The Business of Value Investing.pdf

Avoiding Common Stumbling Blocks 237

Company A decides to purchase Company B for $ 200 million.

The net assets acquired, or the value of the assets minus all liabili-

ties, is $ 110 million. Once Company A consolidates its purchase of

Company B, Company A will book $ 200 million in assets acquired,

but only $ 110 million of that is in the form of physical or tangi-

ble assets; the difference between the purchase price and the

net assets acquired, $ 90 million, will be booked as goodwill, an

intangible asset.

Since all investors are looking to buy assets inexpensively, the

obvious question is why a company would pay more than the value

of a company ’ s net assets to acquire it. One explanation is that

since book value is an accounting fi gure, it might not necessarily

refl ect the real value of a given company. A company that owns

a lot of land or real estate must record the value of those assets

at cost. But over time, land and real estate appreciate, although

that appreciated value cannot be recorded on the balance sheet.

Another explanation could be that the buyer hopes that the target

company will create more value as a subsidiary than it would on

its own.

The Procter & Gamble (P & G) acquisition of the Gillette razor

company in January 2005 is a good example. Procter & Gamble,

one of the biggest consumer products companies in the world

acquired Gillette for $ 57 billion, which was an 18 percent premium

for the shares. 7 But because Gillette ’ s balance sheet included good-

will, P & G ’ s premium paid over net assets acquired exceeded 18

percent. The justifi cation for the premium paid was the tremen-

dous operating leverage that P & G ’ s existing distribution channels

would have on Gillette ’ s products. And since Gillette was already

the number - one razor company, the benefi ts of this increased dis-

tribution with minimal need for additional advertising expense was

even more valuable to P & G. P & G hoped it would benefi t from such

added economies of scale in distribution and advertising and that

this would lead to higher profi ts over time.

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