Price-to-earnings multiples and mergers and acquisitions.

EXECUTIVE SUMMARY

This paper examines the assertion that the financial market pays fixed PE multiples and that the recognition of goodwill and subsequent amortization depresses earnings and stock prices, putting U.S. firms in a competitive disadvantage in the international merger and

INTRODUCTION

The fierce debate and controversy over pooling and purchase has at last come to a conclusion with the issuance of the two new FASB statements eliminating the use of pooling method for business combinations, and changing the rules for goodwill amortization. The objectives, according to FASB, are to better reflect the investment made by an acquired entity, to improve the comparability of reported financial information, and to provide more complete information. The focal point of the issue is goodwill. Goodwill is the difference between the compensation paid and the fair value of the acquired company's net assets. As goodwill is recognized as an asset and assets wear out, goodwill must be amortized with a regular charge against earnings. A dollar of amortization reduces reported earnings by a dollar. An acquiring company that acquires a lot of goodwill and who accounts for it on the balance sheet is also acquiring a drag on future earnings.

Theoretically, goodwill should equal the premium the buyer pays over and above the fair market value of all the acquired company's assets. In reality, acquirers seldom fix a value on the intangibles. Instead they appraise the tangible assets and dump everything else into goodwill. That makes goodwill critically important in deals involving knowledge companies, especially high-tech, e-commerce firms, and pharmaceutical and biotech target firms, all of whom virtually owe their entire purchase price to intangibles, such as goodwill. Prior Accounting rules arbitrarily assign this catch-all category a useful life that can be as long as 40 years, which then means that the value of goodwill must be amortized or written off for that period.

Cisco Systems, Inc. and many high-tech companies used pooling of interest method to account for acquisitions of both big well-established and small low-revenue start-up companies. By taking advantage of pooling, Cisco avoided recognizing goodwill and subsequent amortization, which, they believe, would have otherwise depressed its earnings and penalized its market value for years to come. Pooling is believed to have helped companies like Cisco take risks and remain competitive in a fast-changing world (Roberts, 1999). No wonder FASB's proposal to eliminate pooling of interest method met with such strong opposition from businesses, especially high-tech giants, which lobbied heavily for congressional intervention. Cisco declared that FASB's ban on pooling will "stifle technology development, impede capital formation and slow job creation in this country," which will be detrimental to the technological innovation and the entrepreneurial drive of the leading position of U.S. in the world (Beresford, 2001).

On the other hand, academic researchers generally support the position held by FASB in the two new statements 141 and 142. Accounting profit is only an artifact. The use of either pooling of interest or purchase methods for business combinations and the subsequent amortization of goodwill do not change the economic substance of the business transaction and should have no significant effect upon a company's stock price in a positive or negative manner, if the market is efficient as it is generally believed.

This study examines high-tech companies' claim that the financial market pays fixed PE multiples. It is hypothesized that the capital market adjusts the coefficient on earnings according to the inclusion or exclusion of goodwill amortization and amortization expense does not have incremental information content. The simple earnings capitalization model is used and stock prices are regressed against traditional earnings per share, the new or so-called cash earnings per share that excludes amortization of goodwill, and the new or so-called cash earnings per share and amortization expense together respectively. Evidence indicates that PE multiples are adjusted downward (upwards) proportionally because of the exclusion (inclusion) of amortization expense. Test results support the position of FASB to eliminate the use of pooling method for business combinations and change the rules for goodwill amortization.

Section 2 reviews the related literature. Section 3 describes the data and presents the results of the empirical tests. Section 4 concludes.

ACCOUNTING FOR MERGERS AND ACQUISITIONS

High tech companies, such as Cisco Systems, Sun Microsystems, and America Online, use extensively pooling of interest method to acquire smaller companies. Their opposition to the elimination of the pooling of interest method is based on the concern over the way investors and financial analysts value companies on their earnings per share and price/earnings ratios. They argue that goodwill amortization from the purchase accounting method depresses earnings per share and thus penalizes firms' stock prices (Lindenberg et al., 1999). They go even further by asserting that the recognition of goodwill and subsequent amortization put U.S. firms in a competitive disadvantage in the international merger and acquisition arena (Vincent, 1997).

The controversy over the elimination of pooling method and high tech firms' strong opposition has aroused great research interest regarding the information content of earnings and the efficiency of the capital market. Based on a sample of fifty-seven purchase transactions and thirty-five pooling transactions during the 1979-1986 period, Vincent (1997) examines whether the difference between the two accounting methods for business combination is reflected in stock prices for one method and not the other. His model is based on the theory that share price can be expressed as a weighted average of the firm's book value of equity and its accounting earnings. Findings of the study are inconsistent. There is evidence that pooling firms enjoy an equity valuation advantage over purchase firms, but there is no consistent evidence to link this advantage to the differences in financial reporting.

