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By: David Turney, CFA
Intrinsic has performed hundreds of purchase price allocations over the past few years and, usually, the rate of return assigned to goodwill is the highest among the assets in the weighted average return on assets (WARA) analysis. However, this idea can be challenged in certain situations. This post is not intended to be an in-depth review of the weighted average cost of capital (WACC) or a WARA analysis, but some background is required to support the concept of an appropriate rate of return on goodwill.
Within a WARA analysis, the risk profile of each asset class, or category, should be considered when estimating the appropriate rates of return. In addition, the analysis should consider the liquidity of the assets on the balance sheet on a spectrum from working capital (most liquid) to the intangible assets (least liquid). The Appraisal Foundation notes that “…the risk profile of an entity’s assets generally increases as you move down the balance sheet and, accordingly, the type of financing available for these assets shifts from debt to equity as the risk profile increases. For example, low risk assets such as working capital can usually be financed largely with debt and, as such, a short-term borrowing rate such as the prime rate often can be used to estimate the cost of debt component of the return requirement for this asset. On the other hand, the risk profile of intangible assets is often much higher and, as such, these assets are typically financed largely with equity.”
Given the interrelatedness of the WACC and the WARA, the WARA should result in the same discount rate as the WACC. In theory, the operations of the acquired company (discounted at the WACC) are considered fundamentally equivalent to the combined assets of the acquired company (discount rates estimated via the WARA). Therefore, a comparison of the WACC to the WARA should reconcile the rates of return required by providers of capital with the rates of return required by the various classes of assets on the balance sheet.
The WACC reflects required rates of return for all assets, regardless of risk profile. This includes less risky assets, such as net working capital and other fixed assets, as well as the required rates of return for riskier assets, such as intangible assets (identified and goodwill). When considering the hierarchy of risk across the spectrum of assets on a balance sheet, it is typically assumed that goodwill would require the highest rate of return. However, the Appraisal Foundation notes that “the rate of return on goodwill depends on the relative values of the other (identified) assets, their respective rates of return, and the nature of the risk inherent in the goodwill itself.”
The most common case we encounter where the goodwill rate of return might approach the WACC is an early stage technology company. In this scenario, the financial projections contemplated in determining the purchase price contain significant expected growth over the projection period. Further, a substantial portion of the growth (and resulting business value) tends to be related to assets that are subsumed in goodwill (e.g., future customer relationships, future intellectual property, assembled workforce, synergies, etc.). These companies usually have minimal (or negative) low risk assets, such as net working capital and other tangible assets, and low (or no) debt in the capital structure. Conceptually, if most of the business value is expected to derive from attributes of goodwill and the WACC is equivalent to the WARA, a required rate of return for goodwill near, or equal to the WACC, can be justified. Said another way, if the WACC reflects required rates of return for all assets and most of the acquired assets are goodwill, then the required rate of return for goodwill needs to be near, or equal to the WACC, for the WARA and WACC to balance.