Goodwill Impact on Equity Values

Open Access
Chen, Meixi
Area of Honors:
Bachelor of Science
Document Type:
Thesis Supervisors:
  • John Edward Ketz, Thesis Supervisor
  • Orie Edwin Barron, Honors Advisor
  • goodwill
  • return on assets
  • return on equity
  • cash flow from operations
  • empirical analysis
  • hypothesis
David E. Vance did research on “Return on Goodwill.” He found that return on assets for companies with goodwill was higher than that for companies without goodwill, thereby demonstrating that goodwill contributes to corporate profitability. Further, Vance studied the return on assets by industry and generally found the same results; exceptions were not systemic. I replicate and extend Vance’s work. First, his results may be contaminated because the data included in his study are from both pre-FASB 141 and post-FASB 141 years. The FASB issued Statement No. 141 in June 2001 and became effective for firms in December 2001. Vance’s data are drawn from 1995 to 2004. By choosing firms from the period 2001-2010, I can avoid this possible contamination. Second, I extend Vance’s study by looking at cash flow from operating activities (CFO) in addition to earnings before income taxes (EBIT). I scale these variables not only by total assets (TA) but also by shareholder’s equity (SHE). Vance examined only EBIT/TA. I research EBIT/TA, CFO/TA, EBIT/SHE, and CFO/SHE. These extensions attempt to assess whether Vance’s results are sensitive to his one specification. The major empirical findings are: (a) As Vance found in his study for all industries and for all 10 years, except for minor random differences, return on assets is significantly greater for companies with goodwill than those without goodwill. This is also true for CFO/total assets. (b) For manufactruing and service companies, return on equity is also siginificantly greater for companies with goodwill than those without goodwill. This is also true for CFO/shareholder’s equity. But transportation, retail, and financial service companies generally do not exhibit any statistically significant difference in any industry for companies with goodwill and companies without goodwill. The major conclusion from the empirical analysis is that: All companies with goodwill have higher returns on assets than the companies without goodwill. Companies with goodwill in manufacturing and services industries generate greater returns on shareholder’s equity than those without goodwill. So those companies with goodwill have enough residual profit to pay shareholders an incremental return after they pay off the incremental interest to creditors. Companies with goodwill in transportations, retails and financial services are financing the mergers and acquisitions with debt, so they are generating extra returns on assets to cover incremental interest fully or partially. Once they pay interest, however, companies with goodwill in these industries do not have enough residual profit to pay shareholders significantly higher returns relative to the companies without goodwill.