Studying the explanatory power of three currently available earnings measures, basic earnings per share, primary earnings per share, and fully diluted earnings per share and whether any one is better than the other two, Balsam and Lipka (1998) run regression on the simple earnings capitalization model with the annual data from Standard and Poor's Compustat database of corporate annual report for the years 1975 through 1993. Their findings are consistent with the current literature that all three measures provide investors with useful information in valuing stock prices. Specifically, they find that reporting two measures is more informative than reporting one, and the new standard for basic earnings per share and diluted earnings per share is as informative as the old standard requiring primary earnings per share and fully diluted earnings per share.

With regard to the claim that the market values firms based on a fairly rigid price/earnings multiple, Lindenberg et al. (1999) argue that purchase or pooling and goodwill amortization are simply accounting artifacts, and have no effect on a firm's future cash flows. According to modern finance theory, the choice of purchase or pooling and amortization or not should have no effect on market prices. Their data set includes more than 3,000 companies and over 1,000 mergers and acquisitions from 1991 to 1999. The results from their regressions show that earnings, due to goodwill amortization, does not affect stock prices and thus pooling should not be viewed as favorable because it avoids goodwill amortization. They also find that, contrary to common belief, price/earnings ratio expands by a sufficient amount in response to amortization, making amortization irrelevant to stock valuation. Moehrle et al. (2001) investigate the information content of various earnings measures, traditional earnings before extraordinary items, the new FASB proposed earnings before amortization, and cash flow from operations, and the relative explanatory power of each measure for market-adjusted returns. They find that the traditional earnings before extraordinary items and the new FASB proposed earnings before amortization, or the so-called "cash earnings" by First Call, are equally informative, even in cases where amounts are substantially different. They conclude in supporting FASB's revised position to eliminate pooling and to change the way of goodwill amortization.

This study examines the claim that market pays a fixed multiple to earnings and depressed earnings due to goodwill amortization depresses stock prices. Following Moehrle et al. (2001), we construct the new earnings per share, often called "cash earnings per share," to distinguish from the traditional earnings per share, by adding back the amortization of goodwill and other intangible assets to the reported traditional earnings per share after taxes but before extraordinary items. Based on prior research, we use the simple earnings capitalization model and regress stock prices against traditional earnings per share and the new or cash earnings per share respectively. We focus on high tech companies since they are fiercely opposed to FASB's new position on eliminating pooling method. If we find significant association between firms' market price and the new earnings per share before amortization, the claim that market pays a fixed multiple to earnings and depressed earnings due to goodwill amortization depresses stock prices will be rejected and FASB's position supported.

SAMPLE AND TEST RESULTS

Table 1 is a description of the industries in the sample in the three-digit SIC code. Sample for the high tech companies include firms in the drug, computer, networking, and telecommunication industries. These industries are also believed to be among the most active in business combinations and have relatively bigger expense on amortization of intangibles.

All variables in this study are measured on a per share basis using data from Standard & Poor's 2001 Compustat Research Insight. Firm-year observations are eliminated of which (1) December is not the fiscal year end, (2) stock price three months after the fiscal year end is missing or negative, (3) earnings per share data is missing, and (4) amortization expense of intangibles is negative or zero. We further delete firms reporting negative earnings (Balsam and Lipka, 1998). Negative current earnings post a difficult theoretical dilemma since the simple earnings capitalization model indicates that investors pay a certain multiple for current earnings. Researchers argue that the model is misspecified for loss firms and suggest alternative value variables such as book value of equity (Hayn; 1995, Collin et al., 1997; Burgstahler and Dichev, 1997). The data set spans from 1990 to 1999, as this is the period that high tech companies are at their peak growth and the activities of business combinations are unprecedently hectic. After data treatment, we have a total of 1,096 usable firm-year observations. The ten-year mean of the reported net income (per share) after taxes but before extraordinary items is $0.761, while that of the new net income (per share) after taxes but before extraordinary items and before amortization of intangibles is $0.857, indicating that the mean amortization of intangibles is a substantial 13 percent of the reported traditional net income. (1)

We report, in Table 2, the results of regressing stock price against the traditional earnings per share each year during the ten years from 1990 to 1999. The estimated coefficient on the traditional earnings per share after taxes but before extraordinary items is both positive with a mean of 12.82 and significant at the 1 percent level every year. The average coefficient estimate indicates that every $1 of earnings per share corresponds to $12.82 of market price. The adjusted [R.sup.2] has an average of 43.95 percent meaning that the traditional earnings per share explains 43.95 percent of the variation in equity market values, very much in line with prior reported results of researches in this area. For instance, Collins et al. (1999) report an adjusted [R.sup.2] of 38 percent for all firms, and 54 percent for profit firms, during the 1975 to 1992 period using the simple earnings capitalization model.

