In any acquisition, it’s difficult to predict future cash flows and synergies. Managers, boards, and analysts in the United States and Europe have therefore generally tested the relative attractiveness of a transaction by measuring its positive or negative impact on earnings per share (EPS). Simplistic and flawed as this approach may be, executives could argue that it was valid as long as accounting rules supported it.
That should have changed for US executives two years ago, when companies using US generally accepted accounting principles (GAAP) stopped amortizing goodwill. Under the new rules, nearly every acquisition shows a positive, or accretive, impact on EPS before the cost of restructuring—making the EPS test completely unreliable as an indicator of value created. Yet news releases and public comments from US executives and Wall Street analysts continue to discuss and assess acquisitions in terms of EPS accretion or dilution. In addition, remuneration committees continue to evaluate management teams on their EPS performance. For European executives, the rules on amortizing goodwill have only recently changed.
With basically the same standard for the amortization of goodwill now established in so many countries, it’s time for companies to drop, once and for all, the flawed EPS accretion/dilution test as a measure of an acquisition’s value. At best, the test is inaccurate; at worst, it thoroughly misleads investors. A better proxy, if executives need a new rule of thumb, would be an acquisition’s impact on the acquirer’s economic profit—another imperfect measure but one that is better than EPS because it takes into account an acquisition’s full economic cost.