Hello friends. I hope you are having a good Saturday.
I’ve talked about the goodwill asset before here in a blog post and also discussed it in my book, “Choose Stocks Wisely.” Goodwill is an intangible asset that is recorded by an acquiring company. When a company acquires all or a part of another company, it may pay more than the fair value of the assets identified on the balance sheet. Note, that I wrote “the fair value of the assets ‘identified’ on the balance sheet.”
A company does not record (identify) any of the money it spends on a promotional activity as the goodwill asset, even though it may be increasing its earnings power by the expenditure. It will typically record any such expenditure as an expense rather than an asset (goodwill). For example, a company may increase its future earnings potential by engaging in a successful advertising campaign. Even so, the money spent on that campaign must be recorded as expense in accordance with generally accepted accounting principles (GAAP). Thus, the value added to the company’s worth (its future earnings potential) by the advertising campaign expenditures is not recorded (and thereby “identified”) on the balance sheet as an asset (goodwill) but rather written off as expense (advertising expense in my example).
The goodwill then does not get recognized, that is, recorded, until another company comes along and pays money for it. At that point, it is identified by the acquiring company. So, when you see a balance sheet with no goodwill on it, this means the company probably has not acquired other companies before. It’s possible however that it has acquired another company previously and has written off the goodwill involved since that acquisition. My point is that the presence of goodwill on a balance sheet signifies that the subject company has acquired one or more other companies in the past. Go here to read a brief description of goodwill at Investopedia.
Goodwill is often regarded as the above average portion of expected future earnings. That is, one company will pay for the additional earnings potential of another company, additional earnings as measured relative to its peers. This added earnings potential may be accorded for things like an exceptional brand name or an unusually strong client base. Observe how uncertain this goodwill asset really is. A brand name, for example, might lose its edge after while. Customer demand may collapse in the sector for a myriad of reasons, making a strong client base a much lesser factor.
Many tech stocks were acquiring other tech companies hand over fist before the year 2000, during the dot-com bubble era. Goodwill in many cases represented the majority of purchase prices. I remember reading of situations where goodwill constituted over ninety percent of the purchase price in some cases. When the tech bubble burst, the goodwill no longer meant much as earnings started plummeting across the arena of tech companies.
Today, we often see auditors exhort publicly-traded clients to comply with GAAP provisions to write off goodwill where it is deemed “impaired.” This occurs pretty frequently. If you have been investing in stocks for very long, I imagine you have seen this happen from time to time with some stocks in your portfolio.
The above discussion helps explain why my Scorecard method excludes goodwill from the floor price of a potential buy candidate. Goodwill will always be around. If you have built a company that is growing its profits like a weed and someone comes along and wants to buy you out, of course the price that will have to be paid will likely include a premium for the stellar profits. That premium is goodwill. After the deal, the persistence of that goodwill depends on the persistence of the stellar profits. Thus the goodwill asset may be there today but might not tomorrow.
I would like to take opportunity to thank you for passing the word along about my book. Your support in that way has enabled the theme of the balance sheet and its incredible usefulness in valuation to be shared. Stock investing involves numerous and multi-faceted risks. Mitigating the risks leaves a much greater prospect of reward. The balance sheet exists for the purpose of proper risk assessment.
This is useful insight. In particular I haven’t thought of goodwill in this manner before having it explained: “The goodwill then does not get recognized, that is, recorded, until another company comes along and pays money for it. At that point, it is identified by the acquiring company. ”
When analyzing companies I use two calculations, with and without goodwill, in order to have a comparison.
It would be interesting to see an accounting where all write-downs could be added back to capital. Return on Invested Capital might look a whole lot different for some companies.
David,
Thank you for the comment. And your last two sentences reflect a very astute observation. Indeed, if a “what if” balance sheet which incorporates all the prior write-downs were presented along with the GAAP balance sheet (which reflects the write-downs), it would be eye-opening in many situations and certainly present a more realistic return on invested capital picture. After all, the money invested into goodwill is real money. After the write-off, its absence from the balance sheet going forward is the only evidence (an oxymoron since one wonders how “absence” can be “evidence”) of the premium paid for acquiring another business that proves to be money not well spent. As you aptly highlight in your comment, future returns on the lowered balance sheet position (following the write down) may arguable be described as “overstated.”
Paul