Saturday, July 4, 2009

Understanding Goodwill

To understand a balance sheet requires that we understand every line item, what each means, and how it can be manipulated. Today we are going to look at the line item for Goodwill.

Goodwill Definition

Goodwill is one of the most commonly misunderstood line items in the balance sheet, I once met a junior investor who thought that Goodwill was the amount of money that the company had donated to charitable organizations. This unfortunately is not the case, goodwill, simply put, is the byproduct of two companies merging.

How Goodwill is Calculated

Examples are always easy ways of explaining so lets assume we have two businesses Giant Joe's Grocery and Pete's Corner Market. If Joe's wanted to buy Pete's they must first determine what Pete's is worth. If Pete's were to close their doors, pay off all debt and sell off all of their assets (trucks, stores etc.) We would arrive at the following assessment of the business:

Total Assets$2,000,000$4,000,000
Total Liabilities$1,250,000$1,750,000
Assets - Liability$750,000$2,250,000
Showing up at Pete's with $750,000 isn't going to get you the company though. The company is owned by its shareholders so you need to buy the shares; so what does that cost us:

Outstanding Shares10000001000000
Cost Per Share$2$4
Shareholder Equity$2,000,000$4,000,000

So if Joe's buys Pete's they will have to shell out $2M to buy out the current shareholders- assuming that they accept today's stock price as the purchase price. Through the two parts we see that the company's raw value (book value) is $750,000 but that it will cost $2M to purchase the company, subtraction of these two yields us $1.25M. This is the premium that Joe's will pay for the right to buy Pete's.

When companies merge so too do their balance sheets so all of the assets get summed together, and so to do all of the liabilities. This makes sense, but where then does this $1.25M get assigned to? Goodwill.
So the consolidated balance sheet of our new business would look like this:

Total Assets$2,000,000$4,000,000$7,250,000
Total Liabilities$1,250,000$1,750,000$3,000,000
Assets - Liability$750,000$2,250,000$4,250,000
Assets/Liabilities Ratio1.602.292.42

The problem with Goodwill

As you can see goodwill gets included as an asset in the business, lumped together with more tangible things like real estate, trucks, inventory etc. But is goodwill really an asset? If times were hard could you sell off goodwill to raise money?
Even more interesting is what happens to the Asset/ Liability Ratio after the merger. See the above table and compare the ratios for the two companies before the merger, and then their combined ratio after the merger. As a result of the merger the combination has generated a business that has an even better debt ratio than each did in isolation, and yet nothing has fundamentally changed.

Making matters worse, what if the company that was being bought had stock with a massively inflated price to book, this would drive up the goodwill even further and as such the assets of the business- essentially rewarding the buying company for making a foolish decision.

How you can sidestep this issue

Recalculate any of the ratios that use balance sheet and subtract out the goodwill portions, then compare the two, the truth is somewhere between. This is common practice for bond rating agencies and should most certainly play a role in your own analysis too.

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  1. So how does a company write off goodwill? Seems that inflates expenses. Is there a set period of time that goodwill is usually written off against?

  2. It is worth noting that, 99.9% of the time, the assets are not worth their book value, and in that case, they are written up to their fair values upon acquisition, to which a portion of the purchase price is allocated. Goodwill is the amount left over, the price paid above the fair value of the assets, aka how much you overpaid, basically. Goodwill also includes intangibles like trademarks and MSRs, it is not just a by-product of consolidations, although that certainly can make up a large portion of it, especially for large banks.

    Rustler, the various parts that might make up the goodwill line item on the balance sheet are tested for impairment at least once a year (depends on the company really). The hard and fast accounting rule is essentially that if the amount of goodwill is less than the undiscounted future cash flows, you must then record a write off to the extent that the goodwill is less than the present value of the future cash flows associated with that specific goodwill item. It's pretty open-ended as far as accounting goes. It would inflate expenses in the period incurred since it is atypical, but I don't know what would be gained by that, you don't get any tax benefit from it.

  3. Ignore my last post, there is all kinds of stuff wrong in there. My apologies.

  4. Hi Rustler, A company has to amortize the goodwill over the course of 40 years which allows them to remove it from their books very very slowly.

  5. value investor: SFAS 142, issued in June 2001 discontinued the amortization of goodwill altogether.


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