing assets are misvalued, the greater will be the goodwill.
b. Growth potential: Goodwill be larger, when you acquire a firm with greater growth potential, since the market value will reflect this growth potential but book value will not.
c. Overpayment by the acquirer: There is substantial evidence that acquirers over pay for target firms and this overpayment is attributed to multiple factors - managerial self interest and hubris, over confidence on the part of managers, and conflicts of interests. Whatever the reason, this overpayment, if it occurs, has only one place to go and that is goodwill.
This can be illustrated with a simple example. Assume that company A acquires company B for $ 1 billion and that the book value of company B is $350 million. Assume further that the fair value of company B's existing assets is $400 million and that the value of its growth potential is $ 500 million. If existing assets are not marked up to fair value, the goodwill of $650 million has three components:
the misvaluation of existing assets ($400 - $350), the value of growth assets ($500 million) and overpayment ($100 million).
Accounting changes over the last decade have been directed at addressing the first of these three - misvaluation of existing assets. Thus, appraisers, working under the tight constraints of both accounting standards and tax rules, are allowed to reassess the value of existing assets to better reflect their current value. In the example above, this would lead to existing assets being reassessed to $ 400 million and goodwill to $ 600 million. For the most part, there is little that accountants can do about growth potential, since those assets exist only in investor perceptions.

Can it change over time? 
 To the extent that goodwill is market-based, the value of goodwill will change from period to period. Thus, the value of existing assets and existing assets can change from year to year and the overpayment has to be recognized at some point in time. Until a decade ago in the US and still in most parts of the world, these reassessments of goodwill are put on auto pilot, with goodwill being amortized over 30 or 40 years, irrespective of the facts on the ground.
In the last decade, accountants have argued that the value of goodwill can be reassessed to reflect changes in the three components and the change should be reflected in earnings. While the amortization or impairment of goodwill tries to reflect this reassessment, there are three issues in how it is done:
a. Timing lag: To make their assessment of whether and how much to reassess goodwill, accountants look to markets. Thus, the goodwill accrued by Time Warner from the acquisition of AOL was impaired by $54 billion in 2002, but only because technology stocks had collapsed in the market in the previous two years.  Since everyone in the market already had made this adjustment, the actual impairment of goodwill was treated by the market as being of no consequence.
b. Unidirectional: Goodwill impairments almost always seem to lower the value of goodwill. If this were a fair reassessment, you should see a significant number of companies where the value of goodwill gets assessed upwards.
c. Composite adjustment: The impairment of goodwill is provided as one number, when it includes reassessments of existing asset values, growth potential and overpayment. Since the implications of each are different for valuation, it is one more reason why goodwill impairment is not a particularly useful piece of information.
In summary, goodwill impairment has become an earnings management tool for many companies rather than a test of fair value changes. In the process, it has lost its informational content and is of little help to investors.

What should we do with goodwill?

Here is the million or billion dollar question. Assume that you are valuing a company with a significant goodwill item on its balance sheet. How should it affect the way in which we value or view the firm?
a. Book capital and Earnings: The minute a company acquires another company, the characteristics of book equity and capital change. Rather than reflect just historical values (which is the case when a company has only internal investments), they incorporate market values for at least the target company's assets. Thus, book capital for an acquisitive firm includes the three components mentioned above for a target firm - a mark-to-market of existing assets, growth assets and overpayment. Since the rest of the acquiring firm's assets remain at their old values, the resulting book equity and capital is inconsistently defined. Earnings are also contaminated for a different reason. The impairment of goodwill can cause big swings in earnings from period to period. Since earnings and book capital are the key inputs into return on equity and return on invested capital (ROIC), the presence of goodwill can dramatically alter these returns.
To correct for goodwill, many  analysts adopt the policy of ignoring it all together in the computation. Thus, return on capital is measured as:
ROC = Earnings before goodwill amortization/ (Book value of capital - Goodwill)
However, I have a paper on measuring returns where I have argued that while it is perfectly reasonable to net out the first two components of goodwill - misvaluation of existing assets and growth potential- from book capital, overpayment should not be netted out. In effect, companies like Time Warner should not be allowed to wipe out their mistakes and return their capital to pre-mistake levels, since stockholders have paid the price for these mistakes. Of course, separating out what portion of the goodwill is for overpayment is tough to do, but we need to make an effort. (I propose that we call this stupid goodwill and contrast it with smart goodwill)
b. Valuation: In a discounted cash flow valuation, goodwill really has no direct effect, since we estimate the value from expected future cash flows. Those cash flows will reflect the true value of existing assets and growth potential. Thus, it is in incorrect to add goodwill on to a DCF value, since it double counts these values. If you are doing asset based valuation, where you try to estimate current market values for individual assets on the balance sheet, it becomes trickier, since goodwill is not a conventional asset. Here, there is no easy way out. You have to either take the accounting estimate of goodwill as a fair value or estimate the value of future growth (which would require a DCF). In relative valuation, goodwill does not really affect much if you are using operating income multiples (Operating income or EBITDA is pre-goodwill amortization anyway) but it can affect equity earnings multiples (PE ratio or PEG ratios), since those earnings per share can be affected by goodwill charges. Goodwill can become a problem with book value based multiples. In effect, if you do not adjust for goodwill, companies that do a lot of acquisitions will have lower price to book and EV to Book ratios (and thus look cheaper) than companies that grow with internal investments.
One final thought. Given that goodwill, as an item, really changes nothing about the underlying assets and their value, no company should make or change decisions based upon the accounting measurement and treatment of goodwill. If you pay too much for a target company, what accountants do with or to goodwill cannot undo the damage already done.

