Warren Buffett once said: “If a business does well, the stock eventually follows.”
Stock prices, more than anything, are affected by how a company is doing its business. Is it making profits, growing, expanding? In an attempt to become bigger, companies are always on the lookout for profitable mergers and acquisitions. These deals involve a lot of money and risk, as future profits sometimes don't justify the price paid for such deals.
Every kind of buy and sell involves several factors that figure into the price, especially deals that run into millions of dollars. The tangible assets (such as land, buildings, machinery, and so on) have a price tag on them. So do most of the identifiable intangible assets (such as licenses, patents et cetera). But what about the unidentifiable intangible assets such as goodwill? How does one calculate the value of reputation or brand loyalty? The value is pretty subjective, especially when a company is trying to estimate its own goodwill. Its value is revealed when a company is bought or sold, as it is the extra amount paid over and above the fair value of assets.
Thus, goodwill can be defined as the premium paid over and above the book value of assets during the acquisition of a company by another. If the company being bought has a strong brand name, customer loyalty, and good reputation, the goodwill value paid for it will be at a premium.
Goodwill cannot be sold or purchased independently of the company, and its value is tagged to a company’s performance and market events, which in turn steer investor confidence along with guiding the evaluation of stock prices. A company with high goodwill tends to attract investors, as it makes them believe that the company is capable of generating higher profits in the future.
Analyzing trends and cases from the past reveals an ambiguous relationship between a company’s goodwill and its stock prices. Company share prices have at different times, and situations responded differently to news related to goodwill—it may be due to its write-down, impairment, positive expectations of goodwill value or other factors.
Back in 2001, FASB (the Financial Accounting Standards Board) abolished the amortization of goodwill, which led to an increase in a given company’s EPS, a factor that boosted the average share prices but only for a short time. Investors soon realized that amortization doesn’t really affect cash flow or operations, and thus things returned to normal. Of course, a few companies' share prices dropped on the news. In early 2014, FASB announced new alternative rules for private companies according to which goodwill will be amortized and also tested for impairment when the need arises. The effect of amortization changes in goodwill on share prices is usually temporary and not severe.
The outcome of impairment loss and write-downs on share prices depends on whether the market has already factored in the likelihood of such an event based on any management disclosures. In January 2002, Time Warner announced a massive $54 billion write-off in goodwill. The stock price was slightly higher on the day of the announcement, as the market had already anticipated such an event. But the company's stock had corrected by 37% of its value over the six-month period preceding the announcement. This proves that investors did not take the news positively. However, the response was spread over time and was triggered when such news was brewing.
Interestingly, this process also works the other way around, where stock price declines can trigger the need for an impairment test of goodwill. This is mainly because in goodwill testing for impairment, the market capitalization of the company is relevant and decreases with a fall in share prices.
The Bottom Line
Investors react differently to every situation. No strong or clear-cut evidence links goodwill to stock price movement. But in general, news of an acquisition, which means expansion for a company, tends to boost stock prices. Conditions that show loss of goodwill tend to act as a dampener. The “visible reaction” of investors to such announcements is usually short-lived, and the “real impact” is seen over a period of time. Overall, it is best to conclude that investors tend to look at companies beyond the “goodwill factor” and focus on cash flows, revenue generation, and dividends.