Again, here is the short-form valuation formula:

Adding a target’s NOA to the balance sheet reduces RNOA₁. And it reduces  because NOA₀ increases as well.

Here a typical path of RNOA for a mature pharmaceutical firm that had invested in R&D:

With R&D investment missing from NOA in the balance sheet, RNOA is high from 2020-2022. But at the end of 2022, the firm acquired another pharmaceutical firm That reduces the RNOA because NOA increases.

The mistake is to see the decline in RNOA as a loss of value. No: Carry the Balance Sheet with You. In the valuation formula, the increase in NOA₀ offsets the decline in RNOA and residual income. See the Procter and Gamble acquisition of Gillette in chapter 6 and chapter 11.

There are other issues with the accounting. The total of the fair value of individual assets acquired comes into the calculation, but we understand that, in business, values come from using assets together; fair value of assets is not the sum of their fair values. Yet is another issue: Acquirers pay a premium over the stand-alone price of the target, but this is not recognized in the accounting even though that is usually deemed to be the value added in the merger.

Here is an alternative accounting. Your will recognize it as applying the valuations in this book.

1. Record the acquired assets at their book value in the target’s balance sheet. This is the first component of the building block diagram in chapter 4.
2. Record the additional fair value that those assets generate jointly based on the earnings those assets generate. This is the value added to book value in the no-growth value in chapter 4, the second component of the building block diagram.
3. Record the difference between the no-growth value and the stand-alone price of the target before the acquisition offer as the value of growth in the target that is purchased. This is the third component of the building block diagram.
4. Recognize the difference between the stand-alone price of the target^2Mthe price premium paid^2Mas the added value of the combination.

Components 1‒3 are just the calculation of what an investor is buying, as in chapter 4. Component 4 is the value of the so-called synergies. Components 3 and 4, the excess of fair value of net assets acquired (jointly) and the purchase price can be called goodwill. But now the economic value behind the goodwill is identified.

That identification also guides the impairment of goodwill, for now we see what is to be impaired: Is the growth value in (3) lower than what was paid for? Has the value of the combination not been realized?

See Oh, H. and S. Penman. 2025. A Proposal for Goodwill Accounting, forthcoming, Abacus.

Accordingly, if expected residual earnings are less than zero, the value of goodwill is less than its book value: Impair.

This accounting opens an opportunity to “fiddle with the numbers.” As depreciation and amortization result in lower future profits, acquirers have an incentive to understate the fair value component that is subject to depreciation and amortization. That makes the acquisition look more profitable subsequently. Consequently, goodwill and the value of indefinite-lived intangibles are overstated and thus more likely for impairment. Empirical research lends support to this behavior.

The approach to answering this question follows the same scheme as in the rest of the book: Find the market’s pricing of growth, then challenge that growth rate with sound business thinking and sound analysis. The market’s implied growth rate for the insurance operation was -4.42%. This looked like a BUY: The market was implying negative growth.

Fast forward to March, 2025 when Markel traded at $1,915.50 with no dividends. The return over almost three years was 29.8%.

Chapter 10 vividly reports the effect on net income when Delta Air Lines reversed its valuation allowance. Beware: If Boeing judges at any time in the future that it is more than 50% likely it will return to profitability, it will reverse the valuation allowance, increasing reported profit.  This is not sustainable profit. That is  bleed back.

In early 2025, Warner Bros. Discovery, the parent company of CNN, traded at a market capitalization of $25.1 billion on book value of $35.1 billion, a P/B of 0.72. But, in its latest quarterly report, goodwill alone was booked at $25.9 billion with another $33.8 billion in intangible assets. Looks like goodwill and those intangibles might be due for impairment?

At the same time, CVS Health Corporation, traded at $70.1 billion on book value of $74.9 billion, a P/B of 0.94. Goodwill was recorded at $91.3 billion. Get ready for an impairment?

The Kraft-Heinz Company traded at a market cap of $35.6 billion on book value of $49.5 billion with goodwill contributing $30.5 billion to that book value. An imminent impairment?

Topgolf Callaway Brands with a market cap of $1.5 billion and a book value of $3.9 billion, a P/B of 0.38 after a drop in its stock price of 42% over the past 12 months. It carried goodwill at $2.0 billion on its balance sheet.

By February 2025, the stock price of Sunrun Inc. had declined 45% over the past twelve months to a P/B of 0.37. Goodwill was 59% of that low-priced book value.

In all of this, we must be careful: A P/B ratio might be low because the market is underpricing the firm. But high recorded goodwill with low or declining performance waves a red flag.

In response, the firm issued $24.3 billion of equity, the largest equity offering in U.S. history. 170 million shares were issued to add to the existing 618 million shares outstanding. That strengthened the firm’ s balance sheet, a necessity, but what a shame! Issuing equity at such low prices dilutes the existing shareholders’ equity. The shareholders might avoid bankruptcy but now have to share the possible recovery with other shareholders.  They suffer a double whammy, the large drop in the share price with the operational issues and the effect of issuing stock at a much-reduced share price. Echo of the Deutsche Bank episode mentioned in chapter 5.

Chubb is a large P&C insurer with operations worldwide. It has a wide range of insurance products, including commercial and property, marine, workers’ compensation, environmental, medical, accident, and cyber risk insurance. The company also offers reinsurance and some life insurance.

At the time, Chubb was trading at $58 per share and a market capitalization of $17,242 million. The task is to challenge that price.

Reformulated Financial Statements

As usual, the investigation starts with reformulated financial statements. These statements not only separate operating activities from financing activities but also investment (operating) activities from insurance (operating) activities:

Chubb Corp.

Reformulated Balance Sheet, December 31, 2010 ($ millions)

Reformulated Income Statement, Year Ended December 31, 2010

The Market’s Pricing

Now ask what price the market is placing on these activities. The price of the insurance operations is a particular focus and that is given by a plug to the total market capitalization:

If one accepts the fair value number of investments in the balance sheet (check it!), the number to challenge is the -$21,443 million for the underwriting operation. That is done with reverse engineering to understand the market’s growth pricing. With a calculation of forward residual income from the insurance operation of $1,864 million based on historical average loss and expense ratios,

(Yes, you’ll have to go to chapter 11 to see where the $1,864 million comes from.) The solution for g is less than 1.0, that is, the market sees a negative growth rate; the market sees future prospects as lower than current value added. That could be from a combined loss and expense ratio higher than Chubb’s historical average of 93.4%. Or the market sees a decline in the float. Or it sees investments as overpriced. These are the issues to deal with.

Dealing with those issues involves an understanding of Chubb’s business. Is there a reasonable scenario that would justify a negative growth rate in value added? At the time, that seemed very unlikely so the informed investor would BUY.

By the end of 2024, the shares traded at $273 with a dividend per share of $3.64. The BUY at $58 per share would have paid off handsomely.

Postscript:

In 2024, Berkshire Hathaway took a position in Chubb.