On Intangibles

Why I don’t buy goodwill

On Friday I’ll be posting on the printing group, Grafenia – who’ve recently changed their name from ‘Printing.com’. You may have heard of them, as they’ve been around a few of the small cap blogs, but they caught my eye last week. Today, though, I’m easing back into things after a brief hiatus with a talk about a slightly more abstract topic – goodwill, and the accounting interpretation of it. I realise when I write some of my blog posts that I tend to say some things ad infinitum  – like my refrain on capitalising operating leases or why I think returns are important. Often, I don’t spend much time explaining these things. In this post, then, I’ll put a brief explanation behind my thoughts on goodwill – which I nearly always exclude from any calculation involving any of the company’s figures. It’s pratically an non-entity for me.

What is goodwill?

Goodwill is essentially an accounting creation to make sure the books balance. When a company acquires another, they’ll often pay more than the actual assets inside that business are worth; to be horribly trite, think of Facebook’s acquisition of WhatsApp, the messaging service. They acquired it for about £10bn; clearly, the assets inside WhatsApp – produced by a team of something like 30 people – are not worth (on book) £10bn. Heck, if we were to draw a line from £0 to £10bn and place a dot where WhatsApp’s actual assets sit, I reckon it’d be fairly indistinguishable from zero.

It has its purpose, though. Old accounting rules saw goodwill getting immediately written off in profit or against reserves, which seems in some way to equally fail to capture the essence of what’s happened. Companies acquire for a variety of reasons, and acquiring because it makes good strategic sense – buying one of your key suppliers and thus being able to strip out a number of costs, for instance – can be a great boon. There is obviously something value-creating going on in this case, and slapping the accounts with a big charge doesn’t feel right or accurate. 

What happens to goodwill?

After it’s purchased, goodwill basically just sits on the balance sheet. It’s no longer amortised like it used to be – split up and written off over a few years – rather, it’s supposed to be subject to (at least yearly) impairment reviews. On the face of it, this is a pretty reasonable way of doing it – and I should note that I certainly can’t think of any better ways. It does have its problems, though – notably the sense of discretion involved around generating the forecasts on which ‘recoverable value’ is based. Call me pessimistic, but I’m always a bit nervous when management generate forecasts for business units and tell us that, based on their forecasts (which we’re not privy to, obviously), no impairment is necessary. I feel like my job as an investor is to make these judgements, not them.

So what’s the fundamental problem?

While I understand the reasons for goodwill, the problem is really a more fundamental one – I don’t like goodwill because it feels like it’s trying to do my job for me. Let’s take a company; we’ll innovatively call it Company A. Company A is a great business; aside from its terrible name, it has strong brand reputation, great relationships with its customers and is large enough and efficient enough for competitors to know there’s no point trying to muscle into their chosen market. Widget manufacture, obviously. What happens if a big congolomerate tries to buy company A? Well, it clearly doesn’t just pay net asset value (or fair value of those net assets) – after all, this is a great company, which earns well above its cost of capital. Instead, it buys the company at a premium, and records goodwill on its balance sheet.

Even if Company A is run exactly as before, its accounting valuation now has a huge chunk of goodwill attributable to it. We might suppose the conglomerate paid market price for Company A, too, such that goodwill is basically equivalent to the difference between net book value (technically, fair value of book) and the market price of Company A’s shares on the last day of trading.

What happens is Company A stays private? Well, companies can’t just go creating goodwill accounts because they think they have a reason to; they think they’ve built up a really good reputation over the last few years, for example. No, rather, the company just sits as it was before. What value does goodwill provide in this case, then? All it really does is tell you the difference between the value of the company’s assets and the value a purchaser was willing to pay for it.

Sound familiar? It should do. As investors, this is exactly the bread and butter of what we do – look at companies and value them at a level beyond simply looking at the asset value. We’re the conglomerate – we’re the one deciding what premium above their asset value they should be trading at. We’re the people deciding whether the market price is a fair valuation.

Is goodwill actually harmful, then, to investment decision-making? Not really – not unless you take it seriously. All it does, as far as I’m concerned, is fuzzy up the decision making process. I don’t know what other people do, but I can describe how I think about it, and that’s rather simple. We take our company’s tangible assets; that is, its leased assets (capitalised), property plant and equipment and working capital, and any other tangible items you think are relevant. That’s the tangible capital used in operations. We calculate a return on capital figure based on that, and then we ask ourselves what the company should be earning on its capital. Is the company earning much more?

Great; there’s your goodwill. Your job, as an investor, isn’t to stop there – it’s to go one step further. Where does this goodwill come from? Is it sustainable? Will it erode in a few years and see returns normalise? These are the questions one has to ask. Those are the questions I try to ask; the real difficulty, the value of experience and the benefit to practicing is knowing both what to ask and where to look.

4 Replies to “On Intangibles”

  1. Alex

    From a longtime reader: I used to feel similarly about goodwill as you do but here’s the thing – take Company A’s widget manufacturing machines. They didn’t make them, they bought them (from the hitherto unmentioned Company C.. wait, it’d be German: Kompany C).

    So we say they paid 100 Bitcoin for them and we record it on the balance sheet as such, then depreciate etc. However, within that 100 Bitcoin is Kompany C’s 30 BTC profit margin on a 70 BTC machine, in effect another form of goodwill.

    It seems to me fruitless and misleading to ignore goodwill generated in acquisitions when we implicitly accept the profit-margin-goodwill on other, less ethereal assets. I assume we’d both seek to work out the returns generated on the business assets – since say, a printer records his inputs of ink and paper based on what he paid for them rather than what they cost someone else to make, why should a business that depends on acquisition rather than internal R&D not also account for this sellers’ premium since they will need to keep paying it – as will the printer – to keep running their business?

    Great work BTW on a fantastic and venerable blog!

    • Lewis

      Alex,

      I’ll need to think about this one a bit. I’m not sure I entirely follow the logic of classifying a producing company’s profit margin as a form of goodwill. At least in a perfectly competitive market, it does not make sense; the purchasing price of an asset will simply reflect the cost of producing that asset (cost of wages for producing die Maschine, cost of capital for infrastructure supporting it etc.). In that sense, there is no goodwill.

      But that’s not an intellectually satisfying argument on my part. We’re not in a perfectly competitive market, and I haven’t assumed that in anything else I’ve said.

      I suppose it implicitly depends on two things; firstly, if the company is acquisitive by habit or as a one off (as you say, if it’s recurring goodwill becomes very much a recurring expense and a form of invested capital) and secondly if you assume the in question (in which the goodwill is ‘created’) will remain the same. Clearly, if you buy a company which has invested £10m in software but a new company can come along and produce the same software for £1m, the value is dubious. Equivalently, if you buy a printer for £10m but another company can produce said printer for £1m a few months later, the underlying value the asset is contingent on is undermined.

      I’m not very comfortable with my position here, though.. I need to contemplate what you’re saying!

  2. Investing Sidekick

    Goodwill does have its uses, it can tell you how good at capital allocation the management is, helps keep the ROIC a good indicator.

    If I’m valuing a company though, then I tend to write goodwill to 0. If there is any goodwill, I’ll calculate it myself 🙂

    • Lewis

      In the sense that it’s an indicator of previous acquisitions? Yes, I suppose so in that case; and you’re right in the sense that if management are habitually acquisitive and it’s not just a one off, ROIC (with goodwill included) becomes a perfectly adequate metric to use, since the company is acquiring assets at that price anyway.

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