How Does Goodwill Affect Stock Prices?

How does goodwill affect stock prices? The Oracle of Omaha, Warren Buffett’s many comments on investing include: “If a business does well, the stock eventually follows.”

Stock prices, more than anything, are affected by how well a company succeeds at doing business. Is it making profits, growing in value and size, expanding its opportunities? Are all its efforts attracting the attention of investors?

Investors may wonder whether those efforts carry over to a company’s goodwill. Does the goodwill that a company believes it has affect the prices of shares positively or negatively? Read on to find out.

Key Takeaways

• Goodwill is the financial amount that is paid during an acquisition that is beyond the book value of a company.
• It adds to the overall value of a company.
• Companies with substantial goodwill can attract investors because goodwill can indicate the potential for future profits.
• Stock purchases based on the perception of highly valued goodwill can push a stock price higher.
• Sometimes goodwill impairment, as well as goodwill recognition, can prompt the purchase of stock and stabilize share price or drive it upward.

Goodwill’s Effect on Stock Prices

There tends to be an unclear relationship between a company’s goodwill and its stock price. Company share prices have at times and in certain situations responded differently to news related to goodwill.

This can be due to its write-down, impairment, positive expectations of goodwill value, or other factors.

Stock Prices Can Rise on Goodwill Recognition and Impairment

However, research shows that the goodwill that’s determined by acquisitions results in stronger stock prices. Its value can be perceived to project future cash flows. This indicates that the value of goodwill suggests future economic benefits.

Thus, the higher the value of goodwill, the greater the perception of growing wealth, and the more likely the upward movement of stock price due to investor buying.

In addition, a study of block shareholders found that goodwill recognition and goodwill impairment cause stock price fluctuations. In cases of goodwill impairment, especially when the impairment is significant, stakeholders buy more shares, increasing a stock’s price, to reduce the volatility of prices.

They do this especially when there is abundant private information (controlled by private sources rather than the state) to indicate positive future results due to a merger or acquisition.

Important

A company with highly valued goodwill can attract investors because those investors believe that the company is capable of generating higher profits in the future.

Goodwill Defined

If a company has a strong brand name, noteworthy customer loyalty, and a great reputation, it has goodwill.

The value of goodwill is subjective, especially when a company tries 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.

Where acquisitions are concerned, this goodwill can be given a financial value. It is the financial premium paid over and above the book value of assets when a company is bought.

Goodwill = Acquisition Value – Value of Tangible Assets

Highly valued goodwill can support the perception of the future growth of company value. It can drive investor confidence and interest in a company. This can result in greater buying of a company’s shares, pushing a stock’s price higher.

FASB Actions, Goodwill, and Stock Prices

In 2001, FASB (the Financial Accounting Standards Board) abolished the amortization of goodwill, which led to an increase in a given company’s EPS. This boosted 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 would be amortized and tested for impairment when the need arose. Again, the effect on share prices was 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.

Note

To become bigger and grow their value, companies are often on the lookout for potentially profitable mergers and acquisitions. These deals involve a lot of money and risk, as future profits sometimes may not justify the price paid for a company.

Does Goodwill Sometimes Push Stock Prices Lower?

It can, if it is impaired significantly. Or news or events harm a company’s outlook, for example, for attractive profit potential.

What Is Goodwill Impairment?

Goodwill impairment occurs when the assets that a company bought in an acquisition become unable to produce expected cash flows and the value of goodwill drops below the book value.

Is the Value of Goodwill Just an Estimate?

Typically, yes. The actual financial value assigned to goodwill is based on subjective values. But you’ll see a specific financial figure for it when you examine the purchase price of a company in an M&A transaction. That’s because it is defined as the difference between the price established by the seller—the market value—and the company’s identifiable net tangible assets. It is a specific premium which the buyer pays.

The Bottom Line

Are stock prices affected by goodwill? Investors react differently to every situation. In general, news of an acquisition, which means expansion for a company, tends to boost stock prices. Conditions that show loss of goodwill can dampen prices.

The visible reaction of investors to goodwill-related accounting announcements is usually short-lived, and the real impact is seen over a period of time.

Overall, one might conclude that investors tend to look beyond the goodwill factor and focus on cash flows, revenue generation, and dividends. However, research has shown that goodwill that indicates positive future growth and economic benefits can move share price upward. And in some cases, so can goodwill impairment.