Table 3 reports the results of regressing stock price against the new or cash earnings per share each year during the ten years from 1990 to 1999. The estimated coefficient on the new or cash earnings per share after taxes but before extraordinary items before amortization of intangibles is both positive with an average of 12.19 and significant at the 1 percent level every year. The average coefficient estimate indicates that every $1 of earnings per share corresponds to $12.19 of market price. The adjusted [R.sup.2] has an average of 47.10 percent meaning that the traditional earnings per share explains 47.10 percent of the variation in equity market values.

Table 2 and Table 3 demonstrate that the estimated coefficient of 12.19 on the new or cash EPS in Table 3 is lower than that of 12.82 on the traditional EPS in Table 2, indicating that the market adjusts the coefficient down as the new or cash EPS reports higher earnings due to the exclusion of amortization of intangibles. Both regressions are highly significant and the adjusted [R.sup.2] for the regression of price against the new EPS is actually higher than that of the traditional EPS, demonstrating strongly that the new or cash earnings per share after taxes but before extraordinary items before amortization of intangibles has information content in explaining equity market price. Test results do not support the claim of the high tech "new economy" companies that the market pays a fixed multiple for earnings numbers and will not adjust up or down for non-cash expenses such as amortization. Evidence from this study demonstrates the information content of the new proposed earnings before amortization of intangibles, supporting FASB position to eliminate the pooling method for business combinations and changing the rule for the treatment of goodwill. Figure 1 illustrates the market adjustment regarding the two EPS numbers.

[FIGURE 1 OMITTED]

We further examine the information content of amortization expense in company valuation. One popular explanation for the results reported in Tables 2 and 3 is that amortization is not value relevant and that investors "back out" this component of earnings, in effect, by assigning it a valuation multiple of zero. A second possibility is that amortization expense is priced by investors at a different, but nonzero, valuation multiple. In this case, regressing stock prices on earnings excluding amortization and amortization would result in a positive and significant coefficient for earnings before amortization and a negative and significant coefficient for amortization expense (Jennings et al., 2001). Our test results indicate that the coefficients on new or cash earnings excluding amortization are consistently positive and significant each year with a mean coefficient of 11.440 and a mean t-value of 8.748, significant at the 1 percent level. The estimated coefficients on amortization expense give conflicting signals, four of them are negative and the other six are positive. Of the significant four years, one is negative and another three are positive. The mixed sign of the coefficients give us no clear indication whether the market evaluates amortization expense as positively value relevant because it does not affect real cash flows, or negatively value relevant because it depresses earnings. Evidence seems to indicate that amortization expense is very much a noise and does not convey clear-cut incremental information content regarding company values.

CONCLUSION

High-tech new economy companies fought fiercely against the elimination of the pooling of interest method by FASB for business combination. They argued that investors and financial analysts valued companies on fairly rigid price/earnings ratios. Even when a fair price is paid, goodwill amortization from the purchase accounting method depresses earnings per share and thus penalizes firms' stock prices. They even claimed that the goodwill amortization puts U.S. firms in a competitive disadvantage in the international merger and acquisition arena. We regress stock prices against traditional earnings per share, the new cash earnings per share excluding amortization and the new cash earnings and amortization expense respectively. Our results show that the market adjust price/earnings multiple higher or lower in regard to the inclusion or exclusion of amortization of intangibles, contrary to the fixed multiple for earnings numbers claim of the high tech "new economy" companies. Amortization expense is very much a noise and does not have incremental information content for company value. Evidence from this study demonstrates the information content of the new proposed earnings before amortization of intangibles, supporting FASB's position to eliminate the pooling method for business combinations and changing the rule for the treatment of goodwill.

REFERENCES

Balsam, S., and R. Lipka. (1998). Share prices and alternative measures of earnings per share. Accounting Horizon 12, 234-249.

Beresford, D. R. (2001). Congress looks at accounting for business combinations. Accounting Horizon 15, 73-86.

Burgstahler, D., and I. Dichev. (1997). Earnings, adaptation and equity value. The Accounting Review 72, 187-215.

Collins, D. W., M. Pincus and H. Xie. (1999). Equity valuation and negative earnings: The role of book value of equity. The Accounting Review 74, 29-61.

Francis, J., and K. Schipper. (1999). Have financial statements lost their relevance? Journal of Accounting Research 37, 319-352.

Hayn, C. (1995). The information content of losses. Journal of Accounting and Economics 20, 125-153.

Jennings, R., J. Robinson, R.B. Thompson II & L. Duvall. (1996). The relation between accounting goodwill numbers and equity values. Journal of Business Finance and Accounting 23(4), 513-533.

Jennings, R., M. LeClere & R.B. Thompson II. (2001). Goodwill amortization and the usefulness of earnings. Financial Analysts Journal 57(5), 20-28.

