Equity Valuation Models and Measuring Goodwill Impairment

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AAA Financial Accounting Standards Committee

INTRODUCTION

The FASB faces two main issues in its project on business combinations. The first involves determining whether two separate methods of accounting for business combinations--purchase and pooling of interests--are justified, and the second is determining the appropriate method of charging to income the cost of purchased goodwill and other purchased intangibles. In December 2000, the FASB announced its tentative decision to require that acquisition goodwill be periodically tested for impairment and not be subject to systematic amortization. The following month, the FASB announced its tentative decision to eliminate the pooling of interests method of accounting.

In this article, we focus on the issue of goodwill impairment testing. There are two main points of discussion on this issue. The first is whether impairment testing rather than systematic amortization is the appropriate accounting treatment for acquisition goodwill. The second is whether impairment testing for goodwill is a feasible alternative; that is, whether one or more methods exist to assess the post-acquisition value of goodwill. The purpose of this commentary is to summarize the available valuation models and to discuss their potential application to the valuation and testing for impairment of acquisition goodwill. [1] We do not address the first open issue of whether impairment testing is more appropriate than systematic amortization of acquisition goodwill.

BACKGROUND ON VALUATION MODELS

The dividend discount model (DDM) of Williams (1938) provides the basis for most equity valuation models. In the DDM model, the value of the firm's equity, V, is equal to the present value of all expected future dividends, DIV, discounted at the firm's cost of equity capital, [r.sub.e], which is generally assumed constant through time:

[V.sub.0] = [[[[sigma].sup.[infinity]].sub.[tau]=1] [E.sub.0]([DIV.sub.[tau]])/[(1+[r.sub.e]).sup.[tau]]. (DDM)

Time periods are subscripted with [tau] and the current date is denoted as time 0. The key ingredients necessary to apply the DDM are dividend forecasts and an estimate of [r.sub.e]. Both academics and practitioners generally agree that the DDM provides the appropriate conceptual basis for all equity valuation models.

Discounted Cash Flow Model

Despite its theoretical appeal, the DDM is difficult to apply, particularly over long horizons for firms that do not pay significant dividends. As a result, alternative forms of the DDM emerged with the goal of improved practical implementation. Both practitioners, such as investment banks issuing fairness opinions, and academics apply these models. The most commonly used model is the discounted cash flow (DCF) model because of its direct link to the finance theories of Modigliani and Miller (1958). Most specifications of the DCF model require estimates of free cash flow (FCF). FCF is the cash flow available for distribution to a defined set of capital providers after all operating and investing needs of the firm are met. Although the DCF model has many variants, FCF in the most commonly applied version is defined as the cash flow available for distribution to both debt and equity-holders, and the discount rate is the weighted average cost of capital (WACC). [2] This model estimates the value of the sum of t he debt and equity of the firm; the market value of the firm's debt net of the firm's excess cash must be subtracted from the total value of the firm to obtain the value of the equity. [3]

Because of the inherent difficulty of projecting FCF indefinitely into the future, users of DCF models typically forecast FCF through a specified terminal date, and estimate the terminal value of the net debt plus equity, [V.sub.T]+ net [debt.sub.T], separately:

[V.sub.0] + net [debt.sub.0] = [[[sigma].sup.T].sub.[tau]=1] [E.sub.0]([FCF.sub. …