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Accounting inconsistencies

In the next few posts, I plan to focus on the accounting inconsistencies that bedevil analysts. In particular, here are the items that I will highlight:

1. Goodwill: When a company acquires another, goodwill shows up on the balance sheet of the acquiring company. While the name connotes something of substantial value, goodwill as it is currently computed is really a plug variable, designed to make the balance sheet "balance". Goodwill skews book values of equity and capital and wreaks havoc on earnings.

2. Minority interests: This is perhaps the most misleading item on a balance sheet, at least to the non-accountant. While it suggests something of value that you own (an asset), it is a by-product of another accounting practice termed consolidation. In effect, a company that owns more than 50% of another is required to "consolidate" its financial statements and report 100% of that subsidiary's earnings, capital and assets as its own. Minority interest reflects the value of equity in the subsidiary that does not belong to the parent company and is thus a liability. Not only is the treatment of minority interest a problem in discounted cash flow valuations but it is also an issue when computing enterprise value and related multiples.

3. Investments in other companies: With a firm with minority holdings in other companies (less than 50%), accountants face a different issue. What is the value that should be attached to these holdings on the balance sheet? Unfortunately, there is no one template in accounting and these holdings are sometimes shown at original cost (what was paid to acquire the holdings), sometimes at an updated book value (reflecting retained earnings since acquisition) and sometimes marked to market. Thus, an unsuspecting analyst can make significant mistakes in valuation, if he or she makes an incorrect assumption about accounting treatment.

4. Extraordinary gains and losses: This should be simple, right. Any items that do not comprise regular operating income or earnings should be consigned to this line item. If that were the case, dealing with extrardinary items would be simple. Since they are extraordinary, we can assume that they will not occur in the normal course of events and ignore them. In practice, though, companies use extraordinary income (expenses) for line items that are recurrent but with shifting effects (exchange rates gains and losses), related to operating adjustments (restructuring charges) as well as a device to show higher operating earnings (by shifting operating expenses into the extraordinary expense column). Thus, separating the truly extraordinary from the ordinary has consequences for both discounted cash flow valuations (by changing base earnings) and earnings multiples (PE ratios, EV/EBITDA etc.)

5. Deferred taxes: Deferred taxes can show up either as assets or liabilities. A deferred tax asset reflects a company's belief that it has paid too much in taxes over prior periods and can thus expect to get tax relief in future periods. A deferred tax liability is a measure of the opposite - a company that has been able to use the tax code to good effect and paid less in taxes (legally) than it should have (assuming the statutory tax code were applied to taxable income) can reasonably expect to pay higher taxes in future periods and has to show this as a liability. While the logic for both items is impeccable, it is worth noting that they reflect expectations of future tax savings (in the case of deferred tax assets) and tax liabilities (in the case of deferred tax liabilities). There is no contractual obligation or time line for these expected cash flows and that can create problems in valuation.

6. Intangible assets: In the last decade, accountants have discovered that accounting standards are not consistent about how they deal with intangible assets as opposed to tangible assets. The rules on capitalizing the latter are well established and the assets on a manufacturing firm's balance sheets reflect the firm's investment in land, buildings and equipment. For firms with intangible assets, which can range from technological prowess (Google) to brand name (Coca Cola) to patents (Amgen), the treatment of the assets has generally been benign neglect. As a consequence, the earnings and book capital at these firms is skewed and can affect both intrinsic and relative valuations.

7. Leases: The biggest source of off-balance sheet debt in the world is leases. A firm that leases its assets (rather than borrowing money and buying these same assets) can hide these assets (and the implicit debt in these assets) if it can meet the accounting requirements for lease expenses to be treated as operating expenses. As a result, we understate the debt ratios of retail firms and restaurants and misvalue these firms.

While the accounting logic behind the treatment of each of these items make sense to accountant, I think that they lead to poor measures of earnings and value. The post that highlights each item will examine not only the potential problems created by the current accounting treatment but also present  solutions to those problem.

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