Using Bloated Stock for M&A Is Costly

A company that uses overpriced stock in an acquisition often is nagged over the long term by poor returns, and may well be subjected to big goodwill write-offs and investor litigation later on.

That’s the conclusion of a study, titled "Overpriced Shares, Ill-Advised Acquisitions, and Goodwill Impairment," that appears in the current November issue of the American Accounting Association’s publication, The Accounting Review.

The Review article is written by the distinguished analytical accounting team of New York University’s Baruch Lev and State University of New York at Buffalo’s Feng Gu, who contend that it is often argued by academics and practitioners “that when a firm's shares are overpriced, it is beneficial to current shareholders to acquire businesses, and even overpay for them, as long as the overpayment is lower than the bidder's share overpricing."

Say the authors:  "We show that this is not the case. Corporate acquisitions with overpriced shares -- many leading to goodwill write-offs -- exacerbate the post-acquisition negative returns beyond the overpricing correction."

Misunderstanding Goodwill

Some of the argument hinges on their contention that there’s much misunderstanding surrounding goodwill, the accounting treatment for the amount a buyer pays in excess of the acquisition’s fair value in the time before it realizes hoped-for earnings benefits from M&A synergies. They consider a goodwill write-off not some rational employment of overpriced shares – a mere byproduct of the process -- but, rather, "a very consequential event...an important indication of a flawed investment strategy."

One example cited is eBay's 2005 purchase of Skype, the Internet phone company, for $2.6 billion, half of which consisted of eBay stock that had been climbing sharply in value -- three and a half times the rate of the S&P 500, in fact -- the previous two years. The authors observed that "things soon turned ugly” for eBay, which in October 2007 announced a $1.43 billion goodwill write-off from the Skype acquisition. EBay CEO Meg Whitman retired soon in January 2008.

"Similar stories have become depressingly frequent," according to Prof. Gu, who notes that the percentage of U.S. firms reporting goodwill in their financial statements rose from about 25% in 1990 to about 33% in 2000 to about 50% in 2009. As the study put it, "EBay's chain of events from overpriced shares through stock-financed acquisitions and ultimately to substantial goodwill write-offs is, in fact, a general phenomenon."

Weak Governance a Factor

Profs. Lev and Gu found that, when they divided their sample into quintiles, from lowest to highest relative pricing, the payment in stock among the most overpriced group resulted on average in a 17% increase in goodwill on their books compared to a mere 4% increase among the least overpriced firms, suggesting the extent to which the former group tends to overpay. (Among cash-paying firms, such a disparity in goodwill increase wasn't observed.) The most overpriced firms also took write-offs that were as much as 13 times higher in goodwill than were the least overpriced firms. Lawsuits also were more likely when stock was the deal currency.