Lindenberg, E., M. P. Ross, & S. S. Barney. (1999). To purchase or to pool: Does it matter? Journal of Applied Corporate Finance 12, 32-47.

Moehrle, S. R., J. A. Reynolds-Moehrle, And J. S. Wallce. (2001). How informative are earnings numbers that exclude goodwill amortization? Accounting Horizon 15, 243-255.

Roberts, B. (1999). FASB tries to eliminate pooling of interest: Will the move slow the high-tech acquisition frenzy? Electronic Business, 25(12), 26.

Vincent, L. (1997). Equity valuation implications of purchase versus pooling accounting. The Journal of Financial Statement Analysis, 5-19.

(1) We do not report a separate number for amortization of goodwill and amortization of intangibles for two reasons. First, Standard & Poor's Compustat Research Insight does not provide a separate data, in the 2001 version, for amortization expense of goodwill. Second, Jennings et al. (2001) report that for 80 percent of their sample firms, recorded goodwill asset is either equal to, or 90 percent of, their respective firms' intangible assets.

Lianzan Xu

Lianzan XU is an Associate Professor of Accounting at the Cotsakos College of Business, William Paterson University of New Jersey in Wayne, New Jersey

Francis Cai

Francis CAI is a Professor of Finance at the Cotsakos College of Business, William Paterson University of New Jersey in Wayne, New Jersey

TABLE 1
Sample: Industries in the High Tech "New
Economy" *

283 Drugs
357         Computer and Office Equipment
360         Electrical Machinery and Equipment,
            Excluding Computers
361         Electrical Transmissions and
            Distribution and Equipment
362         Electrical Industrial Apparatus
363         Household Appliances
364         Electrical Lighting and Wiring
            Equipment
365         Household Audio, Video Equipment,
            Audio Receiving
366         Communication Equipment
367         Electronic Components,
            Semiconductors
368         Computer Hardware (Including Mini,
            Micro, Mainframes, Terminals,
            Discs, Tape Drives, Scanners,
            Graphics Systems, Peripherals, and
            Equipment)
481         Telephone Communications
737         Computer Programming, Software,
            Data Processing
873         Research, Development, Testing
            Services

* The three digit SIC codes and names of the
industries are reported. Industries are selected
based on, among other reasons, whether firms in
the industry are likely to have significant intangible
assets, reported or unreported (Jennifer Francis and
Katherine Schipper, 1999).

TABLE 2
Test results: Regressing Stock Price on
Traditional EPS

(1) [P.sub.t] = a + b [X.sub.t] + [e.sub.t]

Year   Obs.          a               b         Adj [R.sup.2]

 90       55      0.67882        17.48362         0.9146
                  (0.84)        (24.07) **
 91       65      7.58638         13.5198         0.3125
                 (3.61) **       (5.49) **
 92       74      3.80447        16.12519         0.6583
                 (2.74) **      (11.90) **
 93      102      5.48007        13.57364         0.5620
                 (4.78) **      (11.43) **
 94       93      7.9791           9.328          0.3422
                 (5.80) **       (6.99) **
 95       95      5.79899        14.69026         0.5556
                 (4.59) **      (10.89) **
 96      129      8.59635         9.95866         0.4146
                 (7.76) **       (9.57) **
 97      144     12.30181        13.13464         0.3081
                 (7.25) **       (8.04) **
 98      167     14.80349        10.07614         0.2119
                 (7.57) **       (6.75) **
 99      170     25.97909        10.51961         0.1153
                 (7.94) **       (4.80) **
Mean   1,094      9.30086        12.82095         0.4395
                (5.288) **      (9.993) **

TABLE 3
Test results: Regressing Stock Price on Cash
EPS

(2) [P.sub.t] = a + [cCX.sub.t] + [e.sub.t]

Year   Obs.        A            c        Adj [R.sub.2]

 90       55    0.20251      16.46340       0.9029
                 -0.23      (22.43) **
 91       65    6.84242      13.15690       0.3677
               (3.38) **    (6.18) **
 92       74    3.35694      14.93710       0.6709
               (2.43) **    (12.24) **
 93      102    5.25755      12.4349        0.5622
               (4.53) **    (11.43) **
 94       93    6.70845      9.83944        0.4195
               (5.01) **    (8.21) **
 95       95    4.90475      14.2803        0.6239
               (4.16) **    (12.53) **
 96      129    7.35565      10.2312        0.5040
               (7.01) **    (11.45) **
 97      144    11.6128      12.4881        0.3214
               (6.75) **    (8.29) **
 98      167    14.6706      8.99459        0.2178
               (7.52) **    (6.87) **
 99      170    26.0043      9.09761        0.1198
               (8.04) **    (4.90) **
Mean   1,094    8.69159      12.1924         0.471
               (4.906) **   (10.453) **