Cash Is King On October 1 1974

-12 -6 0 6 12 Months from the date of accounting change

-12 -6 0 6 12 Months from the date of accounting change

Souric; i. Sunder, "The Relationship Between Accounting Changes and Stock Prices: Problems ol Measurement and Some Empirical ["viil ence ,nl Empirical Research in Accounting: Selected Studies (1973): 18.

to increased cash flow, which is what the DCF model predicts. After adjusting for movements in the broad market and other contemporaneous effects, companies switching to LIFO experienced significant share price increases, while firms switching to FIFO saw share price declines (see Exhibit 5.6). In fact, Biddle and Lindahl2 (1982) found that the larger the reduction in taxes resulting from the switch to LIFO, the greater the share price increase attributed to the change.

Much more topical than the LIFO-FIFO debate are accounting standards for mergers and acquisitions. In the United States, a transaction accounted for as a purchase requires that the difference between the price paid for the target and the book value of its assets (with some adjustment) be recorded as goodwill, and amortized over a period of up to 40 years.

2 G. Biddle and F. Lindahl, ''Stock Price Reactions to LIFO Adoptions: The Association Between Excess Returns and LIFO Tax Savings," Journal of Accounting Research, vol. 53 (1982), pp. 548-551.

Exhibit 5.7 Market Reaction to Purchase and Pooling Transactions

Exhibit 5.7 Market Reaction to Purchase and Pooling Transactions

Under pooling-of-interests accounting, the acquisition is reported at book value with no goodwill or amortization. Goodwill is generally not deductible for tax purposes so the acquiring company's cash flow will be the same regardless of the accounting method. Reported earnings will be higher under pooling accounting because there is no goodwill to amortize.3

There is a common perception that the market mechanically accepts the earnings impact of transactions. So investors should view more favorably deals treated as a pooling of interests. But Lindenberg and Ross4 have shown that the reverse is true. Analyzing more than 1,400 transactions, they found that the market responded positively to the purchase transactions paid for in cash, negatively to the pooling transactions, and was neutral about purchase transactions paid in shares, as shown on Exhibit 5.7. The authors hypothesize that the negative reaction to pooling may reflect the following:

• The market's view that pooling acquirers have less purchase price discipline than do purchase acquirers.

3 The Financial Accounting Standards Board has proposed eliminating pooling of interests accounting for transactions completed after December 31, 2000.

4 E. Lindenberg and M. Ross, ''To Purchase or to Pool: Does It Matter?" Journal of Applied Corporate Finance, vol. 12, no. 2 (summer 1999), pp. 32-47.

• The market's realization that the pooling acquirer will be unable to implement value creating activities, such as spinoffs or asset sales, or to conduct nonroutine stock buybacks in the near future.5

• The revelation that the management of the acquirer cares more about accounting cosmetics than financial flexibility.

Lindenberg and Ross go one step further and test whether companies with goodwill amortization are valued differently than other companies. If the market sees through goodwill, then price-earnings multiples should be much higher for companies with lots of goodwill amortization relative to other companies. This is because goodwill amortization reduces earnings, yet is not a cash charge. On the other hand, valuation multiples based on a cash flow measure like EBITDA (earnings before interest, taxes, depreciation, and amortization) should be in the same range as other companies in the same industry. The authors examined 3,633 companies and found that, as expected, companies with goodwill had higher PE ratios but not higher EBITDA multiples.

An interesting example of the goodwill issue was the 1995 acquisition of First Interstate Bank by Wells Fargo.6 One analyst was quoted as saying that the "Wells offer was futile" because it would be accounted for as a purchase, while a competing bid from First Bank System had the advantage of a pooling of interests. But the market ignored the conventional view of the analyst and chose Wells Fargo's bid despite $400 million per year of goodwill amortization. In fact, Wells Fargo's share price went up 3 percent on the day it was announced that its bid had prevailed and more than 20 percent during the next 10 trading days.

The other side of the coin is the story of AT&T's acquisition of NCR in 1991. Lys and Vincent concluded that AT&T incurred additional costs of $500 million to get NCR to agree to terms that would allow the telephone giant to do pooling accounting (primarily by agreeing to pay a higher price in exchange for NCR's removing obstacles to pooling). The authors estimated that the market value of AT&T fell by $4 billion to $6 billion during the merger negotiations.7 You could infer that AT&T's insistence on pooling made the market even more skeptical about the value creation potential of the transaction.

5 These actions are prohibited for several years under pooling accounting.

6 M. Davis, "The Purchase vs. Pooling Controversy: How the Stock Market Responds to Goodwill," Journal of

Applied Corporate Finance, vol. 9, no. 1 (spring 1996), pp. 50-59.

7 T. Lys and L. Vincent, "An Analysis of Value Destruction in AT&T's Acquisition of NCR," Journal of Financial

Market Focuses on Long Term

A lot of confusion about how the market evaluates accounting earnings has to do with the time frame of investors. Many managers believe that the stock market focuses too narrowly on near-term earnings. They believe that the market does not give credit for long-term investments. A quick look at the high values the stock market has placed on emerging Internet companies, without any earnings or even any products to sell in many cases, should be evidence enough that the market takes a long view. In October 1999,'s stock market capitalization was $23 billion. Yet, as of that date, Amazon was still reporting accounting losses. (See Chapter 15 for a discussion of the valuation of very high growth companies.)

In this section, we summarize research showing that the market does take a long-term perspective. You may note that some of the research is more than 10 years old. In the academic community, this issue has been settled for some time, so academics have no more interest in pursuing it.

A simple test of the stock market's time horizon is to examine how much of a company's current share price can be accounted for by expected Exhibit 5.8 Present Value of Expected Dividends for 20 Fortune 500 Companies, December 1997


Present value of dividends expected aver the next five years

Share price Dividends as percentage of stock price


American General


Be I lAt Ian tic







Hewlett-Packard Kellogg

Lockheed Martin McGraw-Hill Nordstrom PPG Industries Procter & Gamble Reynolds Metals United Technologies Wachovia Corporation Xerox

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