Page 109 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes
What is P/E Ratio?
Did u know?

As a rule of thumb, the P/E ratio of a stock should be equal to the earnings growth rate.
Mathematically, this can be shown as follows:
P = D/r + PVGO
e
where P = Price
D = Annual dividend
r = Return on equity
e
PVGO = Present value of growth opportunities.

For high growth firms, PVGO usually dominates D/r . PVGO is equal to the earnings
e
dividend by the earnings growth rate.
3.9 Treatment of Goodwill

Goodwill is considered to be one of the largest intangible assets, the value of which companies
want to reflect correctly in their financial statements. Accounting for this asset, poses many
challenges for accountants, as it is an unidentifiable intangible asset.

Definition of Goodwill

This intangible asset can be defined from two approaches:

1. Residuum approach: Under this method, goodwill is taken to be the difference between
the purchase price and the fair market value of an acquired company’s assets.
2. Excess profits approach: Under this method, the present value of the projected future
excess earnings over normal earnings for similar businesses is recorded as goodwill. Due
to uncertainty of future earnings, valuing goodwill using this method is difficult.
Accounting Treatment of Goodwill

1. Capitalisation and amortisation method: Companies valuing goodwill, follow the
residuum approach to capitalise their assets. The net affect of this approach is that, the
goodwill account also includes all other assets that are identifiable by the company.
Thereby the goodwill account reflects an incorrect picture of intangible assets. One method
of correcting this error is to use the ‘Hidden Assets approach’. Under this method, the
excess purchase price that companies pay over the fair market value of assets is for assets
that are not shown or hidden from the balance sheet.

These hidden assets can be both tangible and as intangible in nature. They must be
identified, recorded in the balance sheet and then amortised over their appropriate
economic life. Then, the goodwill account reflects the true picture of only intangible
assets.

Amortisation of recorded goodwill enables the company to match the cost of intangible
assets with benefits from their use. The point of focus in this case is the period over which
amortisation must take place. If the life of the asset is not determinable, as in the case of
goodwill, amortisation of its value is done over a period of about 40 years. This will cause
a minimal impact of writing off of goodwill on the annual net